Congress Considering Hedge-Fund Tax Bill, But 'Nowhere Close'

May 8 2007 | 9:57am ET

Senate Finance Committee Chairman Max Baucus (D-Mont.) says Congress is “nowhere close” to a new tax system for hedge fund and private equity firms and managers, but that will likely be cold comfort to those in danger of paying more.

“I’m not close to having legislation, not yet, but I may,” Baucus told the National Press Club. “My view is, first I want the fact. I want to know what’s going on here.”

One of the fact-givers, however, is likely to send shivers down their well-dressed spines. Congressional tax committees met with Victor Fleischer, a professor at the University of Colorado School of Law, the author of a study of hedge fund manager pay. Fleischer is critical of the carried interest payment structure, under which managers pay the salary tax rate—as much as 35%—on their management fees, but just the 15% capital-gains rate on most of their performance fees. Fleischer argues in favor of a blended rate that would lead to higher tax bills for firms and managers.

“People need to keep their shirts on here,” Baucus said of the doom-and-gloom mongers. “I’m looking at it all. This is all very preliminary. I’m nowhere close to knowing what we should do and should not do.”

One thing he says he does know is that he won’t be swayed by the huge campaign contributions hedge fund employees make to his fellow Democrats. “That’s not relevant to me,” he said.

Hedge funds and hedge fund managers aren’t the only target of the Congressional inquiry, as the Senate Finance Committee is also looking into questionable behavior among some of the biggest beneficiaries of alternative investing: university endowments. In particular, Bloomberg News reports, the committee is studying the very large and very heavily hedge-fund dependent endowments of Harvard, Stanford and Yale universities.

While universities are generally tax-exempt, they remain on the hook for “unrelated business income tax” on profits from debt-financed investments. The rule, which dates to 1950, was designed to prevent charities from buying for-profit firms with borrowed funds. But, according to Bloomberg, that definition may also cover certain profits from hedge fund investing.

To avoid paying the tax, hedge funds set up so-called “blocker” companies in tax havens that convert an “unrelated business income” into dividends, which, if you are a tax-exempt university, are yours tax-free. That method has received Internal Revenue Service approval in certain individual cases, but there is no blanket rule allowing it for hedge fund investing.

Should Congress choose to outlaw “blocker” strategies, university endowments would have to pay the same taxes on those investments as everyone else.

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