S. HRG. 110–943

CARRIED INTEREST

HEARINGS

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED TENTH CONGRESS

FIRST SESSION

JULY 11, JULY 31, AND SEPTEMBER 6, 2007

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Printed for the use of the Committee on Finance

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53–637—PDF 2007

S. HRG. 110–943

CARRIED INTEREST

HEARINGS

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED TENTH CONGRESS

FIRST SESSION

JULY 11, JULY 31, AND SEPTEMBER 6, 2007

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

MAX BAUCUS, Montana, Chairman

JOHN D. ROCKEFELLER IV, West Virginia

KENT CONRAD, North Dakota

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

RON WYDEN, Oregon

CHARLES E. SCHUMER, New York

DEBBIE STABENOW, Michigan

MARIA CANTWELL, Washington

KEN SALAZAR, Colorado

CHUCK GRASSLEY, Iowa

ORRIN G. HATCH, Utah

TRENT LOTT, Mississippi

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

PAT ROBERTS, Kansas

JOHN ENSIGN, Nevada

RUSSELL SULLIVAN, Staff Director

KOLAN DAVIS, Republican Staff Director and Chief Counsel

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C O N T E N T S

JULY 11, 2007

OPENING STATEMENTS

Page

Baucus, Hon. Max, a U.S. Senator from Montana, chairman, Committee

on Finance ............................................................................................................ 1

Grassley, Hon. Chuck, a U.S. Senator from Iowa ................................................. 3

WITNESSES

Solomon, Hon. Eric, Assistant Secretary for Tax Policy, Department of the

Treasury, Washington, DC .................................................................................. 6

Orszag, Peter, Director, Congressional Budget Office, Washington, DC ............ 8

Donohue, Andrew, Director, Division of Investment Management, Securities

and Exchange Commission, Washington, DC .................................................... 10

Mitchell, Kate D., managing director, Scale Venture Partners, Foster City,

CA .......................................................................................................................... 12

Gergen, Mark P., Foundren Foundation Centennial Chair for Faculty Excellence, University of Texas School of Law, Austin, TX ...................................... 14

JULY 31, 2007

OPENING STATEMENTS

Baucus, Hon. Max, a U.S. Senator from Montana, chairman, Committee

on Finance ............................................................................................................ 55

Grassley, Hon. Chuck, a U.S. Senator from Iowa ................................................. 57

WITNESSES

Bankman, Joseph, Ralph M. Parsons professor of law and business, Stanford

Law School, Stanford, CA .................................................................................... 59

Kingson, Charles, adjunct professor, New York University Law School, New

York, NY; and lecturer in law, University of Pennsylvania Law School,

Philadelphia, PA .................................................................................................. 60

Jones, Darryl, professor, Stetson University College of Law, Gulfport, FL ........ 62

Ifshin, Adam, president, DLC Management Corporation, Tarrytown, NY ......... 63

Frank, John B., managing principal, Oaktree Capital Management, LP, Los

Angeles, CA .......................................................................................................... 65

Rosenblum, Bruce, managing director, The Carlyle Group, Washington, DC;

and chairman of the board, Private Equity Council, Washington, DC ............ 66

Stanfill, William, founding partner, Trailhead Ventures, LP, Denver, CO ........ 68

SEPTEMBER 6, 2007

OPENING STATEMENTS

Baucus, Hon. Max, a U.S. Senator from Montana, chairman, Committee

on Finance ............................................................................................................ 91

Grassley, Hon. Chuck, a U.S. Senator from Iowa ................................................. 93

Page

IV

WITNESSES

Auerbach, Dr. Alan J., Robert D. Burch professor of law and economics

and director, Robert D. Burch Center for Tax Policy and Public Finance,

Department of Economics, University of California, Berkeley, Berkeley, CA 94

Read, Russell, chief investment officer, California Public Employees’ Retirement System, Sacramento, CA ........................................................................... 96

Trone, Donald B., president, Foundation for Fiduciary Studies, Coraopolis,

PA .......................................................................................................................... 97

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Auerbach, Dr. Alan J.:

Testimony .......................................................................................................... 94

Prepared statement .......................................................................................... 113

Responses to questions from committee members ......................................... 121

Bankman, Joseph:

Testimony .......................................................................................................... 59

Prepared statement .......................................................................................... 125

Baucus, Hon. Max:

Opening statements...................................................................................... 1, 55, 91

Bunning, Hon. Jim:

Prepared statement .......................................................................................... 131

Cantwell, Hon. Maria:

Prepared statements............................................................................. 132, 134, 135

Donohue, Andrew:

Testimony .......................................................................................................... 10

Prepared statement .......................................................................................... 137

Responses to questions from committee members ......................................... 143

Frank, John B.:

Testimony .......................................................................................................... 65

Prepared statement .......................................................................................... 148

Responses to questions from committee members, with attachments ......... 154

Gergen, Mark P.:

Testimony .......................................................................................................... 14

Prepared statement .......................................................................................... 173

Responses to questions from committee members ......................................... 179

Grassley, Hon. Chuck:

Opening statements...................................................................................... 3, 57, 93

Prepared statement .......................................................................................... 186

Ifshin, Adam:

Testimony .......................................................................................................... 63

Prepared statement .......................................................................................... 189

Responses to questions from committee members ......................................... 196

Jones, Darryl:

Testimony .......................................................................................................... 62

Prepared statement .......................................................................................... 205

Responses to questions from committee members ......................................... 214

Kingson, Charles:

Testimony .......................................................................................................... 60

Prepared statement .......................................................................................... 225

Responses to questions from committee members ......................................... 228

Mitchell, Kate D.:

Testimony .......................................................................................................... 12

Prepared statement with attachments ........................................................... 235

Responses to questions from committee members ......................................... 342

Orszag, Peter:

Testimony .......................................................................................................... 8

Prepared statement .......................................................................................... 353

Responses to questions from committee members ......................................... 370

Read, Russell:

Testimony .......................................................................................................... 96

Prepared statement .......................................................................................... 380

Responses to questions from committee members ......................................... 388

Roberts, Hon. Pat:

Prepared statement .......................................................................................... 397

Page

V

Rosenblum, Bruce:

Testimony .......................................................................................................... 66

Prepared statement with attachments ........................................................... 398

Responses to questions from committee members ......................................... 431

Salazar, Hon. Ken:

Prepared statement .......................................................................................... 458

Solomon, Hon. Eric:

Testimony .......................................................................................................... 6

Prepared statement .......................................................................................... 460

Responses to questions from committee members ......................................... 469

Stanfill, William:

Testimony .......................................................................................................... 68

Prepared statement .......................................................................................... 490

Trone, Donald B.:

Testimony .......................................................................................................... 97

Prepared statement with attachment ............................................................. 495

Responses to questions from committee members ......................................... 504

COMMUNICATION

American Federation of Labor and Congress of Industrial Organizations

(AFL–CIO) ............................................................................................................ 509

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CARRIED INTEREST, PART I

WEDNESDAY, JULY 11, 2007

U.S. SENATE, COMMITTEE ON FINANCE, Washington, DC.

The hearing was convened, pursuant to notice, at 10:04 a.m., in

room SD–215, Dirksen Senate Office Building, Hon. Max Baucus

(chairman of the committee) presiding.

Present: Senators Bingaman, Kerry, Wyden, Schumer, Salazar,

Grassley, Hatch, Lott, Snowe, Kyl, Bunning, Crapo, Roberts, and

Ensign.

OPENING STATEMENT OF HON. MAX BAUCUS, A U.S. SENATOR

FROM MONTANA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. The hearing will come to order.

In his 1906 message to Congress, President Theodore Roosevelt

said, ‘‘The man of great wealth owes a peculiar obligation to the

State because he derives special advantages from the existence of

government. Not only should he recognize this obligation in the

way he earns and spends his money, but it should also be recognized by the way in which he pays for the protection the State

gives him. He should assume his full and proper share of the burden of taxation.’’

One of the jobs of this committee is to ensure that our tax system

is fair. Today we examine whether some people who are earning

great wealth are also avoiding their full and proper share of the

burden of taxation.

Some hedge fund managers and private equity managers are taking home more than $100 million a year in what is called carried

interest income. Much of that income is being taxed at the longterm capital gains rate of 15 percent. They are not paying the higher rate for ordinary income.

Now, professional athletes, Silicon Valley executives, and lawyers

on contingency fees will also often take home a great deal of income: God bless them! A lot of that income is also based on performance, but they tend to pay taxes at the ordinary income rate.

So the question arises, is the income that these managers are

earning properly capital gains income, or are some people of great

wealth merely taking advantage of the tax code to pay less than

their full and proper share?

The amount of assets under management in venture capital, private equity, hedge funds, and real estate funds is growing rapidly.

American hedge funds, for example, now manage nearly $2 trillion

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in assets. These kinds of alternative investments are often providing phenomenal returns for investors and managers alike.

Managers of these alternative investment vehicles generally conduct business in a series of entities that, for tax purposes, are

treated as partnerships. Managers of these funds generally receive

two types of income: management fees and what is called carried

interest.

Our primary focus today is the carried interest. A carried interest is essentially an interest that the manager has in the profits

of the investment partnership. The manager receives the interest

when the fund is created, and the manager receives payment on

that interest only after the initial investment is returned to the

outside investors and the fund exceeds a certain level of profit.

The Internal Revenue Code provides that when a partnership

sells stock that is held for more than a year, the partners receive

money from that sale and treat the proceeds as long-term capital

gains.

Now, there are many views of what these managers are doing to

earn their income. One view is that the manager is a service provider. Under this view, they are taking advantage of the tax law

to change ordinary income into capital gains.

Another view is that the managers truly own these funds. Under

this view, the managers bring capital to the partnership in the

form of their ideas, and the investors bring capital in the form of

cash; the managers are allowing the investors to share in the manager’s enterprise. Alternatively, the managers bring capital to the

partnership in the form of their intellectual property, goodwill business contacts, and know-how. Once again, the investors bring capital in the form of cash.

In either event, under these views the argument is that capital

gains treatment is appropriate. Maybe the right answer is that

there is a blend of services in capital income. The right answer

may vary from one investment strategy to another: venture capital,

hedge funds, private equity, real estate.

The purpose of these hearings is to explore the economics and

understand the arguments. No matter what we may ultimately decide to do, we will in no way wish to change the tax status of the

limited partners.

Another issue that we’ll want to address today is publicly traded

partnerships. Last month, Senator Grassley and I introduced a bill

on this subject out of the concern that several fund managers

might go public without paying corporate tax.

The tax code generally requires a corporate level of tax on an entity that seeks to access public capital. There is also a good argument that the fund managers who are becoming publicly traded

partnerships are stretching the law.

The United States’ economy is strong. It is dynamic. Our entrepreneurship creates new jobs. We do not want to stifle the mother

of invention. On the other hand, we wish to ensure fair treatment

under the tax code. That fair treatment may make our economy

more dynamic.

These are challenging issues. We want to ensure that our entrepreneurial system continues to function well. We want to ensure

that people are free to continue to create great wealth. At the same

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* For additional information on this subject, see also, ‘‘Present Law and Analysis Relating to

Tax Treatment of Partnership Carried Interests,’’ Joint Committee on Taxation staff report, July

10, 2007 (JCX–41–07), http://www.jct.gov/publications.html?func=startdown&id=1423.

time, we want to ensure that people still contribute their full and

proper share of the burden of taxation.

I look forward to, I think, a very spirited discussion, not only

today, but certainly over the next weeks and months.*

I now turn to Senator Grassley.

OPENING STATEMENT OF HON. CHUCK GRASSLEY,

A U.S. SENATOR FROM IOWA

Senator GRASSLEY. Mr. Chairman, my statement is based a little

bit upon a frustration I have with the obfuscation, the muddying

of the waters, and the propaganda that is always a part of this

town, so I hope you will forgive me.

I thank you very much for calling this hearing. I would like to

address this hearing in two parts: the first part is what this hearing and the committee inquiry are about today; the second part is

what this hearing and committee inquiry are not about.

So let us, first, discuss what the hearing and committee meeting

are about. The issue that we’re examining today arises from the

intersection of partnership tax rules and the lower rates on capital

gains.

A carried interest is an interest in a partnership’s profits that is

received in exchange for performing services for that partnership,

as opposed to contributing capital. While this issue is not new to

the tax law, it has received heightened attention from the proliferation of private equity and hedge funds structured as partnerships.

The carried interest issue relates to the timing and the character

of income.

In 2003, I fought long and hard to get the lower capital gains

rates into law. I continued the fight last year, over the fierce opposition of the Democratic leadership, to get the lower rates extended

through 2010, and I will be at it again in the years leading up to

2011.

In each battle, the opposition will call the lower rates tax cuts

for the rich. We justify the lower rates on capital gains as a remedy

against double taxation of investment income and the resulting

benefits of economic growth.

As a Republican who supports lower capital gains rates, I am

concerned that, to the extent we permit the dilution of investment

concepts, we risk undermining the argument we have made for

lower rates, and also making it more expensive to extend them. We

cannot allow the carried interest tail to wag the capital gains dog.

The partnership tax rules came into being in the code of 1954.

Under these rules, a partnership itself is not subject to tax, unlike

a corporation. Instead, the income and the character of that income

flows through to its partners.

If a partnership realizes ordinary income, then partners are

taxed on that income at ordinary tax rates. But if the partnership

realizes capital gains, then the partners are taxed at capital gains

rates. This makes, really, perfect sense when all the partners invest capital in the partnership and share in the profits according

to the invested capital.

