By John Gapper
Published: September 1 2010 23:29
Try to extract money from a hedge fund manager or the founder of a private equity fund and he loses all sense of proportion.
The first example came in July when Stephen Schwarzman, the co-founder of Blackstone, compared the US government’s attempt to increase the amount of tax paid by the partners of financial firms to Adolf Hitler’s invasion of Poland in 1939. Mr Schwarzman had to apologise for the analogy, made privately to the board of a non-profit group.
The second came last week when Daniel Loeb, founder of the hedge fund Third Point, described a proposed change in the taxation of sales or initial public offerings of such funds as an “arguably unconstitutional Bill of Attainder” that showed the Obama administration was “operating from a playbook quite different from the one we are used to as American business people.”
Mr Schwarzman’s rhetoric was self-evidently ludicrous (except in the sense that the invasion of Poland was followed by the “phony war” in which nothing much happened for several months) and Mr Loeb is wrong too. The proposed “enterprise value tax” on sales of financial partnerships is not a bill of attainder as prohibited by the US constitution – a law that victimises an individual or a small group.
If it were, as one private equity executive says, it would probably already have passed instead of being stuck in Congress with the November elections likely to doom it. No one has much sympathy for Mr Schwarzman or the partners of Kohlberg Kravis Roberts, which has just listed on the New York Stock Exchange, but the provision is so broadly drawn that it would ensnare 1.2m small real estate partnerships, and thus a lot of voters.
Mr Schwarzman and other Wall Street figures are equally wrong in their opposition to paying more tax on “carried interest”, the performance-related element of private equity and hedge fund compensation – the 20 of the so-called “two and 20” structure. They are used to paying only capital gains tax on carried interest but ought to be paying income tax.
The best way of looking at carried interest is as a performance-related fee for investment and management services, which there is no reason to treat as other than ordinary income. The fact that the income is uncertain does not turn it into a capital gain – if that were the test, then (as my colleague Martin Wolf points out) authors could avoid income tax on their book royalties.
They are, however, right about one thing. The enterprise value tax would go a step too far by imposing income tax on the goodwill element of the sales of financial partnerships, as opposed to other partnerships such as car dealerships or technology start-ups. Tempting as it is to single out Wall Street and to narrow a tax loophole widely employed on Wall Street, it is not justified.
Although this seems to be a technical matter of interest only to financiers and their highly-paid tax lawyers, it has a broader relevance. There are social arguments for reducing the attractions to bright people of joining hedge funds and private equity funds, compared with founding the next Google, but using the tax code as a mechanism is a poor way to go about it.
It could also have perverse effects. It is useful for financiers to have incentives to take risks inside funds that can safely fail without having to be bailed out by taxpayers. The most insidious form of institution is the “too big to fail” bank, not the small, richly rewarded partnership.
The issue is what happens when financial partnerships sell out to other investors, often in initial public offerings. If partners are to pay income tax on fees and carried interest then the sale value of the contracts should also be subject to income tax. Otherwise, an IPO would constitute a giant tax loophole.
But what about the (often large) portion of the sale proceeds attributable to goodwill? Normally, when a partnership is sold, most of the goodwill is taxed as a capital gain to the seller but the Senate has been considering imposing a “rough justice” formula for financial partnerships. Under this, half of the goodwill on financial sales would be taxed as ordinary income.
The incentive to do so is that Blackstone and other funds have employed an aggressive tax structure for their IPOs, under which the tax benefits from the sale of shares to investors flow through to the partners. If goodwill sales were taxed more heavily, that would “take some of the air out of the tax arbitrage”, says Victor Fleischer of the University of Colorado.
Mr Fleischer, a driving force of the tax push on carried interest, suggests that “rough justice” is also justified in principle. He says it is right to tax a proportion of a financial firm’s goodwill as income because some of it is attributable to the networks and expertise of the partners, making it a form of labour income.
This seems to me to be stretching a point – it is not obvious why the goodwill of a financial partnership is different from that of any business built up by its partners. Once the carried interest exception has been dealt with, it would be wiser to call a halt, even if the Blackstone tax structure survives.
There are tactical reasons for doing this. The enterprise value tax proposal has stirred up opposition – as well as rhetoric – far beyond Wall Street. In this political climate, if everyone calmed down and hedge fund managers paid some more tax, that would be fair enough.
Copyright The Financial Times Limited 2010.
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