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Comment: Taxing questions in London and Washington

Taxation, directly or indirectly, of the alternative investment industry has been in the headlines on both sides of the Atlantic this week. In the UK, Chancellor of the Exchequer Alistair Darling announced in his pre-budget report, for the most part a heads-up on next year’s taxing and spending plans, that the government would implement a one-off 50 per cent tax to be paid by banks on bonus payments above GBP25,000.

The proposed tax will include investment and trading businesses within banking groups, which appear to include proprietary trading activities and alternative investment businesses that are part of the groups affected.

As a means of persuading banks to adopt more prudent policies and to build up their capital reserves rather than rewarding the kind of risk-seeking behaviour that brought the world close to financial disaster over the past couple of years, Darling’s tax is a fairly blunt instrument. It also won’t bring in much revenue, even by the by the government’s reckoning – a bare GBP500m.

However, the measure also aims to head off public anger about bankers again being paid huge bonuses little more than a year after the sector had to be bailed out with tens of billions of pounds from the public purse, while those active in the ‘real economy’ remain mired in recessionary misery.

Of course, depriving bankers of their bonuses won’t do much to improve the lot of the main in the street. And the bail-out was undertaken not to save banks from their own folly but to ensure that they did not collapse and drag the country’s entire economic infrastructure down with it.

Still – and this is something for the alternative investment industry to consider, not just banks – the root of the issue is that rewards in the financial sector have in recent years become more and more out of kilter with the rest of the UK economy. In the circumstances, it might be tactful for the bankers and other financial folk to keep a lower profile. Any suggestion that employees affected might look for temporary transfers away from London to allow their institutions to avoid the one-off charge would do little to assuage public resentment at the industry, and perhaps more damaging measures in the future.

Financial sector pay is also an issue in the US, where the Treasury is imposing swinging salary caps at institutions that benefited from public financial assistance, though there’s no suggestion of broader measures targeting banks and other groups that did not take federal assistance or have already repaid it.

But another significant development this week was the passage by the US House of Representatives of the Tax Extenders Act, the latest version of the carried interest bill that has been floating around Washington for a couple of years. This would tax the share of fund profits earned by private equity firms (or more precisely, their partners) as income at 35 per cent rather than capital gains at 15 per cent, as is the case at present.

The industry – backed up by hedge fund industry body, the Managed Funds Association – argues that carried interest is really a capital gain and should be taxed as such, since it is part of the profit earned by a partnership by buying companies, in theory improving them and selling them later for a profit.

The flaw in this argument is that it is not the private equity firm that has made the capital investment, but the fund’s limited partners – mostly pension funds and other institutions. To many people the carried interest fee looks like income in the same way as any other payments received by providers of services, and therefore its recipients should pay income tax.

Changing the rules now will depress investment and hinder economic recovery, say the bill’s opponents. Certainly its passage through the Senate right now is far from certain, but many observers believe that in the long term it’s inevitable that carried interest will be taxed as income. Given the current mood in London, probably before long in the UK too.

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