4

But the carried interest issue involves a partner receiving a

share of partnership profits, not for invested capital, but for performing services or contributing intangible know-how. Even if current law is relatively clear, I wouldn’t call it a no-brainer that all

of those profits should be taxed as a return on investment rather

than a return on labor.

Keeping taxes low on investment returns is, I believe—and a lot

of people believe—very sound tax policy. But we need to, at the

same time, preserve the integrity of that policy in order to maintain that policy.

A separate issue, the publicly traded partnership issue, also involves tax code integrity. I joined Chairman Baucus as an original

co-sponsor of a bill that would require private equity and hedge

fund managers that go public to pay corporate taxes.

Some have inaccurately described this bill as an attack on capital

formation, and some have even said it is a tax increase on a single

industry. But this issue is about closing loopholes, not raising

taxes. A hallmark of corporate status is access to public markets.

Our bill prevents the long-term erosion of the corporate tax base,

which was Congress’s initial concern in creating the current rule

that publicly traded partnerships are taxed as corporations.

Any type of business can operate in any partnership form that

they choose. However, if that business decides to go public, it will

generally be taxed as a corporation and pay an entity-level tax.

Now, our bill merely clarifies that firms who manage private equity funds and hedge funds will be treated no differently than their

competitors or any other active business that goes public.

I agree with those who say our corporate tax rates are too high,

but that is a different debate. We will never get there if we stand

by and watch a significant part of our economy escape the corporate tax system, while still accessing public markets.

Now, Mr. Chairman, I want to move on to the second part of my

statement and address what this hearing is not about. Contrary to

the claims of some press reports, lobbyists, and politicians, our inquiry and our proposal that it may produce are not about raising

taxes on capital income. It is not an attack on the investor class.

It is about the definition—simple definition—of capital income

versus labor income.

Since 1922, our tax code has taxed long-term capital gains at

lower rates than ordinary income, except for a brief period following the Tax Reform Act of 1986. I make this point because some

Republicans and some Democrats have come down on this issue on

opposite sides before they even know the facts.

Mr. Chairman, Steve Forbes, for instance, described our publicly

traded partnership loophole-closing proposal as ‘‘putting special

taxes on equity funds.’’ He went on to say that ‘‘envy’’ was a basis

of our publicly traded partnership proposal.

Another commentator, a Heritage Foundation economist, said,

‘‘Senators Baucus and Grassley apparently think it is wrong that

fund managers get a slice of the capital gains pie if investments

rise in value, and they want to tax these gains as if they were income instead of increases in net worth.’’

I would direct Mr. Forbes and other critics to cool it, particularly

on the hysteria that is out there, and get the facts straight. This

5

is a bipartisan, Finance Committee process that has not reached

conclusion, hence, that is what this hearing is all about.

And while we are talking about charges of fictitious tax increases, I would like to remind folks on my side of the aisle—and

not just the nine that are here, but the other 40 altogether—that

during my tenure as chairman and ranking member I never put

forward a proposal for the purpose of raising revenue. If the proposal was good policy, then I recommended it to our committee

whether it raised or lost revenue. For those who want to recklessly

charge that our deliberate, transparent policy inquiry that is going

on now is a tax increase exercise, I would ask them this simple

question: which Finance Committee chairman in the last generation cut the American people’s taxes more than I did?

For folks on the other side of the aisle, and maybe all 51 Democrats, I would like to have them take a look at John Harwood’s recent article in the Wall Street Journal.

Mr. Harwood noted the shifting sands of the composition of the

Democratic base, and he pointed to the fact that roughly half of the

voters with incomes over $100,000 now vote Democratic.

Mr. Harwood said, ‘‘These changes have altered the election risk

calculus that Democrats confront as they consider whether to raise

taxes on hedge fund managers or tax Fortress Investment or the

Blackstone Groups as corporations. The Democratic benefactors on

Wall Street may not vote their wallets—abortion rights and global

warming move them more—but they aren’t eager to become political punching bags either.’’

So this hearing and this committee’s inquiry are not about a revenue grab from private equity firms or hedge funds. Folks on both

sides ought to roll up their sleeves, move away from partisan talking points, and join Chairman Baucus and me in finding the facts.

That is what this hearing and the next hearing that we will have

are all about.

Second, this hearing is not about well-settled tax policy principles regarding capital gains or the propriety of current capital

gains rates. Capital gains arise from the sale of capital assets. We

know what capital assets are: they are shares of stock, real estate,

and other property held for investment.

The code’s definition of a capital asset recognizes the distinction

between investment income on the one hand and labor income on

the other hand by disqualifying certain property held by those

whose personal efforts created the property.

As I indicated above, the Congress has spoken on the 15 percent

current law top rate on capital gains. I am a strong supporter of

the permanent top rate of 15 percent. Our hearing today, and the

committee’s larger inquiry, is not about well-settled notions of capital gains and current tax rates.

Mr. Chairman, I would encourage all members to keep an eye on

the ball. It is appropriate for this committee—in fact, the responsibility of this committee—to thoroughly examine all of these tax

issues, particularly those that are new, particularly those that have

maybe been on the books for 50 years, to find out whether they are

working the way they ought to work.

And so it is appropriate to examine the carried interest issue and

determine if the tax law is operating consistently with the sound

6

policy on which it is based. Lower taxes on capital gains and corporations can help American businesses compete in the global economy.

But to maintain and improve these sound policies, we need to

preserve the integrity of our tax laws. Knee-jerk opposition to our

inquiry will only serve to bolster opponents of these policies.

I also have the privilege, Mr. Chairman, of welcoming a new Republican to this committee. Mr. Ensign, thank you very much for

wanting to serve. I know you will serve well. You work hard on all

the committees on which you serve. Welcome.

The CHAIRMAN. Thank you very much, Senator.

I also, on behalf of the committee, welcome our newest member,

John Ensign from Nevada. John, for those of you who may not

know, first came to Congress in 1995. He was appointed to the

House Ways and Means Committee as a freshman Congressman.

Senator Ensign is the fifth Senator from Nevada to serve on the

committee. Many members will remember that his predecessor on

the committee was Dick Bryan, the last Senator from Nevada to sit

on the committee, and some Senators—not many—will also recall

Senator Paul Laxalt from Nevada, who served on the committee in

the 95th Congress. Senator Ensign will become the 344th Senator

to sit on the committee. Welcome.

Now to our panel. We will start with Eric Solomon, Assistant

Secretary for Tax Policy at the Treasury Department; then Peter

Orszag, the Director of the Congressional Budget Office.

I might say, Mr. Orszag had a very busy week with this committee, working on trying to help get the scoring on the State Children’s Health Insurance Program. He will be appearing before this

committee in just a day or two—I think it is tomorrow—on the authorization of the Airport and Airway Trust Fund. And here he is

today. Thank you for all your work.

Next, Mr. Andrew Donohue, the Director of the Division of Investment Management, Securities and Exchange Commission.

Thank you very much, Mr. Donohue, for taking the time to help us

out here. Kate Mitchell, next, the managing director of Scale Venture Partners, a venture capital firm in California. Thank you for

coming. Finally, Professor Mark Gergen. Professor Gergen joins us

from the University of Texas Law School. Professor Gergen teaches

and writes on the taxation of partnerships and carried interest.

Thank you all very much. We’ll start with you, Mr. Solomon.

STATEMENT OF HON. ERIC SOLOMON, ASSISTANT SECRETARY

FOR TAX POLICY, DEPARTMENT OF THE TREASURY, WASHINGTON, DC

Mr. SOLOMON. Mr. Chairman, Ranking Member Grassley, and

distinguished members of the Finance Committee, thank you for

the opportunity to testify regarding the Federal income tax treatment of carried interests.

Carried interests have received increased public attention recently. However, carried interests are not a new phenomenon. They

have been used successfully for many decades by small and large

partnerships, across many industries, to pool the capital of investors with the ideas and skills of other entrepreneurs in joint profitmaking enterprises.

7

The U.S. economy is, by any measure, among the strongest and

most resilient in the world, and partnerships play an important

role in that success. While there are many ways for U.S. business

activities to be organized for tax purposes, a partnership in many

instances allows the parties the greatest flexibility to match the

form of business with their economic deal and joint undertaking.

The partners decide what each will contribute in capital, ideas, and

skills, and how they will share in profits and losses.

The tax rules applicable to partnerships permit taxpayers to conduct joint business or investment activities through a flexible economic arrangement without incurring an entity-level tax. Partnership income is not taxed at the partnership level, but flows through

to the partners and is taxed to them based on its underlying character as either ordinary income or capital gain. In contrast to this

pass-through treatment for partnerships, income earned by a corporation is subject to two layers of Federal income tax, once at the

corporate level and again at the shareholder level as dividends are

paid.

Accordingly, partnerships for both business and tax reasons are

an attractive business model that encourages entrepreneurs to

combine capital, ideas, and skills and build businesses, both small

and large, across all industries. In 2006, over 2.8 million businesses

filed a partnership tax return.

A carried interest, the topic for today, is another way to describe

a profits interests in a partnership. Profits interests are used by

partnerships of all sizes in a wide variety of businesses.

Upon receipt of a profits interest, the recipient becomes a partner

in the partnership and pays tax in the same manner as other partners on his distributive share of the partnership’s taxable income.

The character of the income included in the partner’s distributive

share is the same as the character of the income recognized by the

partnership. If the partnership earns ordinary income, then each

partner’s distributive share includes a portion of that income. If the

partnership recognizes capital gain, then each partner’s distributive share includes a portion of that capital gain. For example, if

the partnership sells stock of a corporation that it has held for

more than a year, the partner’s share of the long-term capital gain

will be taxed at the 15-percent Federal long-term capital gain rate.

It is important to emphasize that a partner receives a benefit from

owning a profits interest only if the partnership is successful.

The following example illustrates the application of these tax

rules. An entrepreneur and an investor form a partnership to acquire a corner lot and build a clothing store. The investor has the

money to back the venture and contributes $1 million. The entrepreneur has the idea for the store, knowledge of the retail business,

and managerial experience. In exchange for a 20-percent profits interest, the entrepreneur contributes his skills and know-how. The

entrepreneur and investor are fortunate. They are fortunate in

that, by their combination of capital and efforts, the clothing store

is successful. At the end of 5 years, the partnership sells the business for $1.6 million, reflecting an increase in the going concern

value and goodwill of the business.

8

Under the tax rules, the entrepreneur has $120,000 of long-term capital gain, 20 percent of the profits. The investor has $480,000

of long-term capital gain, reflecting their business arrangement.

Under current IRS guidance, the entrepreneur does not have

compensation income at the time of receipt of the 20-percent profits

interest. He is treated as a partner from the date he receives the

interest and is subject to tax at capital gains rates on his portion

of the gain from the sale of the business. To the extent the partnership generates ordinary income from operations prior to the sale of

the business, the entrepreneur is subject to tax at ordinary income

tax rates on his distributive share of the operating ordinary income.

The central theme is that an entrepreneur who contributes skill

and knowledge to the success of the enterprise and receives a profits interest will succeed only if the enterprise succeeds. The entrepreneur has acquired a profits interest in the enterprise, betting

that his upside will provide an ample economic reward. The incentives provided by this structure align the goals of the investors and

the entrepreneur.

The current tax treatment of profits interests provides certainty

for taxpayers in planning their transactions and, at the same time,

is administrable for the IRS. The current tax treatment also encourages the pooling of capital, ideas, and skills in a manner that

promotes entrepreneurship and risk-taking.

The CHAIRMAN. Mr. Solomon, I neglected to remind everybody to

keep their remarks to 5 minutes.

Mr. SOLOMON. Yes. I am on the last paragraph.

The CHAIRMAN. All right. Fine. Thank you very much. [Laughter.] Based on deep experience before this committee, thank you

very much. [Laughter.]

Mr. SOLOMON. Yes.

Partnerships of every size and in every industry have established

and operated their businesses in reliance on the existing tax rules.

While it is important to review our tax laws and policies, we must

be cautious about making significant changes to partnership tax

rules that have worked successfully to promote and support entrepreneurship for many decades.

Thank you for the opportunity to testify before the committee

today. I would be pleased to answer your questions.

The CHAIRMAN. Thank you, Mr. Solomon, very much.

[The prepared statement of Mr. Solomon appears in the appendix.]

The CHAIRMAN. And obviously all your statements will be totally

included in the record.

Mr. Orszag?

STATEMENT OF PETER ORSZAG, DIRECTOR,

CONGRESSIONAL BUDGET OFFICE, WASHINGTON, DC

Mr. ORSZAG. Chairman Baucus, Senator Grassley, members of

the committee, thank you for inviting me to testify this morning on

the taxation of carried interest.

A growing amount of financial intermediation is occurring

through private equity and hedge funds, which are typically organized as partnerships or limited liability companies and now have

9

$2 trillion or more under management. In 2006, private equity

funds raised $240 billion in capital, roughly 10 times the annual

capital they raised in the early 1990s.

These organizational forums are growing rapidly for many reasons, including their tax advantages relative to traditional financial

services corporations. In particular, as has already been noted,

such partnerships do not pay a separate corporate income tax. Instead, they pass all income and losses through to the partners. The

manner in which that income is then taxed to the partners is the

central focus of my testimony.

The partnerships have two types of partners: first, limited partners who contributed capital, and, second, general partners who

manage the partnership, determine investment strategy, and sometimes make modest capital contributions of their own.

The general partners receive two types of compensation: a management fee tied to some percentage of assets under management,

and a carried interest tied to some percentage of profits generated

by those assets.

So, for example, if a fund had a billion dollars in assets under

management and the typical 2-percent management fee, those fees

would amount to $20 million a year and that amount would not depend on the return on the $1 billion in assets. The $20 million management fee is taxed as ordinary income to

the general partner, since it reflects compensation for services provided. If the fund also generated $150 million in realized profits,

the general partner enjoying a 20-percent carried interest would receive another $30 million, that is, 20 percent of the $150 million

in profit.

