TAX SERVICES The State of Play with Carried Interests TAX James B. Sowell Washington National Tax May 24, 2010 ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser. © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 2 Carried Interests In 2007, Representative Sander Levin introduced bill to address carried interests Later in 2007, House of Representatives passed the “Temporary Tax Relief Act of 2007,” which included provision on carried interests Similar provision passed House of Representatives in “Alternative Minimum Tax Relief Act of 2008” On April 2, 2009, Representative Levin introduced bill revising technical aspects of House legislation On May 11, 2009, Administration budget describes provision to tax carried interests On September 8, 2009, Joint Committee on Taxation released its Description of President’s Budget Proposals On December 9, 2009, House of Representatives passed “Tax Extenders Act of 2009,” which included carried interest provision (the “2009 House Bill”) On February 1, 2010, Administration budget again describes carried interest provision On May 20, 2010, amendments to the Senate’s extenders bill were introduced in the House of Representatives under the title the “American Jobs and Closing Tax Loopholes Act of 2010” (the “House Bill”); amendments include revisions to the carried interest provisions included in 2009 House Bill © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 3 Carried Interests House Bill would provide that, for purposes of section 83, where a partnership interest is transferred in connection with the performance of services provided for (or on behalf of) the partnership Liquidation value would be treated as the FMV of the partnership interest; and The person receiving the partnership interest would be treated as making a section 83(b) election unless the person affirmatively elects not to have section 83(b) apply (i.e., section 83(b) election is the default rule; no protective election required). © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 4 Carried Interests Who is covered by section 710 of the House Bill? Holders of an “investment services partnership interest” (“ISPI”) An ISPI is a partnership interest held (directly or indirectly) by a person if it was reasonably expected (at the time that such person acquired such interest) that such person (or any person related to such person) would provide (directly or indirectly) a substantial quantity of any of the following services with respect to assets held (directly or indirectly) by the partnership : advising the partnership as to the advisability of investing in, purchasing, or selling a specified asset (i.e., securities, real estate held for rental or investment, partnership interests, commodities, or options or derivative contracts with respect to these assets); managing, acquiring, or disposing of any specified asset; arranging financing with respect to acquiring specified assets; or any activity in support of any of the previously described activities. © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 5 Carried Interests Service Partners Mgmt Co Mgmt Services LPs GP FUND Investment Assets GP entity is “related” to party providing investment services (Mgmt Co.), so GP’s interest in Fund is an ISPI . (“Related” is by reference to section 267 or 707(b).) Service Partners are “indirectly” (through Mgmt Co.) providing services with respect to investment assets that are held “indirectly” (through Fund) by the GP entity, so Service Partners’ interests in GP entity are ISPIs © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 6 Carried Interests Who is covered by the House Bill? Although the statute generally applies by reference to a person’s anticipated services at the time the partnership interest is received, if a person who did not anticipate providing investment management services at the time the partnership interest is received subsequently begins to provide investment management services with respect to specified assets of the partnership, that person’s partnership interest can become an ISPI as of the time of such change. The qualified capital of such person immediately after the change in services is treated as not less than the fair market value of the interest. Unclear how the “allocation rule”(discussed on slide 28) applies by reference to this qualified capital interest © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 7 Carried Interests What is the potential impact of the House Bill for a party who holds a carried interest? Net income and net loss with respect to an ISPI generally is treated as ordinary. Net losses are allowed only to the extent that aggregate net income for prior years exceeds aggregate net losses for such years. (Prior years include only years for which section 710 is in effect.) To the extent not utilized, the losses carry over to the following year. Basis in partnership interest is not adjusted downward where loss is not allowed for a given year. © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 8 Carried Interests What is the potential impact of the House Bill for a party who holds a carried interest? A blended rate applies with respect to individual partners The general rule relating to classification as ordinary income applies only with respect to the “applicable percentage” of such income For taxable years beginning prior to January 1, 2013, the “applicable percentage” is 50% For subsequent taxable years, the “applicable percentage” is 75% The rule relating to loss deferral applies only by reference to the “applicable percentage” of the net loss for the taxable year Blended rate applies only to individuals, so presumably will not permit REIT to pay any capital gain dividend attributable to income related to ISPI that is not a qualified capital interest © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 9 Carried Interests What is the potential impact of the House Bill for a party who holds a carried interest? Example: Individual partner is allocated, with respect to an ISPI, $100X ordinary income and $100x LTCG for the taxable year ending December 31, 2011 50% of income is reclassified under the ISPI rules Accordingly, $50x of ordinary income and $50x of LTCG would not be reclassified The other $50x of ordinary income and $50x of LTCG would be reclassified as all ordinary income attributable to an ISPI © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 