 |
|
Posted December 13, 2007 The full Governing Management Letter | Subscribe to The Governing Management Letter Bonus columns: GIRARD MILLER’S BENEFITS BEAT Fair Taxes on Hedge Funds Lobbyists are hiding behind the skirts of public pension plans. Questions, success stories or anecdotes about benefit issues in government? Despite the recent "patch" to keep the Alternative Minimum Tax out of the hair of millions of middle-class Americans for their 2007 tax returns, Congress ultimately will need to find revenues to pay for long-term AMT reform. One proposal, suggested by House Ways and Means Committee Chairman Charles Rangel, is to raise taxes on hedge fund managers. 
Rangel's proposal had broad — but lackluster — support among many Congressional Democrats. They sense a growing sense of populist outrage over favorable tax rates granted to wealthy hedge fund managers. Their lightning rod is the alleged loophole of granting ultra-low 15 percent capital gains tax treatment to "carried interest," which is industry jargon for the fund managers' share of profits earned by their limited partnerships. Rangel's alliance wants to tax these profits at normal 35 percent tax rates on earned income and not as capital gains. Republicans in the Senate blocked that move, because they had the votes to filibuster a tax bill that needed to get passed in time to send out the 2007 tax forms. And with the economy wobbling, last week seemed an inopportune time to raise taxes on anybody. As might be expected, the hedge fund industry fought this proposal vigorously. They want to have their cake and eat it too — raking in millions for managing others' money while paying taxes at lower rates than other professionals. Their lobbyists have boldly drawn their best clients, the public pension funds, into the debate — suggesting that police officers and retired schoolteachers will somehow suffer if Congress taxes the income of the hedge fund managers at the same rates as ordinary money managers. Critics call that a blatantly disingenuous argument.
The lobbyists' first-round victory may prove short-lived. Permanent AMT reform and hedge fund taxation are likely to become 2008 presidential campaign issues. Here's the lay of the land: Hedge funds invest in stocks, bonds, commodities, real estate, foreign currencies and market indexes — virtually anything in the world that has a price. By definition, they can also sell short. They are exempt from most Securities and Exchange Commission rules for retail investment advisors and mutual funds (the ones that you and I purchase as retail investors). They work in a privileged world because their clients are limited in number and are presumed to be wealthy, sophisticated investors who don't need federal government protection. Public pension funds are great clients for hedge funds because they control large quantities of long-term capital that can wait patiently for market cycles to turn around. Public pension funds will probably double or triple their holdings in hedge funds in the coming decade, so changes in federal tax policy could be a real concern for pension funds if the investment returns are truly impaired by federal taxes. Hedge fund managers typically get two fees. They collect a management fee based on a percentage of assets under management. Often this is 2 percent of the assets managed. Mutual funds typically charge 1 percent or less, and institutional mutual funds usually charge less than half a percent, with index funds often managed for less than 1/10th of 1 percent. So hedge fund managers collect management fees that are four to 20 times their mutual fund counterparts. This income is taxed at ordinary income tax rates. No tax debate here. But most hedge funds also distribute a percentage of the funds' profits to the money managers, which is called a "carried interest." This profit-sharing arrangement is unique to the industry. Mutual funds may have a performance-based fee, but that income is taxed at ordinary rates, and if the funds under-perform, they must, by SEC rule, give up some of their base fee. Hedge funds, however, argue that their carried interest is somehow a capital gain and thus should be taxed at preferentially lower long-term capital gains tax rates, without ever putting their capital or even their base fee at risk! On one hand, hedge fund managers are clearly entitled to capital gains tax rates when they invest their own capital in the hedge fund. If they eat what they cook, their investor shares of the profits earned on their own capital are obviously entitled to capital gains tax treatment. But the carried-interest arrangement is different: It is simply high-octane compensation for managing the fund. Thus, the portfolio manager doesn't need to invest a single penny, yet when profits are distributed under the profit-sharing scheme, they call it partnership income but it's treated entirely as capital gains. Result: They get lower, preferential, "risk-rewarding" long-term capital gains taxes on income that requires no capital! Plus they don't even have to forfeit their lavish 2 percent management fees if they underperform or lose investors' money. Hedge fund managers argue that they contribute "intellectual capital." But there is plenty of intellectual capital floating around this country and it pays ordinary income taxes. Architects, lawyers, doctors, authors and musicians contribute intellectual capital to their businesses, and unless they have an ownership stake in the operating company that reflects a business or investment risk, they pay ordinary income taxes. Actually, the best rationale I've heard on this topic came from a long-time family friend who works for a hedge fund with one on the biggest names in the industry. He's bright, astute and shrewd. His version of the argument goes like this: The carried interest is really a special security — something like an option or a zero-coupon bond — that is issued by the hedge fund to the manager at the startup. It has no nominal value on day one, but as profits are generated by the limited partnership, the value of the security increases. Hence, my friend contends, it should be eligible for capital gains treatment. I'm not buying that argument either. Take the analogy of qualified stock options, which have many of the same characteristics (for example, there is no downside risk to the recipient). Company executives have to pay for the strike price of their stock options when they exercise them — and then pay capital gains taxes for the appreciation. And get this: They are subject to Alternative Minimum Taxes on the options' capital gains. So, the first obvious permanent AMT tax reform is to make the AMT apply to all carried interest income, just the same as stock options. In the eyes of most working Americans, nobody deserves to pay the 28 percent AMT more than the multimillionaire hedge fund managers. But the AMT won't catch those who are clever enough to find ways around it. Clearly, what we have here is a hybrid security that deserves a hybrid solution to this tax policy conundrum. Fortunately, Congress has already solved this same problem elsewhere. And the White House was evidently willing to accept a compromise. For decades, commodity traders and commodity funds have enjoyed a special tax code provision. It allows them to treat 60 percent of their profits as long-term capital gains (a preferential tax rate) with the remaining 40 percent treated as short-term profits subject to ordinary income taxes. The blended tax rate for commodities profits today is 23 percent, which is almost midway between the long-term and short-term capital gains tax rates. It's a compromise engineered by former Congressman Dan Rostenkowski when he chaired the Ways and Means committee and represented Chicago, home to America's two largest commodity exchanges. That compromise reflected similar arguments about taxes on commodity profits, ranging from tax-evasive "silver spreads" to trading profits on short sales in complex "straddle" (combination long-short) trades that resemble hedge fund transactions. Hedge funds work very much like commodity funds. In fact, many hedge funds now trade in commodities like oil, corn, wheat, gold and silver. So there are several reasons to extend the same tax treatment commodities receive to the carried-interest portion of hedge fund profits. Congress should extend similar treatment to a whole host of hybrid and exotic private partnerships that reward the operating managers with a piece of the action to avoid higher taxes. Will public pension funds be harmed if their hedge fund managers are forced to pay a higher tax on carried interest? It's hard to imagine how. I can't think of anybody who would quit managing hedge funds over this. Would they golf instead of managing money because they can keep only 72 to 77 percent of the risk-free profits they receive? Would they go back to managing mutual funds where they would pay taxes 50 percent higher? Will they raise their fees to offset higher taxes and invite congressional and SEC investigation into their fee structure? Of course not. And if the public pension fund leadership lets the hedge fund lobbyists hide behind their skirts when the issue resurfaces in 2008, then shame on all of you. Last month: Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net. © 2007, Congressional Quarterly, Inc. Reproduction in any form without the written permission of the publisher is prohibited. Governing, City & State and Governing.com are registered trademarks of Congressional Quarterly, Inc. |
