Tax net tightens on big hedge earners

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The US Congress and the House of Representatives have this month passed a bill that would increase the tax bills of hedge fund
managers.

In early December, Charles Rangel, a New York Democrat who chairs the House ways and means committee, proposed an amended version of the Tax Extenders Act that would also impact private equity and real estate managers.

Among other things, the bill would count a manager’s carried interest – a share of profit on investments – as personal income, not long-term capital gains. This would catapult earnings generated from carried interest to the highest personal income tax bracket of 35 per cent, compared with capital gains rate of 15 per cent. However, the bill would continue to tax carried interest at capital gain tax rates to the extent it reflects a “reasonable return” on invested capital, the bill said.

Additionally, the legislation seeks to catch and prosecute Americans using foreign financial institutions, trusts and corporations to evade US taxes. To that end, managers are being asked to disclose the identity and bank account details of US investors in their offshore funds.

Failure to do so would mean the Internal Revenue Service would impose sizeable withholding taxes, including 30 per cent of gross proceeds generated from US stock transactions. Additionally, dividend equivalent payments under certain total return swaps would be subject to similar withholding taxes.

These provisions are expected to generate some $32bn (£19.5bn, €22bn) in tax proceeds over a decade.

The Rangel bill marks the latest attempt by the Obama government to
formulate coherent policy and taxation rules for private investment funds, rules that have already gone through numerous permutations.

The Managed Funds Association, however, opposes this bill that now awaits the Senate’s approval. Notably, it would have “potentially serious and negative consequences” on US capital markets, Richard Baker, chief executive of the MFA told Mr Rangel in a three-page letter. In an attempt to thwart the bill, the trade body has kicked its lobbying effort into high gear.

Steven Etkind, a tax specialist at Sadis & Goldberg, a New York law firm, says: “There’s nothing new here; five prior versions have tried to do the same thing.” With political leaders mired in healthcare reform, he is not expecting quick Senate action. “It’s been shut down previously and I’m not particularly convinced at this point the outcome will be any different,” he adds.

Nonetheless, some see the latest bill’s timing as a wildcard. US tax revenue has fallen as a result of the recession, but federal spending is at an all-time high. With a mammoth budgetary shortfall, one can see why the government is under pressure to target wealthy hedge fund and private equity executives.

Simultaneously, the Internal Revenue Service and the US Treasury have started a drive to close off tax evasion and money laundering loopholes. Case in point: earlier this year, the IRS forced UBS to divulge identities of Americans holding secret Swiss bank accounts.

Incorporating some elements from the Rangel-sponsored Foreign Account Tax Compliance Act from earlier this year, this bill wants US individuals to disclose their foreign accounts holding more than $50,000 in custody as cash or securities, including gross withdrawals and payment, for tax purposes once a year and now gives the IRS six years to bring enforcement actions for under-reporting income on foreign assets. Penalties of $10,000 to $50,0000 could apply to those who fail to comply.

Additionally, shareholders of a passive foreign investment company would have to file an annual report. Finally, the Treasury may require financial institutions to file their returns electronically under certain circumstances.

“Given the financial challenges being faced by the federal coffers and the political climate, the incentive to close off some loopholes is too great,” says Kim Budinger, founder of boutique law firm KTB Counsel in Oakland, California.

Even so, the bill marks a shift of reporting responsibility toward managers, notes Joseph Pacello, a tax principal at Rothstein Kass. “The onus would be on fund managers to provide the IRS the information, and this would represent a significant compliance burden,” he says.

In June, the IRS specified that offshore hedge funds were reportable as “foreign financial accounts” under its Report of Foreign Bank and Financial Accounts, or FBAR.

Now, each US investor in a master/feeder structure could have to file an FBAR, whether or not they directly hold an offshore bank or securities account. This has caused a furore among hedge fund investors. The IRS, meanwhile, has extended its deadline for reporting commingled fund holdings. It may, however, clarify its rule before then.

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