To read the Bloomberg story, you’d think the end of the carried interest loophole in a small country was the end of the world. The fact is that tax mavens in the US were telling me that hedgies already accepted that this tax break was on its last legs, that it was just a matter of time before it was toast.
Just to review why this loophole is an abuse, the starting point is to understand that partnerships were never intended to be vehicles for large scale, arm’s length passive investment. The original intent was for partnerships to be vehicles for owner-operators, like dentists and lawyers, and later, Wall Street firms. Even as of the early 1980s, Goldman had only 80 general partners.
But business interests and creative tax lawyers kept pushing the envelope, so here we are.
The specific beef with carried interest, which is technically a “profits interest,” is that it allows people to convert labor income into lower-taxed capital gains income. In a typical private equity fund structure, the general partners (which here we mean are the natural persons who are employed by the fund management entity that manages various private equity funds) typically contribute only 1% to 3% of the monies in the fund. And on top of that, that 1% to 3% is often not hard dollars, but comes in the form of funny money (management fee waivers), meaning the fund investors are actually providing a lot of that nominal capital too.
Yet the fund management entity gets to take 20% of the profits on the investment. And it regularly winds up being more than that if the fund has companies sold early on where the investors do show profits, but they are offset by losses on some deals later on. The investors lose out two ways, the biggest being that the clawbacks are just about never paid, and even when they are, the method for computing them is after general partner general taxes, assuming the highest conceivable applicable tax rate. In what other line of work is the business owners’ tax problems inflicted on investors in paying a refund?
There’s another way all the angst expressed in the Bloomberg article is overdone. If the US or any other economy were to crack down on the carried interest abuse, the general partners could preserve their privilege. They could get a true “carried interest” by borrowing the funds so as to get them to a 20% investment in the fund’s assets. The investors would almost certainly agree to that. The only fly in that ointment would be that the general partners would also be exposed to 20% of the fund’s losses. But given how cavalier general partners often are with bankruptcies of portfolio companies (they take so many fees they make money regardless of whether the fund is a success), having their incentives more aligned with those of their investors would be a salutary development. But limited partners are too cowed to pitch for tax changes that would be in their interest.
Private equity partners in Sweden are reeling from a court decision that ends the tax break known as carried interest. Sweden is not the first country to target the widely reviled exemption, which lets some high-income fund managers pay taxes at a lower rate by counting their earnings as capital gains rather than salaries. The ruling, which could force some managers to pay back taxes on profits earned a decade ago, puts Sweden Inc. at loggerheads with the state and may even lead some firms to leave the country. Sweden’s tax agency, which pursued the case for years, says bringing clarity to what had been a tax muddle will be good for everyone.
The Swedish tax authority argues that payments to private equity partners are partly based on their performance as managers and not just a result of passive investment returns. That means the money should be treated as salary, rather than capital gains, which are taxed at a lower rate to encourage people to put their money at risk by investing it. The latest ruling means the government will get at least 2.3 billion kronor ($260 million) more in back taxes…
The decision reverses a 2013 ruling in which private-equity funds prevailed. The tax authority asked courts to retry the case, based on new arguments, to claim higher tax payments for the years 2007 to 2012. The matter may still go before Sweden’s Supreme Administrative Court.
The article states that this ruling affects about 85 general partners. My impression is that the implication that it affects portfolio too is incorrect, that this is strictly an issue at the fund/investor level. One would assume that private equity funds will redline private equity investment from Sweden going forward. But unless Sweden also imposes restrictions on portfolio company investment, it’s not clear that this is at all affected. The article nevertheless implied that the 200,000 employees in PE owned firms (out of a national population of 10 million) would somehow be affected. Any tax experts who can provide further input please pipe up!
But in general, it’s gratifying to see a government not intimidated by private equity special pleadings. Given the need for tax revenues all over Europe, given that Eurozone countries can’t print their own currency, and that Europeans are much less impressed by capitalists than Americans (Europe has already imposed regulations on private equity, such as leverage restrictions), it’s not out of the question that some other countries may follow suit, although it would take time for new tax rules to be implemented. But better late than never.