The Taxes Update

I referred to this a month ago when it first came out, but Rep. Rahm Emanuel (D-IL), along with Sen. John Kerry (D-MA) tomorrow will introduce legislation in the House and Senate that would limit deferral by hedge fund managers (among others) of compensation paid offshore. The bill would impose a limit equal to the amount people are allowed to defer into 401(k) and Roth IRA accounts (approximately $20,000).

Some background - Hedge fund managers receive management fees for operating their hedge funds equal to 2% of the NAV of the funds. In addition, they receive a performance based fee equal to 20% of the net appreciation of the funds (called, "2 and 20" in industry parlance).

It is common practice for fund managers to defer receipt of the 2 and 20 fees, avoid current tax on these amounts, invest them back into the funds they manage, and then receive them later, having compounded tax free in the interim (kind of like what happens to your 401(k) - you defer tax on the amounts you contribute into a 401(k) account, it earns a return tax-free while it is in there and then you pay tax at ordinary rates when you pull it out).

The perceived abuse is that this deferral opportunity is not available to regular taxpayers - only managers of offshore hedge funds. From a tax policy standpoint, so long as the deferred amounts are at risk and may be lost (which they are - the amounts are usually reinvested back into the hedge funds the managers run), I do not see how this is any different than any other deferred compensation plan. It's simply a matter of quantum.

Here is the press release from September when he first announced his intentions.

And here is my client alert on the same topic.

Update: I should have mentioned in the above that one of the reasons given for the "fairness" aspect of the bill is that deferrals of comp made by employees of US-based companies result in a economic detriment to the employer, as the employer loses the deduction until the employee is ultimately paid. By contrast, the deferrals that Kerry's and Emanuel's bill will apparently target, are made by employees of hedge fund management companies domiciled in tax havens (Cayman, Bermuda, etc). Thus, there is no lost deduction and no economic detrminent to the employer of allowing the deferral.

However, this grossly misunderstands why hedge funds are set up offshore in the first place - they are set up offshore to allow tax-exempt and non-US investors invest in hedge funds without becoming directly subject to US tax. Tax-exempt and non-US investors, of course, would also have no use for the tax deduction associtaed with payments of compensation to hedge fund managers, because they do not ordinarily pay US federal income tax. Thus, even if the hedge fund managers engaged directly with investors in these deferral arrangements, there would be no lost deduction.

It's a function of the nature of the taxpayer, not the domicile of the management company that creates the mismatch.

My personal view on the topic (which I should have included above) is that this is a small issue in the larger scheme of taxation of private equity funds and their managers and is a distraction from the larger debate. This bill (along with Rep. Sander Levin's bill on UDFI) would probably at least encourage hedge funds to come back onshore.

It's all moot, however, because no tax raises will be signed by President Bush, in my opinion.

Further update: The bill apparently has an easy workaround - organize the fund and management company in a country that can be low tax, but not a tax haven (e.g., Switzerland). The summary of the bill (no actual text yet) says that the cap on deferrals does not apply where the corporation is domiciled in a jurisdiction that imposes an income tax on corporate income, has deductibility rules that work similarly to the US rules and has a tax treaty with the US. Thus, an offshore fund manager could be set up in Switzerland, obtain a ruling to negotiate a low local rate of tax, and continue deferring as usual. There would be some tax slippage, but presumably the tax benefit would outweigh the slippage if the return on the deferred amounts was high enough.