10 Carried Interests What is the potential impact under the House Bill for a party who disposes of a carried interest? Gain from the disposition of an ISPI is treated as ordinary income (or blended ordinary/capital based upon applicable percentage for individuals). Loss from the disposition of such an interest is an ordinary loss (or blended) to the extent that prior post-enactment net income attributable to such interest exceeds prior net loss. Deferred losses do not reduce the basis of the partnership interest, so that deferred losses will, in effect, be recognized on the disposition of the interest. However, the losses would be capital rather than ordinary. Exception for individual partner in PTP if neither the partner nor a family member provided investment management services with respect to specified assets held by the PTP (although section 751 reference in section 710(b)(5) is not turned off for these purposes ) © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 11 Carried Interests What is the potential impact under the House Bill for a party who disposes of a carried interest? Provision generally overrides non-recognition rules for gain transactions Exception for contributions of an ISPI to another partnership where taxpayer elects to treat partnership interest received as an ISPI and agrees to comply with applicable reporting and recordkeeping requirements For individuals, gain is recognized only to the extent that gain is treated as ordinary income by reference to applicable percentage © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 12 Carried Interests Sponsor RE1 RE2 REIT RE3 Some Partnership Interests Contributed UPREIT Sponsor of Real Estate projects (together with a portion of the LPs) transfers interests in partnerships to UPREIT partnership in exchange for UPREIT partnership interests Transfer of ISPI to another partnership is subject to nonrecognition so long as transferor properly elects and follows reporting and recordkeeping requirements © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 13 Carried Interests Sponsor RE1 RE2 RE3 Some Partnership Interests Contributed Corp Sponsor of Real Estate projects (together with a portion of the LPs) transfers interests in partnerships to corporation Transfer of ISPI to a corporation triggers recognition of gain to the extent that will be treated as ordinary income attributable to an ISPI (i.e., applicable percentage relevant for an individual) © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 14 Carried Interests What is the potential impact of being subject to the House Bill for a party who receives a distribution of property with respect to an ISPI? If the partnership distributes appreciated property with respect to an ISPI Gain will be triggered to the partnership as if it sold the property for its fair market value and that gain will be allocated to the distributee as ordinary income (or blended ordinary/capital based upon applicable percentage for individuals) The property is treated as cash with respect to the distributee partner, so that gain will be triggered to the extent that the value of the distributed property exceeds the partner’s basis in the partnership interest (determined after adjustment for gain allocated) Distributee partner takes fair market value basis in distributed property © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 15 Carried Interests What is the potential impact of being subject to the House Bill for a party who receives a distribution of property with respect to an ISPI? If a partner receives a distribution with respect to an ISPI in connection with a partnership merger, division, or termination (under section 708(b)(1)(B)), the provisions discussed on the prior slide will not apply if the partner makes an election to treat the partnership interest received as an ISPI and agrees to comply with applicable reporting and recordkeeping requirements. © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 16 Carried Interests Sponsor RE1 RE2 REIT RE3 Partnerships Merge Assets Over or Up UPREIT Sponsor of Real Estate projects, together with LPs, accomplish partnership mergers through assetover or assets-up form Both merger forms involve liquidation of RE partnerships (distribution of UPREIT units in assets-over or RE assets in assets-up) Liquidation of RE Partnerships will not trigger recognition results under “distribution” rule if make election and agree to comply with reporting and recordkeeping requirements © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 17 Carried Interests Is ordinary income treatment the only thing to worry about? No. Where an individual is engaged in the trade or business of providing the specified investment services, income taken into account as ordinary under the House Bill (by reference to the “applicable percentage”) would become subject to self-employment tax regardless of whether the partner is a limited partner and regardless of whether the underlying partnership income would be exempt from the self-employment tax (i.e., dividends, interest, capital gain, etc). Also need to be cognizant of possible impact relating to deferred compensation rules, such as sections 409A and 457A. © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 18 Carried Interests What provision is made for service providers who also invest capital? The House Bill exempts from its coverage the portion of a service provider’s partnership interest that is acquired for invested capital. This requires that the partnership interest be acquired on account of invested capital and that allocations of distributive share to the service partner satisfy certain requirements. Exemption relates both to ordinary income treatment and loss deferral. © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 19 Carried Interests What provision is made for service providers who also invest capital? A “qualified capital interest” means the portion of a partner’s interest in the capital of the partnership that is attributable to The FMV of money or property contributed to the partnership (but not “deemed” contributions under section 752(a)) Amounts included under section 83 with respect to transfer of interest The excess of Items of income and gain taken into account under section 702 with respect to the partnership interest, over Items of deduction or loss so taken into account. Reduced by Distributions to