In practice, at least within private equity funds, this carried interest often applies only after a hurdle rate is achieved, and then

applies to the excess profits above that. The presence of such a hurdle rate would change the numbers, but not the underlying issues

involved.

Taxation on the carried interest is deferred until the profits are

realized on the fund’s underlying assets and are then taxed to the

general partner at the capital gains tax rate to the extent that the

underlying realized profits reflect capital gains. So, at a capital

gains tax rate of 15 percent, the $30 million in carried interest I

mentioned would generate a tax liability of $4.5 million.

Now, here is the issue. From an economic perspective, a general

partner in a private equity or hedge fund undertakes a fundamentally different role than that of the limited partners, because the

general partner is responsible for managing the fund’s assets on a

day-to-day basis. The carried interest, furthermore, is disproportionate to the general partner’s own financial assets invested in the

fund, if any.

Most economists, therefore, view at least part—and perhaps all—

of the carried interest as performance-based compensation for management services provided by the general partner rather than a return on financial capital invested by that partner. That perspective

would suggest taxation of at least some component of the carried

interest as ordinary income rather than capital gains.

Almost all other performance-based compensation is effectively

taxed as labor income and treated as such in the tax code. ContinVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 53637.000 SFIN1 PsN: SFIN1
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gent fees, for example, on movie revenue for actors are taxed as ordinary income, as are performance bonuses, most stock options,

and restricted stock grants. So, too, are incentive fees paid to managers of other people’s investment assets where those fees are documented as such rather than reflecting a carried interest in a formal

partnership.

Although there does not appear to be any solid analytical basis

for viewing carried interest solely as a return on financial capital

for the general partner, there is an analytical debate about whether it should be viewed purely as compensation for management

services or as a mixture of compensation for management services

and capital returns.

My written testimony discusses one of the analytical perspectives

for carried interest that would view it as partly compensation for

a return on capital and partly compensation for labor services provided.

Given the widespread analytical view that at least part of carried

interest represents compensation for services provided, a variety of

proposals have been put forward to alter its tax treatment, and my

written testimony discusses the relative advantages and disadvantages of those various different proposals.

Finally, it is worth emphasizing that much of the complexity associated with the taxation of carried interest arises because of the

differential between the ordinary income tax rate and the capital

gains tax rate. The characterization of the income would not matter

to a first approximation if those two rates were the same.

From this perspective, further widening of the differential between those two forms of income would create even stronger incentives to shift income into the tax-preferred capital form and would

exacerbate concerns such as the ones surrounding the taxation of

carried interest.

I would just finally note that, as Mr. Grassley pointed out, given

that differential, it is particularly important to classify income

properly between ordinary income and capital income. Again, I

think I have provided the analytical view for it being not entirely

capital income.

Thank you.

The CHAIRMAN. Thank you, Mr. Orszag, very much.

[The prepared statement of Mr. Orszag appears in the appendix.]

The CHAIRMAN. Mr. Donohue?

STATEMENT OF ANDREW DONOHUE, DIRECTOR, DIVISION OF

INVESTMENT MANAGEMENT, SECURITIES AND EXCHANGE

COMMISSION, WASHINGTON, DC

Mr. DONOHUE. Chairman Baucus, Senator Grassley, and members of the committee, I am pleased to be here today to discuss the

Securities and Exchange Commission’s perspective with respect to

the initial public offerings of investment advisory firms that,

among other things, manage hedge and private equity funds.

As the head of the Commission’s Division of Investment Management, I have responsibilities for overseeing and regulating nearly

1,000 investment company complexes with over $11 trillion in assets, and more than 10,000 investment advisors that manage more

than $37 trillion in assets.

11

A number of issues have been raised about the recent IPOs of

Fortress Investment Group and Blackstone Group. I am pleased to

be able to offer the committee my knowledge and expertise, especially as it relates to questions of whether Fortress and Blackstone

are investment companies and, thus, subject to the substantive provisions of the Investment Company Act of 1940.

Congress enacted the Investment Company Act to provide a separate and different regulatory structure for investment companies

as compared to industrial or operating companies.

Among Congress’s stated goals was to minimize the risk that an

investment company might be managing in the interest of its managers or certain shareholders rather than to the benefit of all

shareholders. The Investment Company Act provides important

protections to the investment company investors.

I have great respect for the Investment Company Act and the

role it has had in affording America’s investors an opportunity to

invest in our Nation’s securities markets through a vehicle subject

to meaningful oversight and protection. As a result, I believe the

investment company status to be a critical determination.

The staff reviewed the Fortress and Blackstone registration

statements in the normal course and consistent with past practices

and Commission precedent. Applying tests established by Congress

in the Investment Company Act, the staff concluded that Fortress

and Blackstone do not appear to be investment companies.

First, under the orthodox investment company test, Fortress and

Blackstone are primarily engaged, and hold themselves out as

being primarily engaged, in the business of managing money for

others, not themselves. Their assets, sources of income, officer/

employee activities, historical development, and public statements

are consistent with those of an operating company, not an investment company.

Second, in applying the inadvertent investment company test,

Fortress and Blackstone do not appear to have 40 percent of their

assets in investment securities. In addition to other assets, the primary assets of Fortress and Blackstone are their general partnership interests in the underlying funds they manage.

These general partnership interests raised two questions relevant to the investment company status determinations: first, are

they securities or investment securities? Second, what is their

value?

Under existing law, general partnership interests are not securities if the profits relating to those interests generally come from

the efforts of general partners as opposed to the efforts of others.

In the case of Fortress and Blackstone, the issuers maintain control over the day-to-day management of the underlying funds, with

senior employees exercising such management through whollyowned subsidiaries.

The profits to the general partnership interests result from the

efforts of the general partner managers, not others, thus, the general partnership interests would not constitute securities or investment securities.

With respect to valuation, the Investment Company Act requires

an issuer to assign a fair value to general partnership interests like

those at issue in the Fortress and Blackstone filings.

12

In determining fair value, the right to carried interest in underlying funds may be considered because such rights are inexorably

linked to the general partnership interests. Applying these principles, neither Fortress nor Blackstone appear to hold investment

securities with a value exceeding 40 percent of their total assets.

Put another way, in the context of both Fortress and Blackstone,

the value of assets that are not investment securities, such as the

general partnership interests, including the right to receive carried

interest, is more than 60 percent of their total assets. This asset

composition is indicative of an operating company business rather

than an investment company business.

While conducting an investment company status analysis, the

staff considers the status of a relevant entity prior to the offering,

as well as after giving effect to the offering, and they also monitor

the investment company status of certain companies on an ongoing

basis.

In some cases, the staff may disagree with a company’s investment company status analysis and request that it either register

as an investment company or restructure its business or securities

holdings so as to no longer be an investment company. The Commission will bring an enforcement action against a company in appropriate circumstances.

While the staff did not object to the investment company status

conclusions in the Fortress and Blackstone registration statements,

as noted in the required legends on all public offerings the Commission does not approve or disapprove of the securities offering,

nor does it pass upon the adequacy or accuracy of the disclosures.

Fortress and Blackstone remain liable for the statements contained

in their registration.

Finally, it is important to consider that the public investors in

Fortress and Blackstone are buying an interest in an ongoing business that, among other things, manages some underlying funds.

While the value of their investments in Fortress and Blackstone

may be related to how well Fortress and Blackstone do at managing those underlying funds, as well as how well Fortress and

Blackstone are operating their businesses, investors are not acquiring a share in the underlying fund.

Thank you for the opportunity to appear before the committee,

and I would be happy to answer any questions you may have.

The CHAIRMAN. Thank you, Mr. Donohue, very much.

[The prepared statement of Mr. Donohue appears in the appendix.]

The CHAIRMAN. Ms. Mitchell?

STATEMENT OF KATE D. MITCHELL, MANAGING DIRECTOR,

SCALE VENTURE PARTNERS, FOSTER CITY, CA

Ms. MITCHELL. Chairman Baucus, Ranking Member Grassley,

members of the committee, thank you for having me here today. It

is my privilege to share the role that venture capital plays in building new companies and to discuss the economics of carried interest

within a venture capital partnership.

For 40 years, the venture community has been a catalyst for innovation. We use risk capital to build companies and create jobs.

13

To date, Congress has demonstrated a strong understanding of the

importance of U.S. entrepreneurship.

We are asking you to continue to support this sector of the economy and recognize carried interest from these long-term venture

capital investments as it has been viewed historically: as a capital

gain.

Venture capitalists look for innovative ideas with the potential

for growth. In 2006, venture-backed companies represented 17.6

percent of U.S. GDP and 10.3 million jobs. Our sector has created

9.1 percent of all U.S. private sector employment, yet only invested

0.2 percent of GDP. We are small, but we have a large impact on

the U.S. economy.

We are pioneers of the biotechnology, semiconductor, and Internet industries, and are now focusing on alternative energies. Venture capital is also a national phenomenon, backing small businesses in all 50 States. My firm has recently invested in Utah, Arizona, Georgia, Florida, as well as along the entire West Coast from

Seattle to San Diego.

Venture capital is about creating new companies. We do not rely

on leverage or financial engineering, nor do we buy and sell publicly traded securities or companies. Venture capital helped

launched Google, Microsoft, Genentech, Starbucks, and eBay. While

these companies are household names today, they were launched

as ideas put forth by entrepreneurs who had not grown a small

business before.

As venture investors, our job is to identify and nurture these

promising companies. We sometimes found them ourselves. VCs

are active, providing weekly—sometimes daily—guidance to management on everything from prototypes to key hires, from corporate

governance to intellectual property rights.

Venture capitalists make intangible contributions to our companies by leveraging our business experience and our personal networks to introduce those companies to key customers and business

partners.

The reputation and goodwill that comes with this association is

the key that opens doors which would otherwise remain closed to

a start-up. This is why entrepreneurs actively seek out venture investors as partners.

We invest in companies for 5 to 10 years—often longer, rarely

less—with the goal of going public or being acquired, generating a

long-term capital gain.

But many VC-backed companies fail. On average, 40 percent of

all venture investments lose money. Another 40 percent generate

a modest profit, and only 20 percent achieve meaningful gains. We

dig many dry wells, the cost of which is balanced by gains earned

from our best investments. This balance is critical to support our

entire portfolio of hopeful start-ups.

A venture capital firm receives two types of income: a 2-percent

annual management fee and a 20-percent share of the VC’s funds’

cumulative net profits, what we are referring to here as the carried

interest.

The management fee is guaranteed; the carried interest is entirely contingent upon a profitable fund. The 2-percent management fee is taxed as ordinary income and pays for our business opVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00023 Fmt 6633 Sfmt 6633 53637.000 SFIN1 PsN: SFIN1
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erations, office space, salaries, including all administrative personnel.

As partners, the GP and their limited partners come together to

agree to the 20 percent carried interest and how it will be paid.

Our fund must earn profit on our entire portfolio to return all invested capital, plus all management fees, before we receive any

profit share.

Because the net profits of a fund are only knowable near the end

of a fund’s 10-year term, distributions of carried interest to the GP

often only begin in the 7th year of a fund, if at all.

Consistent with current partnership tax laws, the VC fund structure encourages the pooling of labor and capital by allowing partners to divide the profits from the fund in whatever manner they

determine best rewards the long-term entrepreneurial risk taken

by each partner.

We believe it is appropriate to reward investors of sweat equity

with the same long-term capital gain tax benefits that investors of

financial equity receive. Sweat equity is the result of VC’s contribution of time, skills and counsel, as well as the intangible contributions such as customer contacts, business know-how, and reputation. It is as valuable to the success of the business as contributions of financial capital. Both should be subject to the same tax

treatment.

Carried interest is like the stock received by the founder of a

start-up company, because we both receive equity interest in our

businesses that are disproportionate to the financial capital invested in those businesses.

Each of us invests time, energy, know-how, and money in the

hopes of building value. As a result, we all should, and currently

do, receive capital gain tax treatment when the value is realized.

In the last several years we have begun to see the U.S. venture

model exported to developing countries who have witnessed how

venture capital has benefitted the U.S. economy. They are becoming aggressive in attracting those talents to their shores. The game

is ours to lose.

We believe Congress has understood the value of venture capital

by enacting and maintaining tax policies that promote our activities. We hope you will continue supporting this legacy of innovation. Thank you very much.

The CHAIRMAN. Thank you, Ms. Mitchell.

[The prepared statement of Ms. Mitchell appears in the appendix.]

The CHAIRMAN. Mr. Gergen?

STATEMENT OF MARK P. GERGEN, FOUNDREN FOUNDATION

CENTENNIAL CHAIR FOR FACULTY EXCELLENCE, THE UNIVERSITY OF TEXAS SCHOOL OF LAW, AUSTIN, TX

Mr. GERGEN. Chairman Baucus, Senator Grassley, members of

the committee, thank you for giving me a few minutes of your time.

I have written and taught on this subject for over 20 years. As

Senator Grassley says, this is not a new issue. It is not targeted

at a particular industry or group of people.

Just to clarify, right now a carried interest holder gets two tax

benefits: they get deferral and they get conversion. On conversion,

15

they do not just get ordinary income into capital gains, which is

more than halving the tax rate. They also avoid the Medicare tax,

which is 2.9 percent. If they die with unrealized income, it is not

taxed as income in respect to the decedent, so they avoid tax under

the income tax entirely. They get additional benefits that are available because generally returns from capital are very easy to shield

from tax. The capital gains rate is only one of the smallest preferences we have for returns from capital.

