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http://ssrn.com/abstract=2122696
 
 

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The Return-Reducing Ripple Effects of the 'Carried Interest' Tax Proposals


Heather M. Field


University of California Hastings College of the Law

August 2, 2012

Florida Tax Review, Vol. 13, No. 1, 2012
UC Hastings Research Paper No. 2

Abstract:     
The debate rages on about how to tax private equity fund managers and hedge fund managers who, as part of their compensation, receive rights to share in fund profits (“carried interests”). Commentators have paid relatively little attention, however, to the impact that proposals to change the tax treatment of fund managers will have on fund investors, other than to suggest that investors could suffer because managers may try to raise management fees or because overall fund profitability may decline. This Article argues that there is a much subtler reason why the carried interest tax proposals that are aimed at fund managers pose economic risks to fund investors. The reason is that a change to the tax treatment of carried interests changes the economic relationship that investors and managers created and consented to in their fund agreement, often after extensive negotiations. Specifically, the proposed increase in tax rates on carried interests, when coupled with common provisions found in fund agreements (namely, “clawback” provisions and “tax distribution” provisions), increases the risk that the economic burden of losses will be shifted from the managers to the investors without compensation; incentivizes managers to take more risk when managing fund assets; otherwise erodes the alignment of manager/investor incentives; and delays the return of investors’ capital contributions, thereby imposing a time-value-of-money cost on the investors.

This Article explains the indirect route through which the carried interest tax proposals create these return-reducing ripple effects. This Article also provides guidance to investors about how they can protect themselves from harm. More broadly, this Article illustrates how changes in law can alter the economic relationships to which private parties consented under carefully negotiated contracts, thereby creating unintended (and potentially adverse) consequences to parties who are not the desired targets of the law change.

Number of Pages in PDF File: 47

Keywords: taxation, partnership tax, carried interests, private equity

JEL Classification: H25, K20, K34, M52

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Date posted: August 2, 2012 ; Last revised: November 21, 2012

Suggested Citation

Field, Heather M., The Return-Reducing Ripple Effects of the 'Carried Interest' Tax Proposals (August 2, 2012). Florida Tax Review, Vol. 13, No. 1, 2012; UC Hastings Research Paper No. 2. Available at SSRN: http://ssrn.com/abstract=2122696

Contact Information

Heather M. Field (Contact Author)
University of California Hastings College of the Law ( email )
200 McAllister Street
San Francisco, CA 94102
United States

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