Tax Bills Opposed by Hedge Fund Industry Do Not Advance as Congress Recesses

Congress has recessed for August without taking up a bill that would temporarily extend many expiring tax provisions of the Internal Revenue Code. The bill is opposed by the hedge fund industry because it would wrongly pay for those extenders by increasing the tax obligations of the hedge fund industry, in the view of the Managed Funds Association. Similarly, Congress failed to act on a bill fixing the alternative minimum tax that would also have ended the capital gains treatment of carried interest earned by hedge fund and other asset managers.

Just before the recess, cloture on the extenders bill was rejected by a party-line vote, with 43 Republicans opposing cloture. In a letter to Senate Republicans, the Managed Funds Association said that provisions of the bill would adversely affect the competitiveness of U.S.- based hedge fund managers. The House passed (H.R. 6049) the Energy and Tax Extenders Act of 2008 earlier this year. The bill is now stalled in the Senate, primarily over these and other revenue raisers.

To be competitive with non-U.S. based hedge fund managers and to meet the demands of foreign and U.S. tax-exempt investors, explained the association, U.S.-based hedge fund managers have established investment funds offshore. Currently, the Code makes it necessary from a practical standpoint for U.S. tax-exempt entities and non-U.S. investors to invest directly in those offshore funds. The investors in these offshore funds expect the managers of the fund to invest in the foreign fund in order to align their interests. U.S.-based hedge fund managers establish offshore funds to meet the needs of these investors, even though the managing of offshore funds can have negative tax consequences for the manager and its employees.

Hedge fund managers therefore utilize both qualified and non-qualified deferred compensation to attract and retain key personnel. Further, investors in offshore funds frequently expect managers to make such deferrals because the deferred amounts remain as general assets of the foreign fund, which continues to subject them to risk of loss, thereby continuing the alignment of interests between the manager and the investors. Ultimately, any deferred compensation is repatriated and then generally taxed at the top ordinary income tax rate.

The proposal to eliminate the ability of hedge fund managers to defer taxation on their
compensation could affect existing contracts between hedge funds and their managers and employees in a way that acts as a retroactive change in settled law. The proposal would also have the effect of disrupting compensation programs that have been legitimately established. The MFA argued that such a retroactive change could disrupt the management of offshore funds at a time when the U.S. capital markets need the liquidity provided by such funds.

As explained by the House Way and Means Committee, H.R. 6049 would tax individuals on a current basis if they receive deferred compensation from a tax indifferent party. Current law allows executives and other employees to defer paying tax on compensation until the compensation is paid. This deferral is made possible by rules requiring the entity paying the deferred compensation to defer the deduction that relates to this compensation until the compensation is paid. Matching the timing of the deduction with the income inclusion ensures that the executive is not able to achieve the tax benefits of deferred compensation at the expense of the Treasury. Instead, the entity paying the compensation bears the expense of paying deferred compensation as a result of the deferred deduction.

The Alternative Minimum Tax Relief Act passed the House by a vote of 233-189, but has also stalled in the Senate. To make the bill revenue neutral, the House offset the AMT fix by providing that carried interest earned by hedge fund managers be taxed as income rather than at the lower capital gains rate at which it is currently taxed. Hedge fund managers often receive asset-based management fee of 2 per cent and 20 percent of fund profits, which is called carried interest. The House believes that carried interest is money earned on a service provided by the asset managers and should thus be taxed as income.