the partner, and Losses allocated in excess of income © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 20 Carried Interests Service Partner $1 million 50% until 10% IRR Then 60% LP $1 million 50% until 10% IRR Then 40% FUND RE Assets Partnership was formed on January 1, 2006, and each partner contributed $1 million on that date As of May 31, 2010, each partner has been allocated $1.0 million of net income, and has received $1.4 million in distributions Hypothetically assume June 1, 2010 effective date for legislation Each partner is considered to have a $600,000 qualified capital interest If partnership had made $2 million debt-financed distribution to each partner based upon a refinancing and distribution of unrealized asset appreciation, it appears that the Service Partner would have no qualified capital; Concern that Service Partner can earn no non-ISPI return even though he still is receiving a portion of his return by reference to that of the LP © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 21 Carried Interests Service Partners Bank Mgmt Co Mgmt Services LPs GP FUND Investment Assets GP Entity borrows to make capital contribution to Fund on behalf of Service Partners Service Partners receive no credit for deemed contributions to GP entity under section 752(a) © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 22 Carried Interests Service Partners Mgmt Co Mgmt Services LPs GP FUND Investment Assets GP entity serves as GP in all historic Funds GP uses cash from carried interests in pre-effective date Funds for contribution to post-effective date Fund Service Partners now would appear to get credit in GP for pre-effective date undistributed income and thus, in many situations, would have qualified capital in that entity What if cash distributed to GP entity by existing Fund and contributed to new Fund does not match income allocated to GP entity by existing Fund? (See slides 34 and 35 regarding “allocation rule”) Under 2009 House Bill, Service Partners got no qualified capital for undistributed income © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 23 Carried Interests What provision is made for service providers who also invest capital? Regulatory authority is provided to address situations where the fair market value of property contributed to a partnership differs from the adjusted basis of such property Without some rule, there could be double-counting of qualified capital where property with section 704(c) built-in gain is contributed by the service partner (i.e., by providing credit for fair market value of contributed property and taxable income subsequently recognized that is attributable to appreciation at the time of contribution) Presumably, the section 704(c) gain should be treated as attributable to the qualified capital interest, although the statute does not address this point © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 24 Carried Interests What provision is made for service providers who also invest capital? A partner providing services will not be treated as having a qualified capital interest to the extent that contributed capital is attributable to a loan or other advance made or guaranteed, directly or indirectly, by any other partner or the partnership (or a person related to such partner or the partnership). For purposes of measuring the proportionate qualified capital interest of a service partner, any loan or other advance to the partnership by a non-service partner will be treated as a qualified capital interest. © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 25 Carried Interests Employees Loan Guarantee $ Bank CoInvest GP Fund $ Mgmt Services Pship RE Assets Employees invest capital in partnership promoted by Sponsor/GP Employees provide 1/3 of capital and borrow the remaining 2/3 on a recourse basis Sponsor/GP guarantees debt of employees Employees do not get credit for borrowed capital as “qualified capital” © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 26 Carried Interests What provision is made for service providers who also invest capital? A qualified capital interest is defined by reference to the “interest,” which seemingly permits qualified capital to carry over in a transfer of an interest. The JCT Report accompanying the 2009 House Bill provided that a transferee of an ISPI “in a fully taxable transaction” will succeed to the qualified capital account of the transferor partner. In the context of such a purchase, the qualified capital interest is not measured by reference to the purchase price of the interest. Particularly a problem upon purchase of interest from another service provider who has no historic qualified capital © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 27 Carried Interests What provision is made for service providers who also invest capital? The “allocation rule” provides that allocations with respect to a qualified capital interest will not be subject to recharacterization and loss deferral if Allocations are made to the qualified capital interest in the same manner as such allocations are made to other qualified capital interests held by partners who do not provide investment management services to the partnership (and who are not related to the partner holding the qualified capital interest); and Allocations made to the non-service partners are significant compared to the allocations made to the qualified capital interests of the service partners. © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 28 Carried Interests Service Partner LPs $1 million $1 million FUND RE Assets First, 100% to LPs until 10% IRR Next,100% to Service Partner until 12% IRR Finally, 60% to Service Partner and 40% to LPs Service Partner agrees to subordinate its return on contributed capital to that of the LPs, but will receives a higher proportionate return on its capital, assuming success of venture, to compensate for taking additional risk with respect to its return The Service Partner does not have a “benchmark,” as it is not receiving the same return as a non-service provider in the partnership The allocation rule is not satisfied, so it appears that no portion of the return on the Service Partner’s qualified capital is permitted © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 29 Carried Interests Service Partner $1 million 50% until 10% IRR Then 60% LPs $1 million 50% until 10% IRR Then 40% FUND RE Assets