Wyden Deferred Interest Bill | Cadwalader, Wickersham & Taft LLP

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On August 5, 2021, the Chairman of the US Senate Finance Committee Ron Wyden (D-Ore.) “Which may exceed the actual economic performance of the beneficiaries of the deferred interest. The bill, titled “Ending the Carried Interest Loophole Act”, is essentially similar to the one Wyden proposed in 2019, but arguably has a greater likelihood of being passed under current administration.

Background

Historically, deferred interest has been an important part of an investment professional’s compensation for providing services to hedge funds, private equity funds or other investment partnerships. Deferred interest is partnership interest issued in exchange for services that entitles the investment professional to a certain percentage (usually around 20%) of the net profits of the partnership after third party investors in the partnership have achieved a specified internal rate of return on their capital contributions.

Partnerships are generally not subject to tax at the entity level. Instead, each partner (including each deferred interest holder) annually reports their attributable share of the partnership’s income, gains, losses, and deductions, whether distributed or not. Investment professionals are generally not taxed on the receipt or acquisition of deferred interest. Additionally, because partnership elements retain their character when assigned to partners, investment professionals in partnerships with buy and hold strategies (like many private equity funds) have historically stated significant long-term capital gains, taxed at preferential rates, in respect of their accrued interest.

Over the years, a number of politicians have lambasted the perceived inequity of giving long-term capital gains to investment professionals in return for their services while taxing everyone at the regular rate on their salaries. Section 1061, enacted as part of the Tax Cuts and Jobs Act of 2017, was the Trump administration’s effort to close the “deferred interest loophole.”

Overview of the bill

Here are the most important aspects of the bill:

  • Repeal of article 1061. The bill would repeal section 1061. As we have already seen discussed, Article 1061 imposes a three-year holding period as a precondition for the recognition of long-term capital gains resulting from the allocation and disposal of deferred interest issued to investment professionals (as opposed to normal holding period of one year), and otherwise treats capital gains as short-term capital gains. Section 1061 does not eliminate the ability of investment professionals to recognize long-term capital gains and does not currently tax them on unrealized capital gains.

The Biden administration’s revenue proposals for fiscal year 2022 (the “Green Book”) would not repeal Section 1061, but would tax investment professionals at regular rates on income and gains from the disposition of their deferred interest if their taxable income from all sources exceeds $ 400,000. Thus, under the Green Paper, section 1061 would only apply to investment professionals whose taxable income is less than $ 400,000.

  • Partnership interest applicable. The bill only applies to applicable holdings in partnerships (API), which are defined consistently with the same term in Article 1061. Virtually all holdings held issued to professionals in the investment (either directly or through a pooling entity, such as the general partner of a fund) would be Apis. In addition, the bill would treat as an AP any interest in a partnership issued to a person who received a loan from the partnership, another partner or a person related to the partnership or to another partner, unless the loan is fully utilized by the borrower and has an interest rate at least equal to a “specified rate”, which would have been 10.21% in June 2021. Unlike l Section 1061, the bill also treats equity interests held by companies as APIs.
  • Deemed remuneration. Under the bill, a deferred interest holder would include in ordinary income each year an amount equal to (1) the “specified rate” multiplied by (2) the excess of (a) the “applicable percentage” (which is the highest possible share of the profit for the year, assuming all performance targets are met) of the weighted average capital invested by all partners at certain valuation dates over (b) the weighted average capital invested by the holder on these valuation dates. This deemed remuneration would be subject to self-employment tax.

The theory behind the inclusion of deemed remuneration is that limited partners have made an interest-free loan to the holder of the deferred interest in an amount equal to the excess of the weighted average capital that supports the highest share. of the holder’s profits in relation to the holder’s invested capital. . The holder’s deemed remuneration is the interest lost on the loan, which the bill considers to be 9% plus the face value of five-year high-quality market corporate bonds for the first month of the calendar year. with or during which the taxation year of the partnership begins. The detailed summary accompanying the bill does not provide any valid rationale for the calculation of the deemed interest rate.

  • Long-term capital loss. Presumably to mitigate double-counting of income when the partnership sells assets at a profit and allocates a portion of the gain to a deferred interest holder (or the deferred interest holder sells his deferred interest at a profit), the proposed The law grants the holder of deferred interest an annual long-term capital loss in an amount equal to the holder’s deemed remuneration. Long-term capital losses of individuals must first be applied to offset long-term capital gains, then short-term capital gains, then ordinary income up to only $ 3,000 per year. Any excess can be carried over indefinitely. As a result, deferred interest holders would generally not be able to use their long-term capital losses to reduce their deemed remuneration (which is taxed as ordinary income).
  • Ghost income. The amount of deemed compensation of an interest holder deferred under the bill has no relation to the actual performance of the partnership. As a result, the bill could subject holders of deferred interests to tax on income deemed they never earn economically, arguably extending beyond its original meaning, granting by the Sixteenth amendment of the power of Congress to tax “income”. Additionally, if the partnership does not realize substantial capital gains, or if Congress passes Biden’s proposal to tax most deferred interest allowances as ordinary income, then the long-term capital losses. holder’s term of deferred interest is effectively unusable unless the holder has capital gains from sources other than the partnership.

For example, suppose the limited partners contribute 100 x $ and the investment professional only provides services in exchange for deferred interest that entitles the investment professional to 20% of the company’s profits once. that the limited partners received a preferential return. Under the bill, the amount of the deemed remuneration of the investment professional for the first year would be $ 2.04, which is the specified rate of 10.21% multiplied by the excess of (x) the ” applicable percentage ”of 20% of the total invested capital of 100 x $ of the partners. on (y) the invested capital of $ 0 of the investment professional. This is true regardless of the partnership’s target performance; the bill makes the irrational assumption that the investment professional would have borrowed 10.21% even to invest in a partnership that paid a lower return. And, if the return of the partnership consists primarily of interest, dividends or other ordinary income, then the investment professional will be taxed on the income attributed to him in addition to the deemed remuneration and cannot use their long-term capital losses. to offset this income.

  • Arrangement of transport. Under the bill, if an investment professional disposes of his deferred interest within 10 years of the last date on which there was an increase in the applicable percentage of the investment professional, the investment professional must immediately recognize the compensation. deemed for the remainder of the 10-year period. . The detailed summary accompanying the bill indicates that the amount of deemed compensation of an investment professional for the year of disposition is the amount of deemed compensation determined as if the disposition had not taken place, plus the proceeds of this amount and the number of taxable years remaining in the 10-Year Period. However, the wording of the bill is not clear.
  • Tax on the granting of porterage. The bill would effectively codify tax procedures 93-27 and 2001-43 by considering that investment professionals (in the absence of a contrary choice) have made a choice under section 83 (b) to be taxed at ordinary income rates on the “liquidation value” of deferred interest earned on them. The liquidation value of deferred interest is the amount to which the owner would be entitled if, immediately after the grant, the partnership sold all of its assets at fair market value and distributed the proceeds (net of liabilities) to its partners. in full liquidation. Normally, deferred interest has a zero liquidation value at the time of grant.
  • Effective date. If enacted, the bill would generally apply to any taxation year of a partner that begins after the adoption date and includes any taxation year of a partnership that begins after the date of adoption. ‘adoption. The paragraph 83 (b) changes would apply to partnership interests transferred after the enactment date.


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