TAX REFORM AND THE EFFECT ON THE ASSET MANAGEMENT INDUSTRY

Change is in the air.

Every day I open the paper (OK – I read online, so I open my iPad), I see another story related to the prospect of “tax reform”. Nobody knows what exactly will be reformed or when any such legislation may appear but there seems to be momentum towards change.

Thanks to Representative Dave Camp (R-Mich.), Chair of the House Ways and Means Committee, we have some inkling of where and how tax reform may come into being and whom it could impact. Representative Camp has been issuing a series of discussion drafts that outline how his committee would propose to reform taxation in the United States. The drafts are broken up into broad areas, such as: international taxation, financial products and passthrough taxation. All of these proposals would have far reaching effects on the alternative investment industry and, thus, need to be taken seriously.

Most notably, the financial products proposal would cause all derivatives to be marked to market on an annual basis and tax gain or loss taken into account. This is a drastic departure from our current realization method of taxation. Moreover, the definition of “derivative” for this purpose is extremely broad and may include such things as physical short positions, ADRs, security loans, etc. Obviously, some of this will need refinement prior to proposed legislation; but, this is the type of change your legislators are envisioning. The good news is that Rep. Camp also proposes that these mark-to-market gains and losses be treated as ordinary rather than capital. This will alleviate the investor issue of suspended capital losses which would be a very favorable change. Another modification would cause all positions which are hedged to be marked to market with gains being currently taxed and losses being suspended till disposition of both sides of the trade. Such a rule would cause simple things like covered call writing to become very tax sensitive.

If you think about a typical hedge fund, a rule like this could cause severe inefficiencies. All synthetic positions (options, swaps, futures, etc), would be marked to market annually – no opportunity for long term capital gains. Physical positions would need to be hedged from time of acquisition or risk the negative tax arbitrage of hedging later and encountering current tax on gains and deferral of losses.

The proposal on passthrough taxation would, under one option, create a unified passthrough regime under which Subchapter S corporations and partnerships would be taxed alike. This scenario would eliminate the ability of partnerships to have special allocations. For many alternative asset managers like private equity funds and real estate partnerships-this would be a game changer.

Yes, change is coming. My advice is be educated and be prepared. The thing about change is that those who can get out in front of it can benefit from it. Almost any kind of tax change can be used affirmatively to drive benefits. If you are interested in learning more about the proposed tax changes or any other tax matters please contact your WithumSmith+Brown partner.

Tony Tuths

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