Service Partner agrees to bear first losses and LPs absorb losses only after Service Partner’s capital is fully depleted Allocation of losses to Service Partner are not made in same manner as losses made to non-service providing LPs, so that allocation rule is not satisfied Losses attributable to Service Partner’s qualified capital would appear to be deferred until income is allocated to Service Partner or interest is sold or liquidated Service Partner’s losses do not become usable once LPs are allocated losses Can income allocations still qualify in this circumstance? © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 30 Carried Interests What provision is made for service providers who also invest capital? Treasury has authority to provide guidance in certain situations Describing a permissible return where no or insignificant allocations are made to non-service providers Describing how the allocation rule may be applied separately with respect to a portion of a qualified capital interest Providing that allocations will not be treated as failing to satisfy the allocation rule merely because the allocations to the qualified capital interest represent a lower return than the allocations made to other qualified capital interests © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 31 Carried Interests Developer Partner 1 Developer Partner 2 $1 million 50% $1 million 50% Development Pship RE Assets Each partner contributes equal capital, performs equivalent services, and receives an equivalent return There are no non-service providers, so must look to regulations for permissible return JCT Report accompanying the 2009 House Bill anticipates that, where there are no nonservice providers, regs would allow service partner to earn a return in proportion to capital Should there be a different return allowed for Developer Partners if they admitted a capital/non-service partner? © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 32 Carried Interests Service Partner $1 million 50% until 10% IRR Then 60% LPs $1 million 50% until 10% IRR Then 40% FUND RE Assets Service Partner and LPs each have been allocated income to match full accrued 10% IRR amount and receive an allocation of $1 million gain pursuant to the 60%-40% sharing ratio – cash from gain transaction is retained by the partnership Service Partner receives credit for qualified capital attributable to disproportionate income allocation – this causes the overall return on the Service Partner’s proportionately larger qualified capital interest to differ from LPs Regulatory authority is provided to permit (1) isolation of return to qualified capital other than the disproportionate undistributed income and (2) the Service Partner to receive a lower return on its qualified capital It appears that no increased return is permitted with respect to increased qualified capital interest, as there is no benchmark return for that qualified capital © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 33 Carried Interests What provision is made for service providers who also invest capital? Except as provided in regulations, in the case of tiered partnerships, all allocations made with respect to a qualified capital interest in a lower-tier partnership which meet the requirements of the allocation rule will be treated as satisfying the allocation rule at the upper-tier partnership level to the extent allocated on the basis of qualified capital interests in the upper-tier partnership © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 34 Carried Interests Service Partners Mgmt Co Mgmt Services LPs GP FUND Investment Assets Note that all partners in GP are service providers Based upon the tiered-partnership rule, the House Bill now would appear to allow Service Partners in GP to determine permissible return by reference to non-service providing LPs in Fund What if Service Partners’ aggregate qualified capital in GP entity differs from GP entity’s qualified capital interest in Fund? (See slide 23) © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 35 Carried Interests Service Partners Bank Mgmt Co Mgmt Services LPs GP FUND Investment Assets Tiered partnership rule does not provide relief in this situation (discussed earlier) because Service Partners do not have qualified capital interest in GP entity (since no credit for section 752(a) deemed contributions). © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 36 Carried Interests What provision is made for service providers who also invest capital? Except as provided in regulations, the allocation rule will not be violated merely because the allocations made to a qualified capital interest do not reflect the cost of investment management services provided (directly or indirectly) to the partnership by the holder of such interest (or a related person) Appears aimed at permitting service partner to satisfy the allocation rule even though the return on such partner’s qualified capital does not bear management fees or the cost of the carried interest borne by non-service partners What if a portion of the costs is attributable to services other than investment management services? Will this rule still provide relief? © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 37 Carried Interests Service Partner LPs $5 million $95 million FUND RE Assets Allocation provisions state that allocations are made, preliminarily, based on percentage interests (95% LPs/5% Service Partner) After the preliminary allocation, amounts allocated to each LP then are re-allocated, with such amounts being allocated solely to the LP until such partner has earned a 10% IRR on contributed capital, and the residual is allocated 80% to the LP and 20% to the Service Partner The expense for the management fee is allocated solely to the LPs The only difference between an LP and the Service Provider is that the return of the Service Provider does not reflect self-charged amounts Allocation rule appears to be satisfied, but impact is not clear (i.e., is full return permitted or only the portion equal to the amount earned by the LPs) © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 38 Carried Interests What provision is made for service providers who also invest capital? Special rule is provided for dispositions of ISPI where a portion of such interest is a qualified capital interest The rule that provides for ordinary (or blended for individuals) treatment