The inequity in this is evident. I’m not going to speak to the policy issues; I will leave that to the accountants. There is a very simple solution within current law and within the texture of subchapter K. That is to amend section 702(b) to provide that whatever the character of partnership income may be at the partnership

level, a distributive share is ordinary income when it is compensation for services.

We can identify when it is compensation for services because it

is such when it exceeds a partner’s pro rata share of partnership

capital. In my testimony I provide some additional technical

changes that would have to be made to implement that.

Now, there are two aspects of this that I want to talk about in

my remaining minutes. One is, it does not impose tax on receipt

of the carried interest. That is, we are not taxing a profits interest

when you get it, we are actually taxing it when you earn the profits.

I think that is the better solution because, first, usually the right

to these profits is subject to forfeiture under section 83 and, therefore, whether you pay tax on receipt is elective. You have to make

the election to be taxed.

Second, it is very, very hard to value these interests. Information

is asymmetric. The taxpayer knows more than the government, and

the government has limited enforcement resources. This is an invitation for strategic behavior if we try to tax on interest on receipt.

But if we are not going to tax on interest on receipt, then what we

ought to do is treat profits as compensation when they actually

earn them.

The second point I wanted to talk about before I conclude is how

we handle the problem of founder’s capital, and I really think it is

a non-problem. To the extent the founders contribute capital to a

venture, returns on that capital will not be taxed as ordinary income, they will be taxed as capital gain.

Let me give you a simple example. A and B start a company.

They each invest $1,000. At the end of 2 years, they have an asset

that is worth $2 million. Now, if that is land they invested in, that

is going to be capital gain to them. If that is a book that they created, that is going to be ordinary income to them because that is

a self-created asset, as Senator Grassley was talking about.

At that point, C comes along and says, I will invest $8 million

because I would like to make this even more valuable. From that

point on, if A and B get a 10-percent return that is not going to

be characterized as compensation, that is going to be a return on

their capital in the partnership and will be taxed accordingly.

If they get more than a 10-percent return, I would submit that

is because they are rendering services to the partnership and that

should be taxed as compensation. This is unlike somebody who

16

starts their own business and builds it up because A and B are

making money by mixing their labor with somebody else’s capital.

That is why it merits a different solution and why a different solution is available to us.

Now, as I conclude, let me just say that this allows us to fix a

technical problem with tax law right now. That is the discrepancy

between subchapter K’s capital account system and section 83. I

talk about that in my testimony. It is a technical problem it would

be good to fix.

The second thing is, it deals with another potentially troublesome transaction, so let me conclude with a case I heard about in

the 1980s, which tells us there is nothing new under the sun. What

I heard about was a film deal, where you had an actor who was

going to take a profits interest in the partnership. The partnership

then went out and bought an asset—I cannot remember whether

it was a house or jet—that they used in the making of the film.

When it was done, they booked up his profits interest before the

royalties were earned so he did not have any ordinary income, and

then they distributed out the house or jet, whatever it was, in liquidation of his partnership interest. He got that tax-free because

that was a property distribution from a partnership. That ought to

be taxable as ordinary income. In any context other than subchapter K, it would be taxable as ordinary income. I have been saying for 20 years we ought to fix this. Please do it.

The CHAIRMAN. Thank you, Professor.

[The prepared statement of Mr. Gergen appears in the appendix.]

The CHAIRMAN. I would like to begin with Mr. Orszag, and say

I would like Mr. Gergen, Ms. Mitchell and others to respond. The

basic question is, why is this an important issue? That is, what the

proper tax treatment is of services provided on the one hand and

capital contribution and partnership on the other?

That is, should the services provided, basically 702(b), be profits

that get a capital gains treatment even though the managing partner has not contributed very much in terms of capital assets but

is providing the intellectual capital, if you will?

So the question is, why is this issue important? Why should the

Congress be involved in all of this? It has become a big issue. It

is a big question. General partners are making a lot of money and

they are not paying ordinary income on interest that they are receiving. Why is this important? Why are we getting into all of this

right now? I will start with you, Mr. Orszag.

Mr. ORSZAG. Well, I think you have touched upon some of the

factors. Clearly the reason—or one of the reasons—it appears to be

receiving attention now is the growth that I mentioned in the

amount of income and money that is flowing through these particular partnerships. But I think that really gets to the real issue

of why it is important.

That is, any time that you have similar activities taxed in different ways, you create distortions. You create incentives for activity to flow into the lower taxed activity.

So an executive at a financial services firm or a manager of a

public mutual fund is taxed in a different way for those services

than a general partner in a private equity or hedge fund, and that

should be of concern to tax policy makers because of the distortions

17

that it can create. And also potentially because of fairness issues

across different kinds of managers.

Another reason, obviously, is that all of this activity does have

some revenue effect. I should emphasize quickly that the Joint

Committee on Taxation is responsible for evaluating the revenue

effects of different proposals, but there clearly is the potential for

a revenue effect from tax treatment changes of carried interest.

The CHAIRMAN. Professor Gergen, why is this important?

Mr. GERGEN. Two reasons. One is, it is an opportunity for fundamental tax reform. It is not often that Congress goes back and

looks at subchapter K. Subchapter K has some flaws in it. This is

one. It is a chance to fix it. It has been around for years.

But the second is, fundamental in our tax system is the effort to

try to impose tax on returns to labor at ordinary rates, and we do

a pretty good job at that. Not a great job at that, but a pretty good

job of that. And any time we open a hole in that bucket, it is very

troubling for efficiency reasons because of distortion, but also because of equity reasons.

This is a hole in the bucket. We are taking some returns to labor

and taxing them at the capital gains rate and giving service providers preferences we give to returns on invested wealth.

The CHAIRMAN. Just to make things clear, no one is suggesting

that anyone is violating the law, just that current law enables this

result.

Mr. GERGEN. Right. Treasury could not fix this problem under

current law. It goes further than that.

The CHAIRMAN. Correct.

Mr. GERGEN. They could not do this by regulation.

The CHAIRMAN. All right.

Ms. Mitchell?

Ms. MITCHELL. All right. What we think is that the application

of the law is fulfilling its original intent, meaning new jobs, growth,

exports are occurring because of the development of these new companies. To shift the structure of the law, at least from the venture

perspective, means it will be much more difficult and there will be

much less incentive to spend the time and the money.

Our current fund that was funded in 2004 is an example. We

took savings from my job many years before joining Scale Venture,

invested those savings in the business, spending a lot of time. From

that fund which we initially put money and time in, in 2004, I will

expect to get returns, from a carried interest standpoint, in 2011

or later. To reduce that incentive, to work with entrepreneurs and

to invest capital——

The CHAIRMAN. I am sorry. My time is about expired, and I appreciate that point.

Another basic question is, how much less creative energy are entrepreneurs going to dedicate, whether it is VC, whether it is hedge

funds, whether it is private equity, or whatnot, if the income they

get can be treated as for the services—not for the capital contribution, but for the services—and is compensated generally at ordinary income rates as opposed to capital gains rates? How much

less effort and creativity are entrepreneurs going to devote?

Ms. MITCHELL. Well, Chairman Baucus, my perspective on that

would be, we would be more interested in staying in safer jobs

18

where you get better current income rather than speculating for

the future. That would be a logical conclusion because that would

be a safer alternative and a safer way to spend time, to stay with

the existing company and not build a new one.

The CHAIRMAN. I would like Mr. Orszag and Mr. Gergen, very

briefly, maybe 15, 30 seconds, to respond.

Mr. ORSZAG. There are a whole variety of other settings in which

performance-based compensation is taxed as ordinary income, such

as non-qualified stock options, fees for movie actors, et cetera, et

cetera, et cetera, and that seems to elicit significant effort and

labor supply.

I think it is also important to realize that the discussion is not

about the tax treatment of the limited partners who are contributing the capital to the funds here. I think that is a very important

point to keep in mind.

The CHAIRMAN. All right. My time is expired. We will get back

to you, Professor. Thank you.

Senator Grassley?

Senator GRASSLEY. Thank you, Mr. Chairman.

Mr. Solomon, based on Secretary Paulson’s recent public comments, has Treasury reached a conclusion that we should not

change the status quo with respect to the taxation of carried interest and publicly traded partnerships?

What effort went into that analysis or what efforts are planned,

and what types of potential unintended consequences, tax policy,

and tax administration concerns should we take into account as we

examine these issues?

Mr. SOLOMON. Thank you, Senator Grassley. There are two

issues here. One issue is carried interest. The second issue is with

respect to the treatment of publicly traded partnerships. Those are

two separate, but related, issues.

First, let me address carried interest. The main theme, as I discussed in my testimony, is that we should be cautious about making significant, potentially unsettling changes to the tax law in an

area where it has worked well to promote and support entrepreneurship and risk-taking for many decades.

So with respect to carried interest, it is important to note that

carried interest has been successful for partnerships of all sizes,

small and large, and for partnerships in many industries, such as

real estate, for many years.

With respect to the second matter that you raised, which is publicly traded partnerships, it is a separate issue, but related. It

raises very difficult issues about the interaction between our corporate system of taxation, which is a two-tier level of taxation, and

our partnership system of taxation, in which there is only a single

level of tax.

Senator GRASSLEY. You answered the last questions. What about

Secretary Paulson and his recent comments? Has he reached a conclusion as to whether or not we should change the law yet?

Mr. SOLOMON. With respect to the carried interest?

Senator GRASSLEY. Yes.

Mr. SOLOMON. With respect to carried interest, we have concerns

and cautions about making significant and potentially unsettling

changes to the treatment of carried interest.

19

Senator GRASSLEY. Ms. Mitchell, how would you describe what

you do in exchange for the carried interest, and why should all of

the associated income be treated as return on investment rather

than compensation?

Ms. MITCHELL. What we do, Senator, is we help a company—we

will take a technologist, as an example, who knows a lot about how

to build a chip, but has never hired a salesperson, a marketing person, never put together an HR plan, and we will advise him on how

to take that technology idea—in the case of life sciences it might

be something funded by the NIH—and be a catalyst to help pull

that technology through the process to ultimately get it commercialized. We sometimes even step in when there is not capital to

pay for professionals and actually help them on a day-to-day basis

with aspects of that.

For that, our goal is to make money at the end. Not only is that

speculative, whether or not we do—and it happens over a long period of time—I could actually even lose money. I could have early

gains in my fund and have that followed by later losses, and pay

taxes on that. So, it is not simply an up side for me, there is actually a down side on the carried interest alone.

Our objective is to try to get these engineers out of CISCO, these

safe jobs, and move them into the garage to create the next CISCO.

That is what we are trying to do.

Senator GRASSLEY. All right.

Now, if a partnership earns ordinary income—anything you want

to say, but I will just say making and selling pies instead of capital

gains from selling stock in companies—should the profits attributable to the carried interest still be considered a return on investment?

Ms. MITCHELL. Yes, if that happens within the course of the year

per the partnership tax laws. If I have a company that I sell within

a year, and the fund was profitable within a year, I would pay ordinary income. So, we intend to comply with the tax laws.

But anything that speculates to build a new business, which is

what our venture is about and what our limited partners expect of

us, should be considered capital gains. It is long-term. We have to

earn it on a whole pool of investments, not just company by company.

Senator GRASSLEY. Do others have views on this issue I discussed with Ms. Mitchell that you would like to throw in?

[No response.]

Senator GRASSLEY. I guess you do not. I think, Mr. Chairman, I

will let you go on to the next.

The CHAIRMAN. Thank you.

Senator Kerry, you are next. And just for information, Senators,

the early bird list is: Senator Kerry, Senator Crapo, Senator

Wyden, Senator Bunning, Senator Salazar, Senator Bingaman,

Senator Kyl, and Senator Ensign.

Senator KERRY. Thank you. Thank you, Mr. Chairman and

Ranking Member, for holding this hearing, which is an important

one.

I think we have to be really careful how we are going to change

what I think has some downstream impact, and I am trying to figVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00029 Fmt 6633 Sfmt 6633 53637.000 SFIN1 PsN: SFIN1
20

ure out whether it is quite as simple and clear as Professor Gergen

is suggesting.

Massachusetts, particularly, I think is number two in the Nation

for cumulative venture capital investment from 1971 to 2006, and

we have created almost three-quarters of a million jobs. You can

find a lot of parallels between REITs, real estate investments, certain kinds of structures that people invest and put their sweat equity into and wind up with capital gains at the end of that. I think

we have to be thoughtful about where this separation is.

In a sense, all capital gain is performance-based, is it not, Professor Gergen?

Mr. GERGEN. No. Some is labor, some is capital. In fact, what we

will end up doing, if you were to move to a system such as I propose, is venture capitalists could turn their carried interest into

non-recourse loans from the people who are providing the capital.

Then they would have ordinary income equal to the very low rate

of interest imputed on a non-recourse loan, which ends up being a

fraction, probably, of the value of their compensation. Or, and this

would have been my answer to your question, they can actually

value their capital they are contributing because they really are

contributing know-how.

Once you do that, you end up segmenting and probably lowballing, under-estimating the returns to compensation, but you are

at least characterizing some of it as a return on labor.

Senator KERRY. But what happens if you are a major real estate

developer and you say, all right, I am going to take a portion of

this in ownership and people invest their capital, and you go out

and you make the decision as to where to build, what to build with,

hire those to do the work; at the end you would be paid, conceivably, a fee for what you have done. But if you have an equity interest, you are also going to get the capital gain, are you not, and that

is going to be treated as such?

Mr. GERGEN. I would treat it as ordinary income unless——

Senator KERRY. But it is not currently treated as ordinary income.

