carried interest stripped down

In all the debate about taxing "carried interest" as ordinary income, I haven't seen any discussion about how the payment is treated in the investor's books - does the investor simply pay capital gains on its earnings net of fees or does it pay (as I believe it should) capital gains on the gross earnings and deduct the fees as a business expense (saving 35%)?

Say, I invest $ 10 million in a hedge fund on terms of 2 and 20; say, it performs well and produces a gross return of 50% - this means that of the $ 5 million earned, I get 78%, or $ 3.9 million, while the manager gets $ 1.1 million

From first principles though, the tax calculation should be quite straightforward

Who owns the capital? Me
What is the total capital gain? $ 5 million
So, I should be taxed at 15% on this gain
What have I done to earn this money? I have employed a hedge fund and so the fees I should get a business expense deduction on the fees I pay
Thus, I would pay $ 750,000 in capital gains tax, $ 1.1 million in fees of which I could set off 35% (or $ 385,000) against my taxes - thus, my net post tax earning would be $ 3,535,000

Since the $ 1.1 million was a business expense in my hands, it must be business income in the hands of the earner - the fund's manager, who would earn $ 1.1 million and be taxed at 35%, for a net post-tax earning of $ 715,000.

The total take for the government would be $ 750,000, exactly equal to the 15% capital gains on the actual gains

Unless of course, as is likely, the goverment IS getting screwed since the investor is being taxed correctly and pays only (in our example) $ 365,000, while the fund manager pays (at 15% of $ 1.1 million) only $ 165,000. This would give a total tax revenue to the government of $ 530,000 on a capital gains of $ 5 million for an effective rate of just 10.6%.

If this is the case, it should be pretty open and shut since, as any tax lawyer would agree, a business expense in one hand (the investor) has to be business income (not capital gains) in the other

Surely it isn't this simple?