In my earlier blog I referred to the unsettled tax position affecting private equity in Australia.
The issue hit high spots immediately after the Myer float. Subsequently, two draft tax determinationsfrom the tax office, now long past their usual finalisation period are back in the news.
In the meantime, there were changes in relevant ministerial faces following the 2010 Federal elections and recent hotting up of private equity activity in Australia, especially by TPG.
The question is whether the profits made by private equity managers should be wholly taxed as ordinary income or capital gains.
Profits are made by private equity (generally a partnership with limited and general partners) when, in the final stages of the endgame, it sells the company it had bought earlier under its restructuring plan.
General partners of private equity entities are invariably their managers and do not, in general, contribute capital. The income general partners derive, including management fees is in respect of their ‘carried interest’.
Managers say income from carried interest is capital, ATO argues that it is ordinary income -TD 2010/D18.
Ensuing tax consequences are blatantly significant for both sides. Capital gains from carried interest will not be taxable in Australia and in the least is entitled to discounts and concessions, whereas ordinary income is taxable.
This burgeoning tax muddle affecting private equity is not confined to Australia.
In the U.S, the Congress has been struggling to bring in law to tax private equity managers for quite some time. This year a near perfect attempt got unfortunately bogged down in the Senate and now hopefully a fresh Bill before Congress is showing signs of life.
The approach in the U.S is substantially different from that in the draft determinations but yet may give a clue as how others are willing to deal with a similar impasse.
The US Bill provided that, to the extent ‘carried interest’ of managers reflects capital invested by them in the partnership, it would be taxed at capital gains tax rates.
The balance would be subjected to a blend of ordinary income and capital gains taxation. According to the House version of the Bill 75 percent of the carried interest will be taxed as ordinary income and the balance as capital gains. In the Senate the ordinary income percentage got amended to 45 per cent in 2011 and 65 per cent in 2014. There it stalled.
There is another difference between the US and Australia that cannot be overlooked. Unlike in the case of the US where general partners, whether resident or not pay capital gains tax in the US on carried interest, in Australia there is no capital gains tax if the general partner is non-resident. Most general partners (who are mangers of private equity) are non–resident.
Will the attempt to tax general partners to the maximum result in limited partners bearing an increased tax burden?
Is multi-taxing based on a percentage split between ordinary income and capital gain the way to go?