Mr. GERGEN. Right. Right. I think that is wrong, because you

have people who are real estate developers who are turning the returns from their——

Senator KERRY. What happens if it fails, on the down side? I

mean, they are taking a risk in creating an asset which is appreciating according to its success. Is there not a parallel if you are,

for instance, a fund manager of one kind or another and you sit on

the board, as most of them do, or many of them do, and you make

board decisions and you have a contingency equity position, is it

possible that the contingency equity position which depends on the

outcome and success of the venture, that that would be treated as

the creation of an asset, which is, in effect, a capital gain, is it not?

Mr. GERGEN. If it is a return to labor, it ought to be taxed as

compensation.

Senator KERRY. But there is always a mix of labor. That is the

difficulty here.

Mr. GERGEN. You talk about the possibility of a loss. People are

in a tax advantaged position with a loss because they are investing

pre-tax income, meaning that if it grows in value they are not

21

going to be taxed until the profits are realized. If they go down in

value, they do not have a capital loss.

Senator KERRY. When Bill Gates starts Microsoft and he puts

Microsoft together, his basis in that stock would be treated as ordinary income, but I do not know what the basis would have been

at the beginning. But once it appreciates and he sells the stock,

that is going to be treated as capital gain as a result of his intellectual capacity, his intellectual input, his decision making, and so

forth. It is treated as capital gain.

It seems to me you would fundamentally flip the capital market

on its ear if you sort of blur the lines—or maybe it is clarify the

lines, maybe that is what we have to do—between what is legitimate performance-based and what is legitimate asset appreciation

and payoff for that risk taking, so to speak.

Mr. GERGEN. If you do it through a corporation, you are right.

Bill Gates did it through a corporation. But then we pose a separate tax at the corporate level.

Senator KERRY. So that would be your distinction.

Mr. GERGEN. With the particular example of Microsoft, that is

the distinction.

Senator KERRY. Well, then is the real question here——

Mr. GERGEN. The partnership, if you come to my example, once

they have created this idea, if somebody else is going to come in

and invest additional capital, they now have a capital interest.

They have now invested capital. Only that slice that they created,

like a painting, is going to be treated as ordinary income. The rest

is capital gains.

Senator KERRY. Well, my time is up. But maybe there is some

clarification that is necessary. Maybe the larger question is not

whether you want to alter this fundamental notion of what is the

legitimate appreciation in the asset that you have created—and the

legitimate question may be whether or not those folks are paying

a sufficient level of taxation. That may be the more fundamental

question.

The CHAIRMAN. Thank you.

Senator Crapo?

Senator CRAPO. Thank you very much, Mr. Chairman. I appreciate your holding this hearing because I do believe we need to get

to the details of what kind of impact this type of proposal would

have if we were to make these changes in our tax law.

I, for one, have very strong concerns about the alternatives that

are proposed to our current system of taxing partnerships, not only

because they would raise the complexity, but also because they

would run the risk of stifling innovation and risk taking, and in

many cases, both. I appreciate the fact that the chairman intends

to hold another hearing, as I understand it, on this issue.

I am also very pleased by the fact that Secretary of Treasury

Paulson will hold a one-day conference on Thursday, July 26 in

Washington, DC to examine ways in which our current business

tax system affects economic growth and U.S. global competitiveness.

The concern I have is that, at a time when many of us are trying

to raise concern about the competitiveness of the United States and

global capital markets, the last thing I think we want to do is to

22

create a disincentive in our own tax law that would encourage business away from the United States and to other capital markets.

That is really the concern that I have and what I would like to use

my few minutes on in terms of asking questions.

But in terms of this notion that labor should be taxed as ordinary income, and I guess asset contributions should be taxed as

capital, maybe, Mr. Solomon, I think any of you could answer this,

but let us just take a typical partnership situation where three individuals decide they want to refurbish a building and then try to

sell it at a profit, and two of them will put up the money and one

of them will put up the labor, the electrical work, the contracting,

the plumbing, and everything else. If that were to be done and

then they sold the building at a profit, how would those profits be

taxed to each individual?

Mr. SOLOMON. The partnership is a flow-through entity, so when

the partnership sells the property, the character, which in this case

presumably would be capital gains, would flow through to all the

partners according to their partnership agreement.

Senator CRAPO. So the partner who contributed, effectively, his

labor would have his income treated as capital gains?

Mr. SOLOMON. Under current tax rules, that is the case and has

been the case for small and large partnerships for a long time.

Senator CRAPO. Now, you indicated in your testimony that there

were sort of three alternatives as to how we could approach this

in terms of tax and carried interest. I kind of took from your testimony, and I want to ask you directly, do you believe that each of

the three alternatives you described are inferior to the current

model and the current way that we do tax partnership income?

Mr. SOLOMON. Certainly the three proposals that we described in

our testimony raise significant issues. For example, one of them

would tax the receipt of the profits interest at the very beginning,

which would result in double taxation in a partnership situation,

which is clearly not the intent of the partnership rules.

Senator CRAPO. Thank you.

With the time I have remaining, I want to move to you, Ms.

Mitchell. And I do not know whether you will be able to answer

this question. I just want to see if I can flesh this out a little bit.

Let us assume that the United States were to change its partnership tax law along the lines of the idea that has been put out here

with regard to carried interest. Could a company like yours, a private equity or hedge fund simply move its operations to London

and obtain a more favorable tax climate and still conduct their

business?

Ms. MITCHELL. I do not know about the hedge fund or the private

equity side of things, but on the venture side there are certainly

funds being formed in Asia in particular, because there is a lot of

activity happening there, and the governments are very interested

in sponsoring that.

These foreign governments will help with lots of other infrastructure around those companies. So, there are funds being formed and

the flows of capital are international at this point into these kinds

of funds. Everybody wants to take advantage of the growth, and so

those funds are being formed overseas today.

23

Senator CRAPO. Would anybody else like to jump in on this issue?

Mr. Orszag, I saw you expressing some interest.

Mr. ORSZAG. I think it is important to distinguish the location of

the partnership from the location, ultimately, of the partner, the

general partner. The key issue here is, the general partner will

often be a partnership itself, but ultimately income, and the tax

due on that income, goes back to an individual.

Unless the individual is going to give up U.S. citizenship or make

other extreme changes, which is difficult to do under U.S. law, it

is very difficult to avoid that tax. This is different than a corporate

setting, basically.

Senator CRAPO. So are you saying that they would have to give

up U.S. citizenship or would they just have to move to London?

Mr. ORSZAG. No. My understanding—and I will defer to the tax

professionals—is that not only would they have to give up U.S. citizenship, but that it is difficult to avoid the tax. Even in that case

there are protections against that happening.

Senator CRAPO. Mr. Solomon, is that correct? Would a U.S. citizen not be able to just conduct business in London and avoid the

U.S. tax structure?

Mr. SOLOMON. I would think that there would be flexibility in

order to try to rearrange one’s business affairs.

Senator CRAPO. Ms. Mitchell? Oh, I am sorry. My time is up.

The CHAIRMAN. Thank you very much.

Senator Wyden?

Senator WYDEN. Thank you, Mr. Chairman. Mr. Chairman and

colleagues, the tax system in this country is broken. It is an incoherent mumbo-jumbo made up of millions of words, with three

changes being made to the tax code for every working day for several decades. Today’s hearing on carried interest is a textbook case

for why it is time to drain the tax swamp, specifically through tax

reform and tax simplification.

On the carried interest issue, knowledgeable people cannot even

agree on the problem, let alone a remedy. Chairman Baucus and

Senator Grassley say their legislation is needed so that certain

partnerships do not gain an advantage over corporations, while our

Secretary of Treasury, Mr. Paulson, opposes the Baucus-Grassley

legislation on the grounds that it singles out those partnerships for

different treatment from other investment businesses. So I think

right at the heart of this is the need to simplify the tax code. I do

that in my proposal, the Fair Flat Tax Act.

What I would like to do is start with you, Mr. Solomon. What

does it say about the grotesque complexity of the tax code when the

chairman of the Finance Committee and the Secretary of Treasury

cannot agree on whether the legislation eliminates an existing tax

preference to level the playing field or singles out one type of business for different tax treatment?

Mr. SOLOMON. I agree with you, Senator Wyden, that we need to

simplify the tax code. It is extremely complicated, and this hearing

is a testimony to how complicated it is. I would also note that our

corporate tax system is very complicated and it is distortive in that

it imposes two levels of tax.

The only observation I would make is that, in moving to any kind

of new tax system, we still may have to deal with issues similar

24

to these. For example, we would still need to have rules about partnerships, which is a very important part of the discussion that we

are having today.

Also, presumably in any new tax system we would still have a

differential in tax rates between ordinary income and capital gains

and dividends, and that differential is also an important part of our

conversation today.

Senator WYDEN. Mr. Orszag, rather than increasing the complexity of the tax code by defining carried interest as an exception

to capital gains, so you would have one rule for ordinary income

and a different rule for capital gains, and then still another rule

for carried interest, would it not be better to go back to the approach that Ronald Reagan and Bill Bradley came up with back in

1986, where all income was treated the same?

Mr. ORSZAG. I think there are a lot of factors that need to be

taken into——

Senator WYDEN. Excuse me. On the question of, would it be simpler to go back to what Ronald Reagan and Bill Bradley talked

about?

Mr. ORSZAG. It would be simpler. There are obviously other considerations also.

Senator WYDEN. Let me ask you then, because I have asked all

of the witnesses who have come before our committee. I may have

to do this on the second round. In 1986, Ronald Reagan and Bill

Bradley said it made sense to keep marginal rates down. That was

enormously important to President Reagan and Bill Bradley. They

also said you ought to clean out a lot of the clutter and keep progressivity.

But the two men said, on a bipartisan basis at that time, that

they did not think preferences were all that important in generating the kind of economic growth we needed. They thought marginal rates were very important, but they did not think preferences

were critical. Could you respond to that? Because I think you have,

in some of your analysis, said almost the same thing, and I think

it would be helpful to get your assessment of the impact of preferences.

Mr. ORSZAG. There is pretty widespread agreement among economists that a broader base and lower marginal rates associated with

that is a preferable tax system to one in which there are higher

rates and lots of scattered tax expenditures throughout the tax

code.

Senator WYDEN. Mr. Chairman, I will, on the next round, ask

what I have asked 16 witnesses before the Finance Committee,

whether on balance, rather than to continue to add clutter and one

bauble here and one bauble there, we ought to, on a bipartisan

basis, take the principles of 1986.

And I gather from the nods of some of our panel of witnesses,

I might have an opportunity to get witness 17 on behalf of my effort. Ms. Mitchell, do you think by and large that the principles of

1986—not all of the details and the like, but the principles of 1986,

remain sound today?

Ms. MITCHELL. The principles, I think, of 1986 remain very

sound. I would argue that what we are talking about today, the

Partnership Tax Code that has been in effect for over 40 years, also

25

operates simply. What we have been doing with our companies is

no different than we did 40 years ago.

It has not been distorted, it has not gotten more complex. The

goal being getting cash out of mattresses and short-term savings

into high-risk start-ups to get people to spend their time, not in

large, safe jobs, but to go work with riskier companies that create

jobs and long-term value.

Senator WYDEN. Thank you, Mr. Chairman.

The CHAIRMAN. Thank you very much.

Senator Bunning?

Senator BUNNING. Thank you, Mr. Chairman.

I do not think that anything that Senator Wyden said was new

since 1986. I have sat 8 years on the Ways and Means Committee

and 4 years on the Finance Committee now and, for every time we

change one tax rule or one thing, we change the tax code. So, we

have added how many thousands of pages since that time, Ron?

Senator WYDEN. The experts say that there have been 14,000

changes, three for every working day.

Senator BUNNING. Thank you very much.

I would like to ask Mr. Solomon and Mr. Orszag, when a founder

of a business builds up a profitable company over a long period of

time and then sells the company, Congress never has attempted to

tax the gain except as a capital gain.

We recognize that whenever an asset is held a long time, part

of that gain is simply inflation. Part of it. That is part of the reason

for the lower tax rate, because of the inflation that has taken place.

Do you believe it makes sense, is it fair, to tax gains from inflation

just like salary income, and how would you avoid taxing inflationary gains on carried interest? I would like to get an answer

from both of you.

Mr. SOLOMON. Senator Bunning, you raise a very important

point here. A sole proprietor begins a business, starts it from

scratch, and, through a combination of capital and a lot of skill and

labor, builds it up over many years and it creates goodwill and

going concern value. Many years later, if the sole proprietor sells

the business to someone else, it will result in capital gain, taxed

at the lower rate.

Mr. ORSZAG. On the question of inflation, economists would generally argue that it would be better not to tax the inflationary component of a capital gain.

Senator BUNNING. In other words, subtract it out?

Mr. ORSZAG. Subtract it out. However, it is important to remember that on the deduction side, with regard to interest payments

made, that you would also have to make a correction there or else

you would create opportunities for tax arbitrage. So if one is going

to take inflation out of capital gains, it also needs to come out of

the deduction side.

Senator BUNNING. On both sides of the equation then, you should

subtract the inflationary spiral or whatever took place during the

entity’s length of time before it was sold.

Mr. ORSZAG. There is an economic argument for doing so. That

would need to be weighed against the complexity and other things

that would be introduced.

Senator BUNNING. All right.

26

Mr. Solomon, since you are more with the Treasury than anyone

else——

[Laughter.]

Senator BUNNING [continuing]. I have to ask you the question

about other countries. Mike talked about it. If I were someone that

was starting a venture capital company, or a partnership, or something like that, no matter where I lived, and I went to London, is

the climate there better or worse?

