Wednesday, October 12, 2011

Broad Definition of Ownership Interest in Proposed Volcker Regulations Would Exempt Carried Interest

While the proposed regulations contain a broad definition of ownership interest in a covered fund, there is an exemption for carried interest. Broadly, an ownership interest means any equity, partnership, or other similar interest, including, without limitation, a share, equity security, warrant, option, general partnership interest, limited partnership interest, membership interest, trust certificate, or other similar instrument, in a covered fund, whether voting or nonvoting, or any derivative of such interest. This definition focuses on the attributes of the interest and whether it provides a banking entity with economic exposure to the profits and losses of the covered fund, rather than its form.

But ownership interest does not include, with respect to a covered fund, carried interest, which the proposal defines as an interest held by a covered banking entity or an affiliate, subsidiary or employee thereof, in a covered fund for which the covered banking entity serves as investment manager, investment adviser or commodity trading adviser.

Hedge funds and private equity funds are typically structured as partnerships for federal tax purposes. Managers of these funds often receive an asset-based management fee of 2 percent of the fund's committed capital and an interest of 20 percent in the profits of the fund. The 20 percent profit interest is referred to as the carried interest. For managers of private equity funds and hedge funds, the carried interest often represents a substantial portion of their total return from the funds.

Many banking entities that serve as investment adviser or commodity trading advisor to a hedge fund are compensated for services they provide to the fund through receipt of carried interest. In recognition of the manner in which such compensation is traditionally provided, the proposed regulations clarify that an ownership interest with respect to a covered fund does not include an interest held by a banking entity in the fund for which the entity serves as investment manager, investment adviser or commodity trading advisor

The carried interest exemption holds so long as the sole purpose and effect of the interest is to allow the banking entity to share in the profits of the fund as performance compensation for services it rendered to the fund, provided that the bank may be obligated under the terms of such interest to return profits previously received.

The carried interest exemption is also conditioned on all such profit, once allocated, being distributed to the banking entity promptly after being earned or, if not so distributed, the reinvested profit of the banking entity does not share in the subsequent profits and losses of the fund. Also, the banking entity cannot provide funds to the hedge fund in connection with acquiring or retaining this interest; and the interest cannot be transferable by the banking entity except to another affiliate or subsidiary.

The proposed regulations thus permit a banking entity to receive an interest as performance compensation for services provided by it or one of its affiliates, subsidiaries, or employees to a covered fund, but only if the enumerated conditions are met.

The agencies ask for comment on whether the proposed rule’s exemption of carried interest from the definition of ownership interest with respect to a covered fund is appropriate. They also want to know if the exemption adequately addresses existing compensation arrangements and the way in which a banking entity becomes entitled to carried interest. Finally, the agencies seek comment on whether the proposed carried interest exemption is consistent with the current federal tax code tax treatment of these arrangements.

Upon receipt of the carried interest the hedge fund manager becomes a partner in the fund and pays tax in the same manner as other partners on his distributive share of the fund's taxable income. The character of the income included in the manager's distributive share is the same as the character of the income recognized by the fund. Thus, if the fund earns ordinary income or short-term or long-term capital gain, each partner's distributive share includes a portion of that income. For example, if the fund sells stock of a portfolio company that it has held for more than a year, the manager's share of the long-term capital gain is taxed at the 15-percent federal long-term capital gain rate.

There have been attempts in Congress, so far unsuccessful, to pass legislation amending the federal tax code to prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund.These measure would generally prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund.

The hedge fund industry has pointed out that the fundamental rationale behind carried interest is that it represents the contributions of intellectual and sweat equity of a partner to a business enterprise. For more than fifty years, the Internal Revenue Code has permitted partners in investment partnerships to pool the capital of investors with the skills of entrepreneurs in joint profit-making enterprises. To align interests and contributions to the partnership, the Code treats a partner's carried interest in the profits on the same terms as the other partners. In the industry's view, legislation changing the fundamental tax treatment of partnerships under the Code would damage the competitiveness of U.S. businesses and capital formation.

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