US hedge funds face ‘draconian’ tax proposals

US hedge fund managers could be subject to higher personal taxes if changes to the taxation rules included in President Barack Obama's 2010 budget proposal are adopted.

The budget proposal includes measures to treat carried interest as ordinary income as opposed to capital gains for tax purposes. That would raise taxes on income earned from performance and incentive fees from the current rate of 15% applicable to capital gains to over 39%.

Carried interest has been a sensitive topic in Washington for many years. Some politicians have argued that hedge funds and private equity groups have used the carried interest exemption to avoid paying their fair share of taxes.

The proposed change in tax rules could have a deep impact on the earnings of hedge fund managers. The compensation structure at many hedge fund companies puts the onus on performance and incentive fees as the principal source of income for the manager.

Hedge funds charge a management fee of around 2% to cover running costs.

The earnings of general partners are principally derived from performance fees of around 15% to 25% of the profits of the fund. The hedge fund manager's share of these profits is currently taxed at the same rate applied to the fund.

Profits that can be characterized as long-term capital gains - returns on holdings for more than one year - are subject to 15% capital gains tax.

"This proposal, if adopted, will be a significant blow for managers who contribute their sweat equity and take capital risks with a view to sharing in the benefits that accrue to their investors," said Mitch Nichter, a partner in the investment management practice at international law firm Paul Hastings.

He believes the proposal could have a number of unintended consequences. "Hedge fund managers may increase their fees to make up the shortfall," said Nichter. That would be to the detriment of investors like pension funds that invest in alternatives. The proposal could also take some of the best managers out of the market if they decide to concentrate solely on investing their own capital.

If adopted the proposed changes would not be effective until 2011.

Some estimate the change in tax rules could bring in $2.7 billion in revenue in 2011 and $4.3 billion in 2012. With a budge deficit topping $1 trillion, the US government will be keen to find new sources of tax revenue.

"Hedge fund managers should start thinking now about how they will respond to this draconian measure because 2011 will be upon them before they know it," said Nichter.

One option on the table is to move the management company and the tax base to an offshore jurisdiction, he added. If a high number of hedge funds takes this option it could result in a net loss of revenue for the US government.

However, the Obama administration has already signalled it is keen to close down what it sees as offshore tax havens. In Europe the European Union has also declared it intends to put pressure on what it perceives as tax havens to impose tighter tax rules.

Generally, governments will be looking to maximise tax revenues and looking for new sources of taxation to fund growing budget deficits brought on by bailouts of the financial system.