House Bill Would Mandate Study of Tax Treatment of Hedge Funds

A bill to create a commission of ten members to study the tax treatment of hedge funds and private equity has been introduced in the House by Rep. John Larson. Membership of the commission would be comprised of experts chosen by House and Senate leaders within thirty days of the bill’s enactment. Once members have been appointed, the commission would have ninety days to complete its study and report back to Congress and the President. The commission will sunset after filing its report. The Commission on the Tax Treatment of Hedge Funds and Private Equity Act (H.R. 3417) has been referred to the Ways and Means Committee.

More specifically, the bill orders the commission to study and report back on the fairness and equity of various tax treatments of hedge funds and the impact of any proposed changes to such tax treatment on job creation, investors, including institutional investors like pension funds, and US competitiveness. The study must also examine the regulatory structure of these entities.

The bill comes against the backdrop of efforts in Congress to change the tax treatment accorded to hedge fund managers and other asset managers, as well as the tax treatment of offshore funds.

A House bill introduced by Rep. Sander Levin would allow tax-exempt entities such as pension funds to invest directly in US-based hedge funds rather than routing their investments offshore. According to Rep. Levin, HR 3501 would fix a problem that unfairly forces pension funds, universities and foundations to make certain investments.Under current law, tax exempt entities that invest in hedge funds are subject to unrelated business income tax UBIT) due to the debt incurred by the fund.

The debt-financed income rules were created decades ago to address a separate issue, said Rep. Levin, but have forced tax exempt investors to channel their investments in hedge funds through offshore blocker corporations. These rules were never meant to apply to this kind of investment, he noted, and the bill would allow these institutions to bring their investments home.The bill would create an exception to the debt-finance income rules that would allow all tax exempt entities to invest directly in onshore hedge funds without being subject to UBIT. The bill is modeled on the exception to these rules that currently allows pension funds and universities to invest in debt-financed real estate. However, this exception would be available to all tax exempt entities, including foundations.

Congress is also looking into the taxation of hedge fund and other asset managers. Currently, hedge and private equity funds are typically structured as partnerships for federal tax purposes. Managers of these funds often receive an asset-based management fee paid annually of 2 percent of the fund’s committed capital and an interest of 20 percent in the profits of the fund. The 20 percent profits interest is referred to as the carried interest. Generally, the management fee of around 2 percent of the capital is taxed as ordinary income, while the domestic component of the 20 percent of the profits is taxed as capital gains income.