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An amendment to the House’s tax reform bill that would create a three-year holding period on carried interest would be less costly for private equity and hedge fund managers than other legislative proposals, attorneys told Bloomberg Tax.
The amendment to H.R. 1 takes “a very fundamentally different approach than the other carried interest proposals that viewed what private equity funds do as not worthy of long-term capital gain” treatment, said Eric B. Sloan, a partner with Gibson, Dunn & Crutcher LLP in New York.
Proposals such as the Carried Interest Fairness Act of 2017, introduced by Democrats in the House (H.R. 2295) and Senate (S. 1020), would tax carried interest at ordinary income tax rates.
The carried interest amendment, part of a package that House Ways and Means Committee Republicans adopted Nov. 7, would impose a three-year holding period for partnership interests received in connection with performing services to be eligible for long-term capital gain tax rates. The change would triple the length of time an asset would have to be held to qualify for the lower rate.
“This, I personally think, is a more appropriate approach, which is to say: ‘If you’re in it for the long haul, you can get long-term capital gain. But if you’re in it for too short of a period, you can’t,’” Sloan said.
Practitioners said the amendment is unlikely to have a drastic impact on private equity or hedge fund transactions.
“For hedge funds, which trade on a regular basis, the proposed change should not have an impact,” said Daniel H. McCarthy, a partner at Wick Phillips Gould & Martin LLP in Fort Worth, Texas. “For investment funds with longer holding periods, the rules may impact a decision of a manager to sell the asset within the three year period,” he said in an email.
Profits on deals that last one to three years would lose their preferential tax status if the bill’s current version were to become law. Since 2000, that would have affected 24.3 percent of private equity deals in the U.S., according to PitchBook Data Inc., a Seattle-based researcher.
Sloan and Jonathan Talansky, a partner at King & Spalding LLP in New York, said the behavior of money managers—in terms of when they choose to sell an investment—would likely only change “on the margins.”
“A typical PE-backed investment is held for a period far in excess of 3 years” so managers wouldn’t have to worry about losing preferential treatment when disposing of those investments, Talansky said in an email.
Most managers would be wary of delaying the sale of an investment—a portfolio company—even if it meant getting a lower tax rate because they could risk angering their investors, which are key to the operation of their business, Sloan said. “I think, for the most part, if a private equity fund manager gets a really good offer for a portfolio company and it’s under three years and the manager is going to end up paying a higher rate of tax, that’s what you will see happen.”
Sloan said that although the new carried interest amendment is more workable than other proposals, it still raises several policy and drafting questions.
The amendment seems to create a “disconnect” between the treatment of a partner that sells its partnership interest and a partnership that sell its assets, he said. “I’m not saying it’s an inappropriate policy choice,” but the amendment appears to say “you can sell your partnership interest to an unrelated third party and if you’ve held your interest for more than three years, you have all long-term capital gain, even if the underlying investments are less mature,” Sloan said.
On the other hand, if the partnership itself sold those less mature investments, it wouldn’t receive the same long-term capital gain treatment, he said.
“In partnership taxation, generally, one does not want to see a different answer if a partner sells its partnership interest versus if the partnership were to sell its underlying assets and allocate the gain out,” he said. But in this case, there may be a good reason for disparate treatment, Sloan said. In particular, it would be an easier approach to administer, he said.
Aaron P. Nocjar, a partner at Steptoe & Johnson LLP who specializes in the taxation of passthroughs, said while this area of the amendment is one of several points of ambiguity, the “disconnect” stems from the pre-existing tax regime applicable to partnerships that mixes entity and aggregate theories.
Sloan said practitioners are also questioning whether the paragraph in the amendment related to the transfer of an applicable partnership interest to a related person overrides general nonrecognition rules. Under the rules, contributions of property to a partnership are usually nonrecognition events—meaning they are tax-free to both the contributing partner and to the partnership—if the contributions are in exchange for a partnership interest.
Sloan said he doesn’t believe the amendment overrides the rules. “When Congress wants to override nonrecognition provisions, they say it. It doesn’t just sort of happen by accident.”
With assistance from Devin Banerjee in New York (Bloomberg)
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Text of the amendment is at http://src.bna.com/t1K.
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