Eric Schneiderman
New York attorney-general Eric Schneiderman © Getty Images

Many of the world’s largest private equity firms face an investigation into strategies that may have helped them to avoid paying hundreds of millions of dollars in US taxes.

The groups being investigated by New York’s attorney-general, Eric Schneiderman, a Democrat, include Bain Capital – formerly led by Barack Obama’s Republican presidential challenger, Mitt Romney– KKR and Apollo Group, a person familiar with the investigation said.

“This is shamelessly political, but it’s to be expected and I’m surprised it hasn’t happened sooner,” said one private equity executive. “You have a right to privacy, but you don’t have a right to be president. If Bain and Mr Romney saved themselves tens of millions of dollars in taxes, then you would expect that to be examined.”

Disclosure of the probe, comes amid a presidential contest in which Mr Romney’s tenure as chief executive of Bain – and his rate of taxation – has been attacked by President Obama’s re-election campaign.

Democrats have seized on the Republican nominee’s failure to disclose multiple years of his tax returns and have called into question his record on job creation while running Bain. But Mr Romney’s camp has championed his role at Bain as evidence that he has the experience needed to turn around an ailing economy.

Mr Schneiderman has issued subpoenas as part of an investigation into the “fee-waiver” strategy, in which executives invested management fees paid by investors back into one of the investment funds. Any profits on those fees would be taxed at the capital gains rate – a much lower tax rate than if it were treated as ordinary income. There is debate over whether the strategy is legal, aggressive or illegal. The strategy was risky and could have resulted in losses for the manager if the investment funds were not profitable.

The investigation is being run by the state’s Taxpayer Protection Bureau, which was started last year by Mr Schneiderman to try to recoup revenues lost by the state. The investigators sent subpoenas to private equity firms that disclosed that they used the fee conversion strategy and to large firms to try to determine how widespread the strategy was used.

With a jurisdiction that includes Wall Street, the New York attorney-general’s office has long held a reputation for being tough on big investment firms. Mr Schneiderman’s predecessors include Andrew Cuomo, the current governor, and Eliot Spitzer, who cracked down on Wall Street firms a decade ago.

Private equity firms have faced increased scrutiny at the federal level, too. The Securities and Exchange Commission is investigating several firms for dealings with sovereign wealth funds. Other private equity firms, including Carlyle, previously settled with the state attorney-general for their involvement in a “pay to play” scheme where middlemen were paid fees to gain access to state pension plans.

Private equity firms fought off a battle several years ago to have their tax structure changed as Democratic lawmakers called for the closing of a “private equity loophole” in the tax code. Most private equity managers receive most of their income from funds profits rather than their salary, leading to a lower tax rate.

Bain, Apollo, and KKR declined to comment. According to regulatory filings KKR used the management fee waivers between 2007 and 2009, but has ceased the practice.

Critics of the tax treatment of private equity maintain that fees paid to firms for investment management do not represent true capital at risk, and so should be taxed as normal income in the same way as bonuses paid to investment bankers, or lawyers working on a “no win, no fee” basis.

The investigation was first reported by The New York Times.

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