Mr. SOLOMON. I cannot speak with precision about the climate

in other countries. I do know that other countries are very eager

to have venture capital and other entrepreneurial businesses come

to their locations. So as a person starting a new business, I would

certainly take tax considerations into account in deciding where I

start my business.

Senator BUNNING. Right. And, therefore, that entity, whatever it

might be—partnership, venture capital company, whatever—would

be taxed in England and then the persons responsible for that

money would be responsible for paying, wherever they lived, the

tax due in that country that they lived in.

Mr. SOLOMON. Our tax laws are very complicated, but there are

tax planning techniques that are used in order to——

Senator BUNNING. Avoid. It is called avoid.

Mr. SOLOMON [continuing]. Decide where to do business and

where tax is paid.

Senator BUNNING. All right.

Well, I just thought it was important because we are talking

about losing our stock exchanges and a lot of other things in the

capital centers of the world from present locations, and I want to

make sure that we do not add another peg in that problem. Thank

you.

The CHAIRMAN. Thank you, Senator. I might add for the record,

though, that the U.K. is going very deeply into the same question,

very deeply. There have been hearings in Parliament, inquiries, the

exchequer, the old Prime Minister, the new Prime Minister, former

head of the exchequer, they are deeply examining these very same

questions that we are examining in today’s hearing.

Next on the list is Senator Salazar. I might say, though, before

you proceed, we are scheduled to have a vote at 11:30. Why don’t

you proceed? Senator Grassley will continue. I am going to leave

right now to get there at the beginning of the vote, and then I will

come right back as soon as that vote occurs. We will just keep

going here. You are next.

If you do not mind, Senator, if you could just take over and I will

come right back. Next is Senator Bingaman after Senator Salazar.

Senator SALAZAR. Thank you very much, Senator Baucus. Let me

just say that I agree with the chairman in terms of his remarks

relative to the objectives as we undertake this examination, and

that is that we do not want to stifle the mother of investment. At

the same time, we want to move forward and we want to have a

fair and equitable tax code.

I am going to ask this question of all of you. I went out and

picked up a copy of the tax code, and it has gotten a little bigger

since the time I actually studied this and did a little bit of work

on it in the 1980s.

27

But it is very interesting. Even over the last 25 years, subchapter K, in most of its essential parts, has not been changed. I

was looking at section 702(b), which you said, Professor, is a place

where we ought to have a fix with respect to this issue of carried

interest.

That section, the relevant part, is very straightforward. It says,

‘‘The character of any item of income, gain, loss, deduction, or credit included in a partner’s distributive share’’ under the foregoing

section ‘‘shall be determined as if such item were realized directly

from the source from which realized by the partnership, or incurred

in the same manner as incurred by the partnership.’’

It is the flow-through concept of the partnership down to the individual partners so you do not have the double taxation that I

think is a central concept of partnership law.

But my question to each of you is this: Professor Gergen has said

that we could do a fix with respect to 702(b) that would address

the issue of carried interest. My question is, what would be the

consequence of that in terms of the venture capital industry that

has been playing such a significant role in our economy to date?

Maybe what we could do is just start down the line. First, with

you, Secretary Solomon, and then just coming across. What would

be the impact if we were to take Professor Gergen’s suggested

change with respect to 702(b)? What would that do to the venture

capital industry in America today?

Mr. SOLOMON. It would change the returns to the parties. The

deal between them would have a new tax aspect. Presumably they

would negotiate their deal in a slightly different way and

reduce——

Senator SALAZAR. I know the consequences. Would we have less

venture capital in the U.S. because of a change in the tax code to

702(b)? Would it dampen what is happening with venture capital

in America today? Give me a paragraph’s statement about the

consequences of that in terms of the venture capital industry that

we have.

Mr. SOLOMON. As I said, it would affect the deal between the

parties. It would reduce the return to the parties and, therefore,

have consequences with respect to venture capital.

Senator SALAZAR. Peter?

Mr. ORSZAG. It would have a variety of effects. To the extent that

the investors in the funds are taxable entities, it actually could increase the benefits to participating because, if you provide ordinary

income to the general partner, there has been a corresponding deduction provided to the limited partners making the investment.

That deduction is more valuable than the current tax treatment.

So, to the extent that there are taxable entities or taxable individuals investing in the venture capital world, the change would actually, if anything, encourage more capital flow rather than discourage it.

Senator SALAZAR. So your view, then, from the Congressional

Budget Office, is that it would encourage more venture capital?

Mr. ORSZAG. No, no. I said I agree that most of this is a reallocation across different types of partners, but to the extent that someone is taxable, and if you are just looking at relative tax burdens

for the general partner and the limited partner, ordinary income

28

deduction flowing through to the limited partner could be more valuable than the current tax treatment.

Senator SALAZAR. All right.

Mr. Donohue?

Mr. DONOHUE. I do not believe I necessarily bring any particular

expertise to this discussion on this point, so I will defer to my colleague in Treasury.

Senator SALAZAR. Ms. Mitchell?

Ms. MITCHELL. I respectfully differ with Mr. Orszag, that I think

it would result in less capital going into venture. One of the issues

we have with the venture asset class is not only is it cyclical, highrisk, and long-term, it is small.

It is inefficient for these pension funds, endowments, and private

charities to put money into all these small funds. So, already we

are an asset class that is less attractive because we are less efficient for them.

If the cost of doing business becomes higher for the funds, it is

going to be one more issue that makes us less attractive overall for

limited partners who want to put money to work, which will reduce

the number of new companies that are formed.

Senator SALAZAR. Thank you.

Dr. Gergen, it is your idea. What is the consequence here on venture capital?

Mr. GERGEN. I am not an economist, but Ms. Mitchell’s concern

assumes that the people who are providing labor and venture capital have just as good alternatives where they can make just as

much, and so, if you lower the yield to them by a fraction, they are

going to go do something else. I am dubious.

Senator SALAZAR. All right.

Ms. MITCHELL. Well, I would remind folks that I can lose money

in this business, too. It is not just making money, I can lose it.

That is different than the other opportunities that I have.

Senator SALAZAR. All right. Thank you not only for the response

to my questions, but for the excellent testimony today.

Senator GRASSLEY. Now, Senator Bingaman.

Senator BINGAMAN. Thank you, Mr. Chairman. Thanks for having the hearing.

I was talking to a partner in a private equity firm, and his comment to me was, there is no justification for giving me different tax

treatment on carried interest than you give someone who spends

5 years writing a book. I would be interested in any of you responding to that. Is there a justification for giving him different tax

treatment than you give somebody who spends 5 years writing a

book? Mr. Solomon?

Mr. SOLOMON. I think there is. The partnership tax system and

the partnership system as a whole is about pooling ideas and skills

with capital and bringing them together and allowing the partners

to allocate the economics of their deal. Therefore, I think there is

a benefit to allowing the pooling of capital and ideas.

Senator BINGAMAN. The fact that capital is added to the equation

in the case of a partnership gives adequate justification for charging 15 percent for the compensation for the individual who does not

put capital in?

29

Mr. SOLOMON. I would look at it in a slightly different way, that

the manager in a particular case could go out and borrow money

himself and engage in a similar enterprise and get capital gain

treatment.

For example, the person who has the idea about buying a particular stock. Rather than having another investor, he could presumably go out and borrow the money from a third party and make

the investment entirely by himself. If the property is held for more

than a year and is sold, he would get a 15-percent tax rate on the

gain.

Senator BINGAMAN. Mr. Orszag, did you have a thought about

this comment as to whether there is a justification for different

treatment for someone writing a book and someone managing

money or investing money through one of these organizations?

Mr. ORSZAG. Well, there certainly is a difference relative to investing money through one of these organizations, but I would go

back to the broader point that I had emphasized, which is that

there is a wide variety of performance-based labor income that occurs in the United States. The example you were putting forward

was one of them.

Most analysts believe, to the extent the general partner is providing management services to the limited partners, that is a form

of performance-based labor income.

Senator BINGAMAN. Another example of performance-based labor

income, it would seem to me, would be contingent fees on lawsuits.

I mean, if a lawyer agrees to take a case and works at it for 5 years

and then gets a judgment, and has agreed that he will take no fee

unless that judgment is successful or that case is successful, we

currently tax that as ordinary income to that lawyer, as I understand it. Why would we do that? Why do we not give him capital

gains treatment on his part of that judgment or that contingent

fee?

Mr. ORSZAG. I would view the question slightly differently. That

is to say, it is ordinary income in that case, whereas, if I buy stock

or participate in a joint venture to buy stock, the underlying gain

is capital gain.

It is important to note that, with respect to carried interest, it

is not all capital gain. That is to say, it is a flow-through from the

partnership and therefore it depends on what the underlying income is.

If the underlying income was from some sort of contingent fee

that the law partnership earned, it would be taxed as ordinary income. If the underlying income was from the acquisition of a capital asset, it would flow through and be taxed at capital gains

rates.

Senator BINGAMAN. I guess the concern I have had, though, and

I think, Ms. Mitchell, you made the point several times, is that

these are investments that venture capitalists make for the long

term, and also that these are risky.

I mean, I think you could find a lot of lawyers who would say,

if I take a contingent fee case, it is a long-term commitment because it takes a long time to get one of these things to judgment,

if at all, and it is risky because I may wind up with nothing after

5, 10 years of work on an issue. Why should we not give capital

30

gains treatment to that lawyer on his part of the judgment, on his

contingent fee?

Ms. MITCHELL. Well, my understanding of the intent behind the

original capital gains treatment was to attract long-term capital, to

build jobs, to build growth, and to build exports. The difference between what the lawyer gets is, he gets his own payment. He has

certainly put time at risk.

We are building companies—again, the Starbucks, the Genentechs, the eBays—and that is what the tax code is meant to encourage, the building of entities that will contribute overall to the U.S.

economy and go beyond any individual ultimately, and hopefully

build a lot of jobs so a lot of people benefit from that entity being

formed.

That was the objective of encouraging people to spend time and

contribute capital together in a partnership to build that kind of

business generation and to fuel what we have done successfully in

the U.S. economy.

Senator BINGAMAN. My time is up. Thank you, Mr. Chairman.

Senator GRASSLEY. Senator Kyl?

Senator KYL. Thank you, Mr. Chairman. I always learn something at these hearings, but I am not sure that what I learn is always true. Director Orszag, your concept that a higher tax rate

could actually encourage investment, I put into that category.

Mr. ORSZAG. Well, can I——

Senator KYL. No. I think your explanation of that would take far

too long, given the brief amount of time I have.

Let me ask you this instead: do you think there is any connection

between the Bush tax cuts and the lower tax rate on investment

income, like capital gains and dividends, and the fact that revenues

grew from $1.78 trillion in 2003 to almost $2.5 trillion in 2006,

about a 35-percent increase?

Mr. ORSZAG. There is some evidence that the tax reductions that

were enacted in 2001 and 2003 had some beneficial effects in spurring economic activity. Most of the revenue gain that has occurred

since 2003 has occurred in the corporate income tax and not in the

individual income tax, when you view revenue as a share of the

economy.

Senator KYL. Let me also ask Professor Gergen, synthesizing

what you said, I think, it is not fair to tax labor income at the capital gains rate. That is a significant summary of what you said. But

I gather that the reason for that is, ordinarily we are taxing the

capital gains at the lower rate because it is on income that has already been taxed at least once. Is that the primary theory for that?

Mr. GERGEN. It is a theory. Inflation is another theory. There are

many explanations for the capital gains rate.

Senator KYL. But the idea is, there is a rationale, a justification

for imposing a lower tax there because there has already been

some other payment.

Let me ask Secretary Solomon a couple questions. Is the current

tax law treatment of carried interest consistent with the main reasons that Congress enacted the lower individual tax rate for longterm capital gains, in other words, to encourage entrepreneurial

risk-taking, reduce double taxation, and to some extent permit

locked-in effects?

31

Mr. SOLOMON. Yes. The current tax treatment of partnerships

with a single level of taxation is consistent with that. Corporations,

as you mentioned, have two levels of taxation: first, earnings are

taxed at the corporate level at 35 percent, and then there is a second level of tax, at 15 percent, with respect to shareholder dividends or capital gains. So, to the extent that one can reduce the

level of taxation on dividends and capital gains, you would reduce

the distortions caused by the double taxation.

Senator KYL. And as a follow-up to that, regarding potential distortions, anyway, given the broad use of the carried interest structure across a variety of different kinds of business and investment

forums—and I have in mind, for example, real estate, which I am

somewhat familiar with, to venture capital, to small start-up businesses, the kind of things that Ms. Mitchell is talking about—

would it be rational tax policy to recharacterize the treatment of

carried interest for some types of businesses but not for others?

Mr. SOLOMON. From a tax policy viewpoint, you would want to

have a consistent rule for all businesses. So in considering these

issues, you would want to look at all the different kinds of businesses that you referred to, both small business and large business,

and all types of business. For example, real estate is a very good

example where these concepts are used. Carried interest is a concept in real estate that has been used for decades.

Senator KYL. And with regard to your conclusion that changing

the carried interest rule alone as opposed to the second question

that Senator Grassley asked which you were less clear in your answer on, these are two of the rationales for not making a change

in the carried interest rule then, the two questions that I have

asked you, the differential that would have to then exist if you

tried to differentiate different kinds of businesses, number one, and

second, the encouragement of the entrepreneurial risk-taking and

the like.

Mr. SOLOMON. I agree with both of those points.

Senator KYL. All right. Mr. Chairman-to-be-in-the-future-I-hopesoon-Grassley, thank you. [Laughter.]

Senator SCHUMER. Not if I have anything to do with it.

Senator GRASSLEY. Senator Ensign?

Senator ENSIGN. But if I have anything to do with it. Thank you.

Thank you, Senator Grassley. Thank you for your kind words welcoming me to the committee. I am very excited to be here. My time

over on the Ways and Means Committee on the other side of the

Capitol gave me a real passion for the issues that we deal with.

Senator Wyden, I thought, said some very good things about the

complexity of the tax code and the inconsistencies that we have in

the tax code, and the way that that skews investment many times.

Venture capitalists know, they look for ways, and one of the reasons that money flows certain directions sometimes, almost it flows

in the direction of least resistance.

If we want to look at other countries as models, we look at Ireland. Ireland is a great example of one of the worst economies in

Europe to now one of the best, if not the best, economy in Europe.

They did it based on several different policies. One of the major

policies they did there was based on their tax policy and lowering

their tax rates.

32

Lowering tax rates attracts capital. The idea that we would now

want to raise rates—and make no mistake about it, if you go from

a capital gains rate to an ordinary income tax rate, you are raising

tax rates—and hurt investment in this country, I think is an absolutely dangerous idea. The fact that we would be taxing partnerships and taxing the sweat equity in those partnerships is also a

very dangerous precedent.

I can speak from experience. I was a veterinarian who started a

practice, had investment capital in the building and land, but had

zero investment in my practice. When I sold my first practice I had

built up sweat equity. One hundred percent of it was sweat equity,

taxed as a capital gain.

To try to go after the mega-rich in some of these private equity

firms and the like, you are going to be setting a dangerous precedent. That is why, actually, I am glad that Mr. Gergen is here, because he has clearly laid out that he wants to go after all labor and

tax it as ordinary income.

So I am glad he his actually very, very clear on what he wants

to do, and I think that is good that he was here to lay that out.

I think that if we start this precedent of going after labor and taxing it as ordinary income instead of a capital gain, I think that we

are setting a precedent to do it across the board.

As Mr. Solomon has laid out, we need consistency in our tax laws

across the board. To try to pick and choose who is going to get this

carried interest and how it is going to be treated, I think, is a very

dangerous road for us to go down.

Another comment I would like to make, is this idea that capital

does move around the globe at the speed of light today. It literally

goes in places, and is going to be invested in places.

And whether you are a U.S. citizen or not, the fact that, if you

look at these private equity funds, who is investing in these private

equity funds, it is not just American citizens. It is the Chinese government, it is governments from all over the world. We want that

capital to come to the United States.

We do not want to say, no, do not bring it here. We are going

to tax you at a higher rate, so do not bring it here. So the fact that

this proposal that has been floated out there is being taken seriously, I think, is wrong-headed. We need to be looking at policies

that make us more competitive, not less competitive.

We need to attract more capital, because capitalism is a simple

prospect. Without employers, you do not have employees. Well,

without capital, you do not have employers, which means you do

not have employees. What you are doing in the venture capital

market is creating jobs. It is a good thing: taking risks, rewarding

entrepreneurs.

That is a good thing and we should be looking, this committee,

as policymakers, at rewarding risk-taking, not at taxing them at

higher rates and basically punishing them. And so I think that we

have to look at what these policies are going to do, not only with

the direct consequences, but also with the unintended consequences.

Sarbanes-Oxley. Mr. Chairman, you brought up the fact that

Great Britain was looking at this. When we were considering Sarbanes-Oxley, they said that Great Britain and Europe were looking

33

at doing Sarbanes-Oxley-type things. Now look. Is it a better place

to go into the public markets in New York City or in London? If

you are going to go on the public markets today because of Sarbanes-Oxley, it is better to go over to London because the regulatory climate is better there. Once again, there is less resistance.

So, Mr. Chairman, I would have loved to spend the time asking

some questions, but I thought it was important to get some of these

statements on the record because the precedents that could be set

here and the unintended consequences of some of the legislation

that is being considered here, I think, are very, very serious and

we need to take a very cautious approach to this.

The CHAIRMAN. Well, thank you.

Senator ENSIGN. I thank you for your time.

The CHAIRMAN. Thank you, Senator. Welcome to the committee.

Senator Schumer?

Senator SCHUMER. Thank you, Mr. Chairman. And I very much

appreciate it. I apologize to the witnesses that I have not been here

on an issue of great concern to me. We have Sara Taylor testifying

in the Judiciary Committee on the U.S. Attorneys, so, as luck

would have it, two of the most important hearings I could attend

are exactly at the same time.

First, I want to thank the chairman and ranking member for

these hearings. I appreciate that the chairman and ranking member are trying to learn as much as they can, and that they have

not rushed to introduce a more comprehensive bill, but rather we

are studying this issue carefully.

Obviously, being the Senator from New York on the Finance

Committee, my phone has been ringing quite a bit lately since the

recent bills have been introduced in the House and Senate.

I have been trying to learn as much as I can about the issues

at hand, and I am carefully studying the Baucus-Grassley and

Levin-Frank bills. I want to spend a moment to talk about some

of the issues that are important to me and the pros and cons of

taking action in this area, because these issues are important not

just for New York, but for capital formation in the whole U.S. economy.

On the pro side of taking action is the issue of pay-go. Previous

Congresses did not keep the commitment to pay-go. I believe we

are doing the right thing by reinstating the rule. If Congress wants

to undertake new initiatives, we should be able to pay for them so

we do not run up the debt burden of our kids even further, and we

need new programs in education, infrastructure, energy, just to

name a few. We should be paying for them.

Another reason is that, if we must raise revenues, and we must,

the likely and logical place to do it should be at the very highest

end of the income scale where average tax rates have actually been

declining. Wealth and income have been agglomerating to the very

richest in our economy at an amazing rate, not necessarily because

of the actions of government, but because of the ways of the world

and the economy. They have changed. When you deal with intangibles, which we do, wealth agglomerates to the top.

Consider some of these statistics, keeping in mind that the top

1 percent means families earning over $400,000 in today’s income:

the top 1 percent of households in income received 22 percent of all

34

pre-tax income in 2005. That is up from 14 percent in 1990 and 10

percent in 1980.

There are different estimates out there. Nearly all of them show

the share of income going to the top 1 percent has more than doubled in the last 25 years. On capital gains, implicit in today’s discussion, the top 1 percent received 60 percent of all capital gains

income in 2004, up from 49 percent in 2000, 38 percent in 1979.

So, if we are going to raise revenues to pay for things, we have

to look at the highest income earners because they are earning so

much more. This is not to say we should reflexively raise taxes on

the wealthy at every opportunity; I do not believe in that. But it

is simply to point out that incomes at the top have been going up

rapidly, while average tax rates have been declining.

But there are also things to consider on the other side. I think

it is important for our tax code to continue to provide incentives for

risk-taking and entrepreneurship, because new ideas and businesses create good jobs. I have never had a problem with general

tax preferences for capital gains and dividends, and I have supported lower capital gains rates in the past, particularly when we

were in more of a surplus situation.

Another important consideration vital to me is that, no matter

what we do ultimately about these issues, the United States and

New York must remain the leading country and city in the world

for financial services and capital formation, and we should not do

anything to jeopardize that position and make it easier for capital

and ideas to flow to London or anywhere else. I will fight as hard

as I can to protect the interests of New York and ensure that it

remains the preeminent financial center of the world.

Along these lines, I am also concerned we make sure all forms

of businesses and partnerships are treated fairly and equally, that

we do not single out one type of business because people in that

line of business are making a lot of money, have their names in the

newspaper, or come from one particular region of the country.

In the end, I will not stand for treating financial service partnerships one way while all other partnerships are treated another

way. This is not to say that we should make no changes. I am

wrestling with these issues about carried interest, how hedge funds

are taxed. But treat everyone fairly.

If we are going to change how we tax financial partnerships, we

should treat oil and gas, and venture capital and real estate, and

everything else the same. My State may depend on financial services; Texas may depend more on oil and gas. It is unfair to treat

one region differently than the other when you are dealing with the

same structure.

So I want to thank the chairman for being thoughtful and deliberative in this. My question to the panel, since I have one second

left, I see here, is just this: what is your view on how imposing any

of these taxes will affect New York as the preeminent financial capital of the world? Anyone? There is a dispute.

Some people say it will not affect it at all, some people say it

will. Some people say some of the issues will, some will not. When

you are dealing with personal income, it is a much bigger change

because you have to become a citizen of another country. Fire

away.

35

The CHAIRMAN. Briefly.

Senator SCHUMER. Briefly. They could submit them in writing if

you want, Mr. Chairman.

The CHAIRMAN. No, go ahead. If you want a response here, briefly.

Mr. SOLOMON. We should be cautious about making significant

and potentially unsettling changes in the tax law in an area that

has worked well to support entrepreneurship and risk-taking for

many decades.

The CHAIRMAN. Mr. Orszag?

Mr. ORSZAG. Again, I would come back to some of the earlier discussion. Proposals that are under discussion do not change the tax

treatment for the limited partners who are putting up almost all

of the capital in these types of partnerships; therefore, it is not

clear that there would be any significant effect from the types of

changes that are being considered.

The CHAIRMAN. Mr. Donohue? I will give you a shot.

Mr. DONOHUE. One of the statutory missions of the Securities

and Exchange Commission is really the promotion of capital formation. We would urge the panel and the Senate in considering these

issues to look to the promotion of capital formation with respect to

any changes that might be made.

The CHAIRMAN. Ms. Mitchell?

Ms. MITCHELL. Senator Schumer, from the venture capital perspective, there are really two issues. One, you do have a fledgling—

and I would say far beyond fledgling—venture capital business in

the State of New York, Silicon Alley, I think it is called there, and

it is doing quite well. I think there would be less capital that would

be attracted to that, and as a result, fewer IPOs that would be

going public on the domestic exchanges.

Mr. GERGEN. I would think it odd if a marginal increase on the

tax on returns to labor at the highest sector in the economy had

any significant effects on the allocation of capital.

Senator SCHUMER. As you can see, this is what makes my job a

particularly hard one here.

Could I just ask unanimous consent that I ask some follow-up

questions to all of the panel on this?

The CHAIRMAN. Yes.

Senator SCHUMER. Because my time has expired, and I have to

go vote.

The CHAIRMAN. Fine. Thank you.

Senator SCHUMER. Thank you.

The CHAIRMAN. Thank you very much, Senator.

[The questions and answers appear in the appendix.]

The CHAIRMAN. I am a little curious. Is there a difference among

industries? That is, if, clearly, services were compensated at the ordinary rates and capital contribution on gain was compensated at

capital gains rates, is there a difference among industries, private

equity, hedge funds, venture capital, real estate, oil and gas, farmers, ranchers, other partnership entities? Is there any difference at

all?

If this committee is going to go down this road of trying to separate out what is capital, what is services and say the character of

income obviously is ordinary for services and capital gains for capVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00045 Fmt 6633 Sfmt 6633 53637.000 SFIN1 PsN: SFIN1
36

ital gain, is there any difference among the industries that basically use this feature of carried interest? I will just go down the

line here, very briefly. Mr. Solomon?

Mr. SOLOMON. I think the issue is the same across all industries.

The basic situation here is that someone puts in capital and someone puts in know-how. There is an allocation of some of the income

to the person who put in the know-how. That is true for all kinds

of partnerships.

The CHAIRMAN. So you say it is basically the same.

Mr. Orszag?

Mr. ORSZAG. I think the underlying issues are basically the

same.

The CHAIRMAN. All right.

Mr. Donohue?

Mr. DONOHUE. I would concur.

The CHAIRMAN. Ms. Mitchell?

Ms. MITCHELL. I concur.

The CHAIRMAN. So you do not think the VC folks put a little

more extra sweat equity into developing Googles and so forth than

other industries? You think it is all the same?

Ms. MITCHELL. I can only speak to mine because I am not an expert on theirs. I think the hard thing is, how do you define it? The

investment class, it is almost a continuum, and so it is hard to segment what is venture capital versus buy-out.

I am not as familiar with the hedge fund business in particular,

so I think the hard part is differentiating it. I do think that the

thing that venture does is create more jobs, and I think that is a

positive. But I would say that there are probably arguments that

will be made in your second hearing that may address this.

The CHAIRMAN. All right.

Professor Gergen?

Mr. GERGEN. There are two differences. One, partnership tax law

is very complicated. Small businesses really cannot comply with

current law, and many of them do not. That is just one dirty secret

of partnership tax law. The system is more than most small firms

can comply with.

But the second, and really the tough issue here, is not the sweat

part, but the equity part. When somebody is bringing not just labor

but also intangible assets they might well characterize as capital,

that raises an interesting question: which of these are we going to

actually see as capital contributions, and then treating them as

capital contributions.

Should this be ordinary income because under 1221 it is like a

painting, or is this more like the goodwill you have built up in a

business that we do not treat under that rubric?

I think as we went across industries we might come to different

judgments on that conclusion. That is, the actual know-how that

they are contributing, intangible property.

The CHAIRMAN. That leads to my next question. You touched on

assets, Mr. Orszag. Although it adds additional complications, does

it make sense to get some kind of a blend, some kind of an assessment that is an intangible, that feels like, sounds like, walks like

capital and should be taxed at capital gain rates? Whereas, other

labor and whatnot should not.

37

I mean, do we want, if we go down this road, a bright-line test

or should it be a blurred line test which adds in more complexity?

Mr. Orszag, you raised the issue a bit so I will start with you.

Mr. ORSZAG. Yes. And I do think there is a perspective that

many outside analysts embrace, that when you get 20 percent of

the profits on a fund it is as if the limited partners are letting you

borrow for free 20 percent of the capital, and so that one could then

treat the carried interest as having two components.

One is the implicit interest on that loan transaction, which is basically effectively the bond rate of return, treat that as ordinary income, and then anything above and beyond that would be treated

as capital gains or capital losses. I think that there are people who

believe that that would be the appropriate treatment to adopt in

this case.

The CHAIRMAN. Do you have a view on that?

Mr. ORSZAG. I am not allowed to have views any more. [Laughter.]

The CHAIRMAN. All right. In some sense, that is true.

Mr. Donohue?

Mr. DONOHUE. I do not have a view on that.

The CHAIRMAN. All right.

Ms. Mitchell?

Ms. MITCHELL. Well, most of what we contribute are intangibles,

contacts, all the work that we provide. I think one of the difficulties—and I will probably offend at least half the people in the room

when I say this—is it will probably mean a lot more business for

accountants and lawyers, trying to differentiate intangibles from

other effort. I think it will make the process of implementing this

more complex rather than less.

The CHAIRMAN. All right.

Professor Gergen?

Mr. GERGEN. Intangible assets make it more complicated.

The CHAIRMAN. But is it worth the effort? And to argue in favor

of services as ordinary income, though you say it is not totally

black and white. Is it worth the effort?

Mr. GERGEN. I think if you did something that allowed people to

avoid the problem by making the 20-percent interest, in effect, a

non-recourse loan, and then you had a very low imputation rate,

in effect you have now solved the problem because they will avoid

the complication, avoid hiring the accountants, take a modest hit

of what is compensation, which is a low imputation rate on a nonrecourse loan. So, you have picked up at least some ordinary income on some of the labor.

On the other hand, you could make it complicated, deny them

that option, and then the tax law looks really, really, really complicated and it is hard to enforce. We try then to nail down what

is an intangible.

The CHAIRMAN. Thank you.

Senator Wyden?

Senator WYDEN. Thank you, Mr. Chairman.

Let me start with you on the point that Senator Schumer just

made, because I think it is an important one. The Wall Street Journal columnist Alan Murray recently wrote: ‘‘All sorts of partnerVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00047 Fmt 6633 Sfmt 6633 53637.000 SFIN1 PsN: SFIN1
38

ships, including real estate, oil and gas, rely on the same tax

tricks, essentially, as investment partnerships.’’

So what he says is, in effect, if you make the kinds of changes

that I am advocating, essentially what Reagan and Bradley agreed

to in 1986, that you eliminate the carried interest problem and that

you address Senator Schumer’s important concern, that you are

not, in effect, advantaging one part of the country or one industry

over another.

Tell me how you would disagree with Alan Murray on that point.

Mr. SOLOMON. From your description, what is a little uncertain

to me is whether the different treatment for capital gains and dividends would continue to exist as compared to ordinary income.

Senator WYDEN. No. He is advocating the abolition. He says that

there is plenty of investment capital out there now. He, like me,

believes that marginal rates are hugely important in terms of investment, as they did in 1986, but not preferences. I am just curious whether you disagree with any of that.

You have said very favorable things, much to my delight, about

the 1986 approach in the past. I just want to see if you still think

that that kind of frame is fundamentally sound. It definitely is a

solution to this carried interest question.

Carried interest is more complexity, more lawyers, more mumbojumbo. It will be a lawyer’s full employment program and it will

add another batch of changes to the code. I think there is a solution out there, and I am wondering if you disagree, particularly

with what Mr. Murray had to say.

Mr. SOLOMON. I think lower tax rates are good, but I do believe

that the preferential rate for capital gains and dividends promotes

economic growth.

Senator WYDEN. Mr. Orszag, do you want to assess what Mr.

Murray said? Mr. Murray also went on to say—and maybe you

have an assessment of this as well—with the world awash in investment capital, there is no need for a tax incentive to encourage

more.

In effect, the argument would be, if all capital gains, including

carried interest, were treated as ordinary income, how would that

take away opportunities for investors to go to venture, private equity, hedge funds, everything else and do it in a way that did not

compound Senator Schumer’s problem? Mr. Orszag?

Mr. ORSZAG. Well, there are lots of considerations in evaluating

the capital gains tax rate. The most traditional is the effect on capital formation and economic activity. CBO has previously stated

that empirical evidence on such effects is modest, that is, that

there is only a modest effect from a preferential rate on economic

activity, saving behavior, what have you.

Another factor that does need to be taken into consideration is

the complexity and the potential distortions of behavior that come

from taxing different types of income in different ways, and the

complexity that we are struggling with today is a manifestation of

that.

Senator WYDEN. Well, that is sure helpful for my case, and I appreciate that.

Professor, would you like to add something to it? You have been

a tax reformer. What is your take, particularly on the basic prinVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00048 Fmt 6633 Sfmt 6633 53637.000 SFIN1 PsN: SFIN1
39

ciples of 1986 providing a solution to this carried interest question,

and also moving our country in the right direction in terms of tax

policy?

Mr. GERGEN. If you get rid of the capital gains preference, you

make the problem worse. If you get rid of the capital gains preference and do not fix anything else, you make the problem worse.

Senator WYDEN. Well, we would, of course, do exactly what was

done in 1986. Yes. I am not talking about just capital gains. I am

talking about lower marginal rates, cleaning out clutter, ensuring

progressivity, having a 1-page 1040 form, and, yes, having all income treated the same.

Mr. GERGEN. It is a wonderful idea, except the real problem with

trying to tax investment yields is not the preference, it is the timing option, the ability to realize it when you want to realize it and

the basis step-up in debt. That led to lots of games-playing, so you

had capital gains shelters in the late 1990s and early 2000s, and

the ordinary income tax shelter fix did not address that.

Senator WYDEN. But the late 1990s is when we brought it back.

Mr. GERGEN. That is not a function of the capital gains preference. The capital gains preference is trying to fix an already very,

very leaky ship, or trying to at least adjust it in a way where we

do not think it will run on a reef.

If you really want fundamental tax reform, go to a cash flow consumption tax or a value added tax and stop trying to tax returns

on capital. That would then solve this problem and you would have

something simple. But if you do not fix the realization rule, you are

not going to make the tax code all that much simpler.

Senator WYDEN. We will put you down, and I will ask the rest

in writing, as the first person of the 18 witnesses before the Finance Committee who did not think the 1986 approach made some

sense, and we will look forward to talking to you about it some

more.

Thank you, Mr. Chairman.

The CHAIRMAN. Thank you, Senator.

Senator Hatch?

Senator HATCH. But what would we do without the IRS and all

of those employees? I mean, my goodness. I just cannot imagine the

upheaval that would occur. I think we all want tax reform. Personally, I agree with you and Mr. Gergen. The best and most simple

way to do it might be a consumption tax. Then people could spend

whatever they want and pay whatever taxes they want. However,

getting there is a very, very tough thing to do.

Ms. Mitchell, I would like to just spend a little time with you.

I remember years ago when limited partnerships were primarily

used to find tax losses and to give people tax benefits and tax

breaks rather than actually create businesses, but you are in a different era.

You are running a venture capital firm that literally, among

many others—we have had hedge funds that have 13,000 or more

businesses—that basically are stirring the venture capital drive in

this country and helping companies to grow.

Let me just ask you this. You mentioned that you have invested

in biotechnology through your fund. As I understand it, the average

new biotechnology therapy—I hate to call them drugs, because they

40

are large molecules and are really not drugs, but let us call them

drugs for the purpose of simplification. It costs about $1.2 billion

to develop a major biotechnology drug, is that not correct?

Ms. MITCHELL. It can be that much.

Senator HATCH. So it is a very risky business, right?

Ms. MITCHELL. Absolutely.

Senator HATCH. So when you ask people to invest with you so

that you can then invest in biotechnology, you have a pretty high

risk there. Is that right?

Ms. MITCHELL. And it takes 16 years from the origination to the

time you can——

Senator HATCH. If you are lucky.

Ms. MITCHELL. And at the end you may not succeed.

Senator HATCH. I only chose that one issue to show, if we do not

have these venture capital firms, we might not have the future in

front of us with regard to development of biotechnology, which may

be one of the ways we might be able to ultimately keep health care

costs down, although they are enormously expensive right now because of the amount of capital that has to be invested. Right?

Ms. MITCHELL. That is the hope. Exactly.

Senator HATCH. And you are really rolling the dice when you invest in some of these ventures, are you not?

Ms. MITCHELL. They can be hugely binary risks: you can put a

lot of money and a lot of effort and——

Senator HATCH. Do you always make profits in your business

and in your investments?

Ms. MITCHELL. No.

Senator HATCH. About what percentages? This is maybe a little

unfair to do this to you.

Ms. MITCHELL. No, I would be happy to. Forty percent lose

money, 40 percent get very modest returns, simply return the capital to the fund, and only 20 percent, in a good fund——

Senator HATCH. So if you are lucky, with a good fund, 20 percent

of your investments make——

Ms. MITCHELL. And some of the investments do not make money.

There are entire funds that are unsuccessful in making money.

Senator HATCH. Could you tell us some of the successful companies that you have helped?

Ms. MITCHELL. Well, one is in the State of Utah, a company

called Omniture that went public about a year ago.

Senator HATCH. Sure.

Ms. MITCHELL. It has been quite successful. We have been invested in a company, a biotechnology company, called Orexigen

that also went public this last year. A company in Washington, Seattle Genetics, as well, with, again, very early cancer therapies.

Senator HATCH. But would you have done that, would you have

invested in these——

Ms. MITCHELL. No.

Senator HATCH [continuing]. These idea companies if you did not

have the current track——

Ms. MITCHELL. Absolutely. I agree. Senator Hatch, the issue is,

there is a lot of investment capital out there. The issue is, can you

find venture partners and founders who are willing to spend the

41

time working those for that long period of time to get to that fruition.

Senator HATCH. It is unfair to ask you about hedge funds, but

the fact of the matter is, we have 11,000 or 12,000 of those. Maybe

I can turn to Mr. Solomon on hedge funds. Not all of them make

money, is that not right?

Mr. SOLOMON. That is correct. Not all of them make money.

Senator HATCH. But the ones who are successful, who really

make the correct investments, as Ms. Mitchell has done, at least

20 percent, and maybe 40 percent if you count just modest returns,

they can make some pretty good money out of the hedge fund business. But it is really a matter of capital risk, is it not?

Mr. SOLOMON. That is correct.

Senator HATCH. And if you do not have the incentives for capital

risk, then it is tough to get the capital to do it. Right?

Mr. SOLOMON. That is correct.

Senator HATCH. Well, what concerns me is, I am basically a tax

cutter and I really believe that we have benefitted tremendously

from the Reagan tax cuts, from the Bush tax cuts. I believe those

are some of the things that are driving this economy right now.

Would you agree with that, Mr. Solomon?

Mr. SOLOMON. Yes. I believe that the lower tax rates, and the

lower rates for capital gains and capital investment, have contributed to economic growth.

Senator HATCH. Now, Mr. Gergen, you did not quite agree with

that, as I understand it.

Mr. GERGEN. I think there are mixed effects. CBO has found

there are two effects from a tax reduction. One is, to the extent it

is deficit-financed over the long term, that imposes a drain on the

economy.

Then there are effects from lower marginal rates that can encourage economic activity. The net impact over the long term is

from both of those components, and you usually get pretty modest

effects, either positive or negative, as a result.

Senator HATCH. But these are marginal rates that are benefitting Ms. Mitchell.

Mr. GERGEN. I’m sorry?

Senator HATCH. These are mainly marginal rates that are benefitting Ms. Mitchell.

Mr. GERGEN. If we are now talking about the specific case, again

I would just come back to, to the extent that the limited partners

are tax-exempt, you are not changing any tax treatment for them,

and they are the ones who are putting up the capital in these

funds.

Senator HATCH. Yes. But Ms. Mitchell, as the leader, is taking

the risk of being sued, of going through untold bankruptcy, maybe,

and other types of difficulties. That is why we did this to begin

with.

I have real difficulties thinking we are going to just start taxing

because some people make a lot of money. I want people to make

a lot of money because they create businesses and opportunity. I

know I am taking a little bit more time than I should, Mr. Chairman, but we are the only two here so maybe I can get away with

it. [Laughter.]

42

The CHAIRMAN. Briefly.

Senator HATCH. Just briefly, I want to congratulate you, Ms.

Mitchell, and all of those companies that are spurring America on,

in spite of Sarbanes-Oxley, which I think has been highly detrimental.

It was well-intentioned, but now highly detrimental because we

in Congress overreached. We need to step back a little bit and relook at that so that we do not stultify the development of benefits

that this country has always relied upon. But I just want to say

I have appreciated the testimony of every one of you.

You, too, Mr. Gergen. I do not agree with you on some of these

things, but by gosh, you are certainly an expert. I just would hate

to have to go up against you on some of these issues, except that

I know I would win. [Laughter.] I am only kidding.

The CHAIRMAN. Thank you, Senator. Thank you very much.

A couple of points I think are worth stating. We are very proud

of our country and capital formation in America, entrepreneurship,

creativity, and innovation. Clearly, we want to, in this committee,

help enhance that, not detract from it. There is no doubt about

that.

Senator Schumer mentioned New York, the U.S., with financial

capital. Our country is historically based on creativity and innovation, and it has made America great. We are very proud of that.

There will be more Googles, more Microsofts, and so forth the more

we maintain that creativity and that innovation.

On the other hand, nobody likes paying taxes. I do not know of

anybody who wants to pay more taxes. Everyone wants to pay

lower taxes. That also, I think, is a truism. The question is, what

is the proper level of taxation, and who should pay it at what level?

That is what we are trying to do in this committee.

I think the more we answer that question correctly, the more we

are going to correctly solve both truisms: (A) we are going to continue to be creative and innovative; and