Will Changes in Taxation Affect the Competitiveness of U.S. Private Equity?Published: May 06, 2008 in Knowledge@Wharton
Supreme Court Justice John Marshall famously declared that the power to tax is the power to destroy. At the 2008 Wharton Private Equity Conference, industry experts invoked Marshall in spirit, if not in name. The typically tedious subject of taxes sparked a lively -- and occasionally acid -- debate among members of a conference panel titled, "The Impact of the U.S. Tax and Legal Environment on Private Capital Competitiveness."
According to some industry experts, U.S. congressional proposals to raise taxes on their industry could hurt it significantly, and perhaps even force it to move offshore.
Given the forthcoming U.S. elections and the likelihood of a broader tax discussion next year, the debate on carried interest may be moot for the moment, but the panelists agreed that it's a hot-button issue.
"Carried interest" refers to the portion of a private equity fund's profits that the fund manager receives. In the common "2 and 20" arrangement, for example, the manager typically gets payouts of 2% of the capital committed to the fund as a management fee, as well as 20% of the fund's capital gains as carried interest.
Since Congress lowered the tax rate on capital gains to 15% in the 1990s, carried interest has been taxed at that rate, instead of the higher tax rate for ordinary income. Critics say that's inappropriate because private equity managers don't have to risk their own money to receive their share of the profits. Thus, the argument goes, they're being compensated for their services and should be taxed at the ordinary income tax rate. (Private equity managers can invest in the investment pools that they manage. When they do, the return on this money is taxed, without controversy, at the capital gains rate.)
Last year, Congress proposed taxing carried interest at the ordinary income tax rate, typically 35% for high earners. Not surprisingly, that set off a firestorm of protest in the private equity industry.
Mark Heesen, president of the National Venture Capital Association, summarized the industry's point of view. "Historically, the Treasury Department and the IRS have said that carried interest is considered capital gains," he said. "I've worked with the Treasury on many issues, and never was there any talk about this being a faulty premise. Then you fast forward to today, and you hear these arguments that all we do is provide a service, and our pay should be exactly like a janitor's pay. But we're more akin to founders and owners of companies than employees."
Owners or Employees?
Charles Kingson, a lecturer at the University of Pennsylvania's law school, said that legal logic contradicted the industry's position. "Carried interest treatment implies you have an interest in the property," he said. "The fact that your compensation is measured by the size of an asset doesn't mean that you own that asset. A jockey who gets 10% of a purse doesn't own the horse."
Instead of being paid for the use of their capital, as owners are, private equity managers get compensated for their "skill and knowledge," Kingson said. They typically manage other people's money, not their own, so they're more akin to employees than entrepreneurs. "It's like comparing a newspaper reporter to J.K. Rowling," author of the Harry Potter books, he said. "When J.K. Rowling writes a book, she carries all of the risk. When a newspaper reporter writes a story, his paper carries the risk, and he's paid for his services -- just like a private equity fund manager should be."
Private equity managers also fail another legal test, he argued. When they sell a company in their portfolio, they're not selling goodwill -- that is, intangible assets like reputation and customer relationships -- that they have created in their business. "Look at the guy who owns a hardware store," he said. "If he sells out, he'll get capital-gains treatment because he created the goodwill. He's selling his intangible assets in a one-shot deal and packing up for Florida. Fund managers aren't selling their goodwill. They're continuing to use their goodwill."
Tom Bell, a New York-based partner with the law firm Simpson, Thacher & Bartlett, argued that the role of private equity managers wasn't as clear-cut as Kingson portrayed it. They don't simply sell their skills the way a lawyer or doctor does, he said. Instead, they're entrepreneurs who contribute sweat equity to the betterment and, ultimately, profitability of the companies in their portfolios. "If you and I set up a company and I contribute sweat equity, I'll get capital gains when the asset is sold," he pointed out.
Legal considerations aside, changing the taxation of private equity could hurt one of the most vital sectors of the economy, he said. "In most of the rest of the world, the taxation is lower for carried interest. It's lower in the UK and Germany. In a globalized economy, where will the profits go [if these proposals are enacted]?" Firms and their professionals would migrate rather than pay steeply higher levies in the United States, he suggested. Bell also questioned lawmakers' motivation in trying to raise taxes on private equity firms. "Members of Congress who are making these proposals aren't trying to do neutral tax policy," he said. "They're trying to nail one group."
An Industry under Scrutiny
The private equity industry has come under scrutiny lately because of the wealth of some of its best-known practitioners and because of political concerns over growing income inequality. Stephen Schwarzman, billionaire chairman of The Blackstone Group, for example, became a lightning rod after throwing himself a lavish birthday party in New York last year. The red-carpet bash, reported to have cost more than $3 million, included a private concert by Rod Stewart. Schwarzman's firm went public last year in a deal that netted him more than $600 million in cash and valued his stake at more than $5 billion at the time of the transaction. (Blackstone shares have since fallen.)
Some politicians, perhaps trying to stir populist passions, have complained of a new Gilded Age in which financiers like Schwarzman potentially pocket hundreds of millions for making private equity deals while working people worry about stagnating paychecks. Kingson, for one, was sympathetic to the populist perspective. "The idea that the buyout people think that they should be favored by the tax law is incredible," he said. "They make a lot of money by savaging the tax law." He also took issue with the notion that higher taxes would push private equity firms abroad. "In 1963, the top tax rate was 91% and people still wanted to become lawyers. Tax is a factor in economic decisions, but it's not determinative."
Jeff Peck, chairman of Johnson, Madigan, Peck, Boland & Stewart, a Washington lobbying firm, pointed out that, for now, the debate over carried interest is probably moot. After threatening higher taxes last year, Congress chose not to act, giving the industry a reprieve. Legislators probably won't move forward with a carried-interest measure this year because of the election, he said. The earliest that they would revisit the issue would be 2009. By then, "you're going to see a new president and probably larger Democratic majorities in both houses of Congress," he predicted.
Chances are, the Democrats will then want to pursue broad-based taxation changes modeled after, say, the Tax Reform Act of 1986 in which Congress lowered tax rates in all income brackets by removing a raft of loopholes. "We're past the point of carried interest being a solo tax issue," he said. "It will be caught up in the larger tax reform debate."
Heesen, of the Venture Capital Association, agreed that the industry had been spared for now. "Congress is looking at a stimulus package [for the economy] right now, so they're not going to destimulate venture capital and buyouts. It's very difficult to see them taking up a carried-interest provision in 2008 because of the election and the stimulus package."