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The Carried Interest Loophole: How the US Plans to Remove It

 5 min read / 

The Treasury Secretary, Steve Mnuchin, has delivered some incoherent messages about tax reform. It appears he has not yet understood that tax policy will be driven by the President working with his new Democratic friends Nancy Pelosi and Chuck Schumer.

One of the tax beasts to be slain is carried interest, the pernicious mechanism by which $20bn of wealth annually is delivered to the 1% with careless regard for the suffering of the middle class. President Trump has promised to fix this. In this, he is not alone. Carried interest has been in the crosshairs for over ten years. Even the 1% broadly agree that it is without merit. But why is it still around?

Background

Carried interest originated in the maritime world. Captains would be given a profits interest in the cargo they carried. It was a way to incentivize safe passage. In the world of private equity, the general partner or sponsor of a fund typically is granted two forms of compensation: a management fee of, say, 2%; and a profits, or carried, interest of 20%, for example. This means that the limited partners who provided 100% of the capital give up 20% of the gains generated on that capital to the fund sponsor who found the deals and managed the deals that generated the profits.

Not such a bad deal for the recipients of the money. The bad press relates to the way this carried interest is taxed. The mechanism by which the carried interest is delivered is through a partnership distribution to the fund sponsor or general partner. Distributions to partners have the character for tax purposes of the gain in the partnership. If the partnership has generated a capital gain, then the distribution to its partners will be capital in character. If the partnership has held the capital investment for longer than twelve months, then that capital gain will be taxed at the rate applicable to long-term gains.

This is the problem. Long-term capital gains are taxed at approximately half the rate of short-term gains or ordinary income. Ordinary income is the kind of income a typical employee makes in exchange for their services.

Many commentators believe that, because the fund sponsors typically invest no capital in the partnership, the carried interest is actually a form of compensation for services and should, therefore, be taxed as ordinary income. It is a reasonable argument and one that many fund sponsors tacitly agree with.

The Treasury Secretary’s Approach

The Treasury Secretary has suggested another approach to the taxation of carried interest. His approach, however, does not sound well-considered. He has stated that the carried interest loophole will be denied to hedge funds but preserved for private equity funds – he describes them as “other entities that create jobs”.

It is unclear how this standard might be expressed in legislation. It is also disingenuous because hedge funds are not the largest beneficiaries of carried interest. Most of their profits are through short-term trading rather than long-term capital gain. Removing the carried interest from hedge funds is like raising the price of gas for a Tesla owner; they are indifferent.

If the tax rate on individual income were reduced to 20%, the issue would largely disappear. Partnership income is also referred to as “pass-through income” because the tax burden is passed through to the partners. Partners are typically taxed at the individual rate. Currently, the highest individual rate is 39.5%, almost double the rate at which long-term capital gains are taxed. If the highest individual rate were lowered to 20%, the relative advantage of the long-term capital gains rate would largely disappear. Unfortunately, that would also deliver a huge windfall to the top 1% of taxpayers, something the President has promised not to do. He has argued for reducing the tax rate on corporations to 15-20%. That is not something that would impact partnerships.

What Has the United Kingdom Done?

The United States is not the only jurisdiction where the taxation of carried interest has been attacked. The Inland Revenue in the United Kingdom addressed the issue in its Summer Budget 2015.

Historically, fund sponsors – while not enjoying any differential between long-term and short-term capital gains rates – were entitled to have a percentage (the same amount as the percentage of profits to which the fund sponsors were entitled) of their limited partners’ cost basis in the assets in which the partnership invested “shifted” to them.

The effect of this was to allow the fund sponsor to offset against their taxable income a portion of the cost of the partnership investments, notwithstanding the fact that the fund sponsor had invested no capital.

The Inland Revenue specifically remedied this, both by introducing legislation to tax “disguised management fees” and by removing the base cost shifting. The legislation appears to have been received without hostility and with a calm acceptance that, finally, the party was over.

