Lawmakers divided on carried interest tax

The U.S. Congress heightened its scrutiny of private equity firms and their profits last week, as committees in both houses examined everything from taxes to federal regulation.

But aside from the discomfort of having a bright public spotlight shine on the industry for the first time, the flurry of activity in Washington, D.C., proved that lawmakers have yet to reach a unified point of view on how to tax and regulate alternative asset managers.

The Senate Finance Committee, which devoted its hearing exclusively to whether private equity firms’ carried interest should be taxed as capital gains or ordinary income, drew much of the week’s attention—and generated the most debate.

The committee’s ranking Republican, Sen. Charles Grassley of Iowa, set the terms of the discussion, saying that he and the chairman, Sen. Max Baucus, D-Mont., were looking to close what they consider a “loophole” in the tax code. That loophole, they argued, allows fund managers to claim a 15% capital gains rate on carried interest rather than a 35% ordinary income rate, even though fund managers are risking little of their own capital.

“It is not an attack on the investor class,” Grassely said. “It is about the definition of capital income vs. labor income.” Grassley, swatting at critics, further called the proposal a “fictitious tax increase.”

The two senators received reinforcement from the Congressional Budget Office, whose director said that “most economists” would view carried interest “as performance-based compensation” deserving at least in part to be treated as ordinary income. Marc Gergen, a University of Texas Law School professor who has long advocated for the tax shift, came to the same conclusion in his testimony.

But a representative from the Treasury Department demonstrated that if a bill emerges from Capitol Hill it will face an uphill battle in the White House. Eric Solomon, a deputy to the Treasury Secretary, told the Senate Finance Committee that it “must be cautious about making significant changes to partnership tax rules that have worked successfully to promote and support entrepreneurship for many decades.”

Kate Mitchell, managing director at Scale Venture Partners, a Foster City, Calif.-based venture firm, was the lone representative from the private equity ranks. She echoed Solomon’s remarks, saying that shifting the tax treatment would stifle the innovation and economic growth that venture capital firms have nurtured.

Despite a unified front from the committee’s chairmen, other senators didn’t follow in lockstep. Sen. Charles Schumer, D-N.Y., said he would support the tax change, but not if it would apply only to private equity and hedge fund managers and not real estate partnerships and oil and gas partnerships. Sen. Ron Wyden, D-Ore., said experts “can’t even agree” on the nature of the problem with carried interest, and he said the debate is part of a larger issue that the nation’s tax code is “incoherent mumbo jumbo.”

“It’s time to drain the tax swamp,” Wyden said, “specifically through tax reform and tax simplification.”

The tax proposals are strongly opposed by the Republican ranks. Plus, the lack of unity from Democrats underscores the difficulty of adopting any major shift in tax policy or regulation of private equity firms. In the House of Representatives, two committees held hearings on July 11, one about the systemic risk posed by private pools of capital and another on whether publicly traded partnerships, such as The Blackstone Group, should be treated like mutual fund managers. Neither committee came to a conclusion.