Private Equity Clutching Pearls Over Sweden Ending Carried Interest Loophole

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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.

From Bloomberg:

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.

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  1. Mikkel Stern-Peltz

    The Swedish tax ruling concerns the so-called 3-12 rules, which refer to the paragraphs they could originally be found in, in Swedish tax law.

    The rules apply to single-person/small companies and how they are taxed. Provided the efforts of the income in these companies, e.g. a private equity partner’s holding company, is predominantly the result of work input/can be mainly affected by the work put it in by the company’s owner, then the revenue is income and should be taxed as such – not capital gains.

    The crux of the matter is that the Swedish courts and Finansinspektionen see the work done by partners in private equity funds, i.e. how they work with portfolio companies, as directly influencing the value and subsequent distributions, which means it should be taxed as income.

    There is and will be moaning from some Swedish PE folk, but I’ve also spoken to others in the industry who take the attitude that it’s a reality of living in Sweden that you get taxed, that they’re still very wealthy after the tax bill, and that they feel they get value for their tax payments.

    Ultimately, the ruling brings carry taxation more in line with the Danish rules, and I doubt any of the PE firms will be leaving Sweden as a result.

    1. sgt_doom

      From Brian Alexander’s extraordinary book, Glass house:

      Corporate elites said they needed free-trade agreements, so they got them. Manufacturers said they needed tax breaks and public money incentives in order to keep their plants operating in the USA, so they got them. Banks and financiers needed looser regulations, so they got them. Employers said they needed weaker unions – or no unions at all – so they got them. Private equity firms said they needed carried interest and secrecy, so they got them. What did Lancaster and a hundred other town like it get? Job losses, slashed wages, poor civic leadership, social dysfunction, drugs.

  2. Jesper

    Having been to a fund-raising event of PE in Sweden I have to say that I’m glad they’re being ‘targeted’. Not sure why they get to use the word target? It implies that they are selectively chosen for enforcement action and while I’d like them to be targeted the reality is that the authorities are trying to enforce the law. Or are we again going to hear the claim they’re persecuted? Any enforcement against them is like Hitler is back?
    Yes, the ruling will be challenged – there is simply too much money involved and there is money to be made by the defendants legal team…. The defendants have lots of money to spend so there will be experts and lawyers willing to advocate their case.

    The reporters implied that there might be a negative effect for the employees of the portfolio companies so the reporters might be the ones asked to clarify themselves. My guess is that they imply that if the after tax incomes for certain individuals are reduced then those same individuals will try to reduce that reduction by pushing it down on the employees in the portfolio companies. If so, then that is something they’d do anyway independently of anything else in the universe – those individuals are that selfish.

    Oh, and the reason why I found them despicable in the fund-raising event is their crude jokes and targeting of religions and races in their jokes. Given the fact that money could be made by ignoring their despicable jokes then it was not censored or even mentioned outside of the room. If ‘populists’ or less connected people made such jokes in public then there’d be outrage. But again, money talks so nothing more is to be said about it.

  3. Science Officer Smirnoff

    Gratifying indeed.

    The next step is to join Joe Stiglitz and others in advocating making tax rates equal on income from capital and labor, eh? Again.


    One would assume that private equity funds will redline private equity investment from Sweden going forward.

    Question is, who fills in the gap then? It’s not like people had no reason to invest in Sweden other than for the carried interest loophole, so someone’s gotta look at PE pulling out and see an opportunity. Best outcome for this wouldn’t just be eliminating the loophole, but exposing that nations can ignore PE’s pleading and not have the sky fall in on them.

    1. Yves Smith Post author

      Sorry, the wording was imprecise there, and I did mention later that I didn’t see how this applied to portfolio companies (particularly since I would assume funds marketed in Sweden are “European” style fund, where the carry fee is paid only after the fund as a whole is showing a profit, and not when a particular company is sold at a profit).

      I meant redline with respect to the investors, that Swedish investors would no longer be solicited for PE funds.

  5. Sluggeaux

    Very good explanation of the Carried Interest scam. If one of the central rationales for special tax treatment of so-called Capital Gains is to reward putting assets at risk, any guarantee attached to Carried Interest eliminates all risk. Of course, anyone in the precariat will attest that all income-producing activity, including wage labor, involves risk — especially when sharp actors are looting vested pensions and benefits earned through labor.

  6. Anonymous

    This is an opposing view to the sentiments Yves expressed above. It was written by a University of Chicago Law Professor David A. Weisbach and published, in 2008, in the University of Virginia Law Review. Its title is ‘The Taxation of Carried Interests in Private Equity’.

    ‘From a line drawing perspective the choice is clear: we should
    not change the treatment of carried interests in private equity
    partnerships. There are two key pieces of evidence that support
    this argument. First, a longstanding, central premise of partnership
    taxation holds that partners should be taxed as though they engaged
    in the partnership activity directly. The major exception to
    this rule, found in both current law and reform proposals, is where
    a service provider is sufficiently distant from the partnership business
    that giving the same treatment as direct engagement in the activity
    does not make sense. They are not, in such a case, properly
    treated as partners. Private equity sponsors, however, are central
    to the partnership activity. They are the managers of the partnership,
    making all of the investment decisions. Viewing them as anything
    other than partners would require reexamining this basic
    premise of partnership taxation, a premise that has underscored
    partnership taxation for more than fifty years. Commentators suggesting
    general, broad-based reforms of the partnership tax rulesas
    opposed to reforms focusing solely on taxation of carried interests-almost
    uniformly attempt to strengthen this historical approach,
    to tax partners more closely to the direct engagement
    model. In fact, the current law measures abuse of the partnership
    tax rules by looking, in large part, at whether the results are different
    than direct engagement in the activity. Reform proposals for
    carried interests run directly counter to this view.
    Second, to treat holders of carried interests as receiving compensation
    income, we have to be able to distinguish service income
    from capital income. This is not feasible in many contexts, and in
    cases similar to private equity partnerships, we do not even try. For
    example, if the sponsor borrowed to make the investments, we
    would not try to distinguish service income from capital gain. Attempts
    to do so in the private equity context are not likely to succeed
    where years of experience show the problem is not amenable
    to solutions. The result will be complex and easily avoidable rules’.

  7. Robert NYC

    The carried interest scam has been on its “last legs” for ten years now; it ain’t going away. The pirate equity grifters own the hen house.

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