of gain or loss on disposition of an ISPI will not apply to so much of such gain or loss as bears the same proportion to the entire amount of such gain or loss as The distributive share of gain or loss that would have been allocated to the qualified capital interest if the partnership had sold all of its assets for fair market value, bears to The distributive share of gain or loss that would have been so allocated to the ISPI of which such qualified capital interest is a part. © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 39 Carried Interests What provision is made for service providers who also invest capital? Not clear how rules treat distributions with respect to a qualified capital interest. Disposition rule technically applies by virtue of cross-reference to section 710(b) (which includes distribution rule), but the mechanics of rule seem to operate only by reference to dispositions. Do you apply exclusion of asset gain at partnership level by reference to proportion measured based upon disposition of all assets? If so, in determining gain based upon fair market value of distributed property over adjusted basis in partnership interest, how does qualified capital exception operate? Or do you trigger all gain under section 710(b)(6), and allocate distributive share between ISPI and qualified capital as part of allocable share of partnership income? © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 40 Carried Interests Service Partner LP $1 million 50% interest $1 million 50% interest FUND RE Assets Service Partner and LP contribute proportionate capital and divide all income and loss 50/50 The interest held by the Service Partner is an ISPI, because the Service Partner provides services in managing the real estate held for rental. However, the Service Partner is compensated entirely through a management fee for those services. Although the Service Partner’s entire interest in the Fund is a qualified capital interest that is allocated income on a permissible basis, any distribution of property to the Service Partner may trigger all gain with respect to that property (which would be allocated to the Service Partner, with a portion possibly attributable to qualified capital), and any additional gain by reference to the fair market value of the distributed property over the Service Partner’s basis in its Fund interest would be triggered as well © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 41 Carried Interests What are some of the other potential effects of the legislation? REITs continue to apply 1.856-3(g) to carried interest for purposes of analyzing income and asset tests. Income received by a REIT pursuant to an investment services partnership interest, however, will be ordinary income, as it is for other taxpayers. Legislation also makes favorable provision for carried interests held by UPREIT partnership in determining qualifying income. Starting 10 years after the date of enactment, the legislation would cause ordinary income allocated with respect to an ISPI to be nonqualifying income for purposes of the PTP 90% income test Exception for income earned by certain PTPs that invest primarily in other PTPs and income from mineral and natural resource activities. © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 42 Carried Interests The House Bill also would apply ordinary income treatment to income with respect to “disqualified interests” received by a party providing “investment management services,” where the value of such interests substantially relates to the income or gain from assets under management. “Disqualified interests” are: Any interest in an entity other than indebtedness; Convertible or contingent debt of such entity; Option or other right to acquire property described above; and Any derivative instrument entered into (directly or indirectly) with such entity or any investor in such entity. But a “disqualified interest” does not include a partnership interest, stock of a taxable corporation (except as provided in regs), or stock of an S corporation (except as provided in regs) © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 43 Carried Interests For purposes of the “disqualified interest” rule, a “taxable corporation” is: A domestic C corporation; or A foreign corporation if substantially all of corporation’s income is (1) effectively connected with a US trade or business or (2) subject to a comprehensive foreign income tax. Regulatory authority is provided to further prevent avoidance of the purposes of the rules relating to carried interests © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 44 Carried Interests Section 6662 would be amended to provide a 40% penalty where a person had an underpayment as a result of being treated as holding a “disqualified interest” or violating anti-abuse regs. The penalty would not apply if Relevant facts affecting tax treatment of the item are adequately disclosed; There is or was substantial authority for such treatment; and Taxpayer reasonably believed that such treatment was more likely than not proper. © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 45 Carried Interests Broad regulatory authority to carry out the purposes of section 710, including Providing modifications to the application of the section to the extent consistent with the purposes of the section; Preventing avoidance of the purposes of the section; and Coordinating the section with other provisions of the Code. © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 46 Carried Interests Effective date under House Bill generally would apply to “taxable years ending after the date of enactment” In the case of a partnership taxable year that includes the date of enactment, the amount of income covered by the legislation is equal to the lesser of The net income for the entire partnership taxable year, or Net income determined by only taking into account items attributable to the portion of the partnership taxable year which is after the date of enactment Applies to dispositions and distributions after the date of enactment. Waiver for estimated tax penalty to the extent underpayment is created or increased by legislation. © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY. 47 Presenter’s contact details James B. Sowell KPMG LLP 202 533 5710 jsowell@kpmg.com © 2010 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. FOR INTERNAL USE ONLY.