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Carried Interest Update — Momentum Building in Congress

26 Jul 2010

Legislative Update
In the last few weeks, potential new legislation that would tax income derived from a "carried interest" (otherwise known as profits interest in a partnership) at ordinary income tax rates became much closer to being a reality when the House of Representatives passed its first version of the American Jobs and Closing Tax Loopholes Act of 2010. After repeated attempts by the House to enact what would be a new Internal Revenue Code Section 710 into law, the Senate Finance Committee has finally drafted its own version of the new legislation, which modifies the House Bill. The Senate has effectively blocked all carried interest legislation in the past, but their resolve seems to be waning. Numerous amendments have been proposed in the Senate to find acceptable provisions that could allow the carried interest provision to move forward. Currently, the Senate has decided to table the proposed legislation, as Congress is recessed and they are struggling to agree, given the effect on the federal deficit. However, the carried interest portion of the bill does not seem to be a major obstacle holding up the bill. While there is a ways to go before the two bodies agree on a version of the new legislation, the legislative branch seems much more likely to pass a new law this year as momentum builds.

Carried Interest in General
As many people may already know, the new carried interest law would treat income and loss derived from a carried interest (both the income and loss from the holding of such an interest and from the sale of such an interest) as ordinary income or loss for federal tax purposes and as self-employment income. In general, this new law would potentially apply to anyone who provides (directly or indirectly) "investment services" in relation to the assets of a partnership and possesses (directly or indirectly) a profits interest in the partnership. The proposed legislation is very broad, and it could apply to numerous taxpayers associated with the private equity industry, the rental real estate industry, the securities trading industry and any other investment management industry. It also could apply to any carried interest arrangement involving these categories of assets even if it is not the primary business of the partnership.

What You Need to Know About Latest Drafts of Carried Interest Legislation
What you need to know is that the latest versions of this bill are very broad and potentially create many significant issues. Most notably, the new versions of this legislation provide for the following:

  • Ordinary losses derived from a carried interest may be disallowed on a current basis if the carried interest partner does not have cumulative ordinary income in excess of cumulative ordinary losses.
  • The acquisition of a carried interest by a non-service provider (including an unrelated third party) would not generally cleanse the ordinary income taint as a result of the change in ownership. Thus, acquisitions of partnership interests using transfers of interest should be analysed carefully to determine the character of the partnership interest acquired in addition to the character of the underlying partnership assets.
  • The proposed law could potentially limit the ability of the holder of a carried interest to take full advantage of various statutory non-recognition or tax deferral provisions (i.e., IRC Section 453 dealing with installment sales). The portion of certain gains treated as ordinary income under the carried interest provisions must generally be recognised immediately.
  • The proposed law would not only apply to profits interest in a partnership, but it may also apply to other forms of ownership (described as disqualified interests) that are deemed to be economically similar arrangements. This may include contingent debt, convertible debt, options to acquire, derivative instruments and ownership through certain corporate structures.
  • Substantial uncertainty exists for partners who provide services and also invest capital. Unless there are non-service providers who invest in the same class of capital, this law may be extremely punitive to these partners who provide capital and services.
  • Property distributed to a carried interest holder in partial or complete liquidation of its interest would generally retain the ordinary income taint even when held directly by the former holder. Thus, a taxpayer should exercise extreme caution when attempting to distribute property in connection with the disposition of a carried interest.
  • Carried interest income may not be qualifying income for purposes of publicly traded partnership testing, which could lead to some PTPs being taxed as corporations. Note that there is a 10-year relief period included where carried interest income would be qualifying income for a PTP. There are also limited exceptions to the rule when publicly traded real estate investment trusts (REITs) own a substantial portion of the PTP.
  • An investment services partnership interest acquired using the proceeds of a partnership loan is not generally excluded from carried interest treatment.
  • There is no de minimis rule. The new law may apply if a partnership owns securities, certain real estate or commodities, even if these are a minor portion of the overall business of the partnership.
  • There is no corresponding ordinary deduction for the non-carry partners in the partnership, thus the same symmetry that exists in a typical compensation arrangement does not occur.

Significant Business Consideration Needed
The potential new carried interest legislation, if enacted, could come into law as early as December 31, 2010. Although a limited phase-in period is included in some of the House and Senate versions of the bill, guidance is needed before year-end to determine the ultimate effect of this new legislation on both current and prospective investment structures. More detailed guidance on many items (through Treasury regulations or otherwise) must be provided by the Treasury Department and/or the IRS to properly apply the new law and to determine the overall effect it will have from a general business perspective.

Taxand's Take

Although statutory proposals continue to evolve, companies are beginning to evaluate whether these proposals need to be considered in current planning before year-end. Decisions about financing arrangements may impact the materiality of the effect of this legislation if enacted. Certain guarantee arrangements by non-service partners could affect the significance of these tax changes. While some believe it may be too early to evaluate how deal structures might change for funds that include carried interests, it may be appropriate to consider these proposals in structuring joint venture arrangements. The structuring of different classes of capital interests should be evaluated in light of these proposals, as none of the various proposals grandfather existing deals.

The amount of uncertainty in these proposals and how they are expected to be addressed in future regulations has caused many taxpayers to ask for clarification in the statutory proposals prior to any enactment. Companies are evaluating what actions they may take before the year-end effective date to identify uncertainties that may make it difficult to take action. In addition, certain companies are trying to estimate the possible impact of these changes on the partners who provide services. Given the potential for a phased-in approach and the reduced impact for investments held for five years or more, the impact may not be material enough for some participants to warrant any action based on reasonable assumptions about the value of the carried interest and the expecting holding period for the assets.

Your Taxand contact for further queries is:
Frank Walker
T. +1 404-260-4086

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