Showing posts with label taxation. Show all posts
Showing posts with label taxation. Show all posts

Friday, July 13, 2007

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?