Conclusion

Re-inspection of carried interest in the United States has been a long-term project for politicians, the press and the tax bar. Reasons to delay its demise have been many. Often, the argument has been that rewriting partnership law to remove the perceived loophole is complex – it is – and should only be carried out as part of comprehensive tax reform. An alternative approach would be simply to allow the Treasury to issue regulations that would treat the carried interest consistent with its economic substance – an option on 20% of partnership profits. Option income is ordinary income after all.

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Americas

Bulletproof Clothing: How US Fashion Is Going Ballistic

 2 min read / 

Bulletproof Clothing

As the US continues to allow civilians to carry weapons and gun violence becomes more of a concern, an increasing number of bulletproof apparel retailers are emerging across the country. Their target clients? The average Joe. Or at least those who can afford the hefty price tags associated with the “exotic” new fashion segment.

Miguel Caballero, a Colombian designer, sells his bulletproof blazers for 4,343.50 euros, and his tank tops for 2,023 euros. At a lower price, but still too high for most people, Joe Curran, who owns BulletBlocker, sells his bulletproof leather jacket for $875 and bulletproof classic two-piece suit for $1,200.

Source: Miguel Caballero

Caballero said that his clients include world leaders from South America and the Middle East, and international businessmen. Damien Ross, another manufacturer of bulletproof clothing, said that his clients are mostly college-educated, professional men, between the ages of 34 and 75.

Ross said:

“They [clients] see what’s happening on the news, and, any time they’re in a crowd or an area that can be prone to attack, they are concerned.”

Source: Bullet Blocker

Body armour manufacturing is a $465 million-a-year industry in the US, according to a report in August from Market Research. The retailers, who mostly entered the industry because of the surge in gun violence taking place around them, are presenting upscale bulletproof clothing, from blazers to tank tops.

Owning body armour is completely legal, and does not require a special permit or background check. However, guidelines vary from state-to-state, and felons are not able to purchase it.

Keep reading |  2 min read

Americas

Trump Promises Tax Cut “for Christmas”

 2 min read / 

Trump Tax Cut

US President Donald Trump has said the country is “just days away” from the biggest tax reform since the Reagan administration.  Speaking at the White House, Trump said he was close to fulfilling his campaign promise “to cut taxes for the everyday working American” and that he wanted “to give [the American people] a giant tax cut for Christmas”.

This week, Republicans and Democrats have reached an agreement on the two different tax bills that were rapidly pushed through Congress last month. If passed, it will be the first significant piece of legislation passed by the Trump administration. The compromise reached by both parties will see a corporate tax cut from 35% to 21% and cap the top tax rate for individuals at 37%.

Following a Democrat victory in Alabama’s senatorial election on Tuesday, the GOP was left with a majority of just 51 out of 100 in the upper house. As such, the Republicans are pushing for a vote on the tax bill for early next week, before the newly-elected Doug Jones can take his seat in Congress.

Tax reform was a keystone in Trump’s electoral campaign and success here would allow other tax deductions at a state and local level to work. It would also give Trump a chance to reverse his low approval ratings which have averaged at 39%, which makes him one of the most unpopular Presidents in the history of political polling.

Keep reading |  2 min read

Americas

Venezuelan Digital Currency Backed by Oil

 2 min read / 

Venezuelan Digital Currency

The Story

Venezuela has announced plans to launch a digital currency, “the petro”, backed by the country’s oil and mineral reserves. The petro aims to help ease the country’s monetary crisis but sceptics claim the proposal has no credibility and will not help those in extreme need.

Why It’s Important


source: tradingeconomics.com

Hyperinflation has eroded the Venezuelan bolivia’s value by 97% this year, making imports incredibly expensive and causing many to abandon trust in the currency. The country’s oil reserves made up 95% of its exports in 2016, while oil and gas extraction accounted for 25% of GDP. Rich supplies of resources provide some initial credibility to the proposal, but President Maduro’s questionable track record when it comes to monetary policy is making many sceptical about the proposal. His currency controls and money printing have only added to the monetary crisis. Maduro has not announced when the digital currency would come into use or any details regarding how the country would create such a system.

Opposition leaders argue the country’s shortages of food and medication are far more pressing and that the digital currency will not address this. The digital currency may provide a more trusted medium of exchange, but it is unlikely to help those in excessive poverty.

Keep reading |  2 min read

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