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May 25, 2010

Defending the Carried Interest (Capital Gains) Tax Incentive

Filed under: Finance,Venture Capital — Steve Krupa @ 8:41 pm
Tags: , , ,

Today I intended to write an editorial, of sorts, in opposition to the US government’s proposal to raise the tax rate on Carried Interest earned by investment partnerships.  This tax increase targets partners of VC and Private Equity funds and is imbedded in a current bill proposed by the House of Representatives called The American Jobs and Closing Tax Loopholes Act of 2010 (H.R. 4213).

Under the category of closing individual loopholes, the House provides the following summary of the provision:

Taxation of carried interest.  The bill would prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund… the bill would require investment fund managers to treat seventy-five percent (75%) of the remaining carried interest as ordinary income (50% for taxable years beginning before January 1, 2013). This proposal is estimated to raise $18.685 billion over 10 years.”

In the course of my beginning to research this topic, I remembered that my partners and I had already addressed this issue in a letter we wrote back in March of 2009.  Below is an edited version of that letter, altered slightly to bring it up to date.  It reads much like an editorial, but I believe it succeeds in making its point.

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Venture Capital and Carried Interest 

The Congress proposes to increase the capital gains tax rate on Carried Interest earned by principals of venture capital firms from the current standard capital gains rate to a hybrid rate weighted more toward the marginal tax rate on ordinary income.  As with all tax rate increases, we believe that this one will serve as a long-term disincentive, in this case to the formation of capital around innovative start-ups, one of the key historical drivers of job creation in the US economy (according to National Venture Capital Association, in 2005 companies that received venture capital from 1970-2005 accounted for 10 million jobs – approximately 9% of the private workforce – and $2.1 trillion in revenues – approximately 17% of GDP).

Unlike other forms of investing, venture capital investment does not involve intricate financial engineering and it does not rely on financial leverage and market arbitrage to generate gains.  Venture capital is about investing equity in young companies for long-term results.  Most venture capital investments are made in companies with less than $50 million in revenues and are held for periods between 5 and 7 years (although some are held much longer), distinguishing them as intrinsically unique, long-term, growth oriented equity investments.

It is expected that for the foreseeable future venture capital will be deployed in clean and alternative energy technologies, a host of computer science-oriented businesses, bio-medical technology and healthcare services and information technology.  These are the precise areas of innovation necessary to solve some of the key issues in our economy and these are the very businesses that seek employees with advanced skills in biology, mathematics, engineering and computer sciences, a major thrust of our government’s education initiative.

In a well-run investment model the venture capitalist operates in partnership with the entrepreneur, focusing on long-term company building, as opposed to the buying and selling of portfolio securities.  The venture capitalist puts its own capital at risk and raises additional funds by advocating investment in the sector to large institutional investors, many of which, like endowments and pension funds, are tax-exempt.  Once the funds are raised, the venture capitalist screens an enormous pool of new ideas to tease out those with the best investment prospects (less than 1% of venture ideas ultimately get funded by venture capitalists).  After the initial investment is made, the venture capitalist supports each new company and its entrepreneur by providing follow-on financings and working with the company as a board member and advisor on matters of strategy, human resources development, sales, marketing, finance and business development.  It is not until the long-term success of the company is achieved that the venture capitalist earns a financial reward for its efforts in the form of a capital gain, known primarily as Carried Interest.  Along the way there are plenty of chances for failure.  Despite the best efforts of all involved, most venture-backed companies ultimately fail, but those that do succeed pay-off well in excess of the failures, rewarding entrepreneurs and venture capitalists for working through substantial financial and operating risk.  Venture capital investment represents absolute value creation, not “zero-sum” value transfer.  The resultant output to the nation is permanent innovation and job creation. 

So why would the House propose to penalize venture capitalists with a tax increase to Carried Interest?  It seems counter productive and will not lead to stimulating innovation (further in and of itself it doesn’t raise much money – $18 billion over 10 years is less than 0.04% of the federal budget over that same period time).  During the campaign President Obama committed to eliminating the capital gains tax for investment in small businesses, clearly supporting the notion that tax incentives stimulate investment activity.  Yet, a carried interest tax increase on venture capitalists would operate in complete opposition to this goal.  The truth is, the venture capitalist and the entrepreneur are long-term partners and should be treated the same.

Today venture capital is a highly competitive global business.  Innovation will develop where there is unity between the talent available to build new innovative businesses and the incentives for capital investment.  We see other countries narrowing the global education gap and providing very compelling capital incentives (e.g. – China is investing heavily in education and does not tax capital gains at all).  Currently, the United States has the most advanced and effective venture capital infrastructure in the world and we believe that this is one of this country’s great competitive advantages, portending future success beyond our current financial difficulties.  As such, we would urge Congress to look for ways to maintain and enhance venture capital as the National Asset that it is and not to penalize suddenly those venture capitalists whose past and ongoing work is in complete harmony with America’s long-term economic objectives.

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