Important late-breaking news for all hedge fund industry participants is the increasing likelihood that legislation ending the favorable federal tax treatment for hedge fund manager's incentivized share of profits (the "carried interest") might be enacted.  If enacted, the provision will dramatically increase the taxes paid by U.S. fund managers.  The President has stated that he will sign the bill passed by the House on December 9, 2009.  This bill, HR 4213, the "Tax Extenders Act of 2009," would pay for extensions of 49 expiring tax benefits with repeal of the carried interest for fund managers, and increased compliance requirements in respect of U.S. taxpayers with financial assets in foreign countries.  A brief description of the carried interest provision follows.

The performance fee is known as “carried interest” and is treated as capital gains under current tax rules, if the fund generates long-term capital gains. Carried interest is generally taxed at the capital gains rate (generally 15%) when realized, again, if long-term capital gains are realized. Short-term capital gains are already taxed at ordinary income rates. The carried interest is composed of the elements of income generated by the partnership in the applicable period, including capital gains, dividends, interest income and other ordinary income, which is not treated as compensation income and thus not subject to the Social Security tax on self-employment income.  Along with its reduced tax rates, capital gains income receives another benefit-termed a tax deferral-because it is not taxed until realized. Carried interest shares this benefit. The concept of tax deferral relates to the timing of tax payments-with the idea that a taxpayer prefers to pay taxes in the future, rather than today because he or she can control the funds longer and use them in some other way. Deferral increases in value with both the length of the deferral period and the taxpayer's marginal tax rate. Carried interest benefits from deferral since it is only taxed when realized.

President Obama's 2010 Budget Outline would instead treat carried interest as ordinary income for the performance of services and be taxed at rates up to 35%. Supporters of this and similar congressional proposals “argued that carried interest is essentially a fee for investment advisory services, and that the appropriate treatment is to tax it like other ordinary income,” Congressional Research Services said. “Opponents maintained that since the source of carried interest is earnings on the fund's investments, it should be treated like any other investment income: capital gains if held for more than a year, ordinary income if the holding period is less.”

The Extenders Bill would reverse the favorable treatment of carried interests, for managers of partnerships holding interests in securities, commodities, options and derivative contracts, other partnerships (such as a fund of funds), and real estate held for rental or investment.

The Extenders Bill would also treat the disposition of any interest in the manager of funds as ordinary income.  Only the manager's own investment in the partnership would be exempt from these new rules.  Hefty tax penalties would be imposed on fund managers that did not report their income properly under the new rules.  The bill would also apply to income received by members of fund managers in respect of their services provided to the manager, as ordinary income from compensation. The Extenders Bill would generally apply to tax years ending after December 31, 2009.

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Best regards,

Spicer Jeffries LLP