‘Hedge Fund Capital of World’ Won’t Cash in on Tax Loophole

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By Jason Mast

A multimillion-dollar windfall from hedge fund taxes could help states grasping for revenue, but the state that may benefit the most—Connecticut—won’t use it.

The windfall, which could bring in tens or hundreds of millions for the cash-strapped state, has been known for a decade, the result of a loophole Congress closed at the height of the 2008 financial crisis. But some legislators in Connecticut, working to close a $2 billion shortfall, hadn’t known about it until weeks into special session negotiations.

Lawmakers there said they won’t use the windfall to solve the fiscal crisis, eyeing long-term stability over short-term solutions. If they did, lawsuits likely would be needed to chase the money from hedge fund managers trying to claim residency in lower-tax states.

“It has not been part of any of our discussions,” Len Fasano (R), Connecticut’s Senate president pro tempore, told Bloomberg BNA on July 25. “As of Friday we had not heard of this.”

Connecticut is home to the world’s largest hedge fund, Bridgewater Associates LP, and is among the top U.S. states by assets under management by hedge funds.

Recession-Era Closure

Congress in October 2008 granted then-Federal Reserve Chairman Ben Bernanke’s request for a $700 billion bailout of the financial industry, passing the Emergency Economic Stabilization Act. Buried on the last four pages of the 169-page text is a lone revenue provision: “Nonqualified deferred compensation from certain tax indifferent parties.”

The Congressional Budget Office and the media all but ignored it, but the Joint Committee on Taxation projected that the bill would yield $8 billion in fiscal year 2017 and $3 billion in FY 2018—just inside the 10-year budget window.

Before 2008, hedge fund managers were allowed to defer the fees they earn on foreign profits indefinitely without paying U.S. taxes. The provision closed the loophole and gave managers 10 years to pay taxes on wealth accumulated to that point.

Payday likely will come at the beginning of 2018, after a summer in which most states faced declining revenue and 10 states began July without a budget. Some may still not have a budget when those taxes come due. Connecticut Gov. Dannel Malloy (D) told reporters on July 26 that the state likely wouldn’t have a budget before fall.

Connecticut, the so-called “hedge fund capital of the world,” and a state that has seen rapidly diminishing revenue from other sources, may stand to benefit most from this provision.

“The largest winners on this will be New York, Connecticut, New Jersey, and California, not only because a large number of residents are fund managers but also because they have relatively high tax rates,” said Glenn Newman, a tax partner at Greenberg Traurig LLP and president of the New York City Tax Commission.

‘Throwing Darts’

Connecticut will probably apply the 6.99 percent top income tax bracket to what resident companies bring back, but no one seems to know how much that will be.

State Sen. Scott Frantz (R) told Bloomberg BNA that he expects the windfall for Connecticut to be about $80 million.

“It’s really hard to put your finger on how large that number will be,” said Frantz, a former venture capitalist who has invested in hedge funds. “I’ve heard estimates of 300, 350 million.”

Most hedge funds are passthrough entities and aren’t obliged to share detailed information on their finances, said Steve Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center at the Urban Institute and former legislative counsel to the JCT.

“They’re throwing darts at a dartboard,” Rosenthal said of the JCT estimates. “There’s so little info.”

No Way Out

The Wall Street Journal reported July 20 that hedge fund managers are trying to find ways to lower the bill, but tax specialists told Bloomberg BNA there is little they can do.

“They have to bring it back, and they have to declare it as federal income,” Newman said of deferred foreign wealth.

Companies can use wealth for employee bonuses, Newman said, but that will be paid back in personal income tax. Philanthropic donations are likely to go up, but charitable deductions scale back in relative size the larger they are.

“If you just gave it away, maybe you don’t have the tax liability,” Rosenthal said, “but then you don’t have the money either.

Expect Lawsuits

Although managers will have difficulty avoiding federal tax, some may try to claim residency in states with lower income taxes, Rosenthal said.

Frantz said he expects lawsuits as managers now living in states without personal income tax, like Florida, try to file there. Connecticut would claim the investment accrued while the manager was living in Connecticut and thus should pay taxes there.

In such cases, Connecticut would be right, Rosenthal said.

Save for Rainy Day

Connecticut doesn’t have money either. Its rainy day fund bottomed out during the Great Recession and has only returned to $236 million as of 2016—about 1.4 percent of annual expenditures, or roughly enough to run the state for five days.

Much of the hedge fund windfall will likely go to restoring the rainy day fund, Connecticut politicians say.

A measure proposed during the special session would divert all taxes on income over $2 million—among the most volatile sources of tax revenue—directly to the general fund or to pay down debt. It’s part of a broader effort to stabilize the state’s finances.

“I feel very confident” it will pass, said Connecticut Senate Majority Leader Bob Duff (D).

Duff said he knew of the potential hedge fund revenue but was never briefed on it, and wouldn’t consider it as part of the new budget.

Dependence on volatile and non-guaranteed revenue is part of how Connecticut fell into fiscal crisis in the first place, Republican lawmakers said.

“Right now, it’s all hypothetical,” Duff said of the hedge fund revenue. “None of us are making any assumptions.”

To contact the reporter on this story: Jason Mast in Washington at jmast@bna.com

To contact the editor responsible for this story: Jennifer McLoughlin at jmcloughlin@bna.com

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