On June 22, 2007, Rep. Sander Levin (D-MI) introduced a bill, co-sponsored by several other House Democrats, including Chairman Charles B. Rangel, that would sharply raise the taxes many managers of private investment funds such as private equity, hedge, venture capital, real estate and oil and gas partnerships pay on their so-called "carried interest". This bill was introduced just one day after Ways and Means Chairman Rangel (D-NY) indicated that his committee would soon hold hearings on private equity taxation.

The carried interest bill comes fast on the heels of legislation introduced by Senators Baucus (D-MT) and Grassley (R-IA) that would dramatically change the taxation of publicly traded private equity firms that list as partnerships. The Baucus/Grassley bill, which would tax as corporations publicly traded partnerships that derive income from investment advisory activities, has become known as the "Blackstone Bill" because of its proximity to the IPO of Blackstone Group LP.

Taken together, these two bills indicate that Congress is conducting a full-scale review of the taxation of private investment funds leading to speculation that more legislation targeting the investment fund industry could be forthcoming. One commonly used structure that could be attacked is the use by tax-exempt organizations of offshore "blocker" corporations for private equity and hedge fund investments.

Proposed Legislation
The carried interest bill would change the tax treatment of the carried interest (also known as a "performance allocation" or the "promote") paid to a manager of a private investment fund. Under current law, the tax characterization of carried interest, as a share of an investment fund's profits, "flows through" to the investment fund's managers so that the carried interest is taxed at the same rates applicable to the partnership's underlying income. Because many private investment funds generate significant long-term capital gains, much carried interest is taxed at 15% to individual fund managers. The carried interest bill would instead treat carried interest as ordinary income, taxed at 35%.

The carried interest bill effects this change by characterizing as ordinary income most income received by a fund manager with respect to an "investment services partnership interest". For this purpose, an investment services partnership interest is an interest in a partnership held by a person who provides, in connection with the active conduct of a trade or business, a "substantial quantity" of any of the following services to the partnership:

• advising on asset values;
  
• advising on whether to invest in or acquire an asset;
  
• managing, acquiring or disposing of, any partnership asset;
  
• arranging financing with respect to acquiring assets; or
  
• any activity in support of the foregoing.

The legislators' clear intent is to tax fund managers the way service providers are taxed, reflecting the legislators' view that private investment fund managers are in effect service providers rather than investors realizing an investment return. However, the legislation's scope is potentially much broader. For example, a lender to an investment fund that receives an equity "kicker" as part of its investment in the partnership could be viewed as receiving that partnership interest in connection with providing the service of arranging financing for the partnership.

The bill provides a limited exception for partnership income received with respect to the capital contributed by a fund manager (i.e., the manager's "return on investment"); however, most fund managers would not consider their return on investment as part of the carried interest in any event. Thus, this exception has little practical application.

In another severe change from current law governing partnerships, distributions of appreciated property to a holder of an investment services partnership interest could no longer be made tax free. Today, distributions of appreciated property by a partnership to a partner, other than in some cases marketable securities, are generally not taxable upon receipt. The bill does not describe mechanically how this gain, and tax, would be allocated, but it is apparent that the legislators do not want to allow a fund manager to defer its tax by receiving a distribution of stock or appreciated property.

Unresolved Questions
The carried interest bill raises many questions. The phrase "active trade or business" is one that has many different meanings in the tax law. Its meaning in this context could have implications for many different kinds of investors in investment funds. For example, many tax-exempt and non-US recipients of carried interest may currently pay little or no tax on the carried interest they receive. Under the bill this could change as they may be considered to receive income connected with a trade or business, subject to tax in the hands of tax-exempt investors as "unrelated business taxable income" and to non-US investors as US trade or business income (to the extent the fund manager conducts its business within the US). This could affect, among others, fund managers who hold their carried interest through IRAs or other tax-exempt arrangements.

The bill also leaves unclear whether there are any related party rules that could attribute the services of one person to the actual holder of the partnership interest (if not, the rules seem easy to avoid by establishing a non-service providing entity with a small capital commitment to receive the carried interest).

There are additional potential consequences of the carried interest bill that could adversely affect the investment funds industry:

• fund managers that do business in New York City (i.e., many hedge funds), or other jurisdictions which impose an entity-level tax on the business income of fund managers, could see their tax bills rise as a result of treating the carried interest as ordinary income;
  
• it is unclear whether an investment services partnership interest retains that "taint" and adverse treatment even if the holder no longer performs services; and
  
• the legislation does not provide for a grace period or other transitional relief. This, despite Chairman Rangel's historic opposition to retroactive legislation.

More Sure to Come
Some commentators have suggested techniques to work around the legislation's restrictions. In our view, it is premature to discuss those techniques without more information on the form any final legislation could take; however, we are analyzing all possible techniques for retaining the beneficial tax treatment carried interest currently enjoys.

Jeremy Naylor is an associate in the tax department of White & Case LLP. He has a general practice in domestic and international tax planning for corporate and partnership transactions, with a focus on the economic and tax aspects of private equity. Prior to joining White & Case, Mr. Naylor practiced for six years in the tax practice of a leading national law firm. He can be contacted by email at jnaylor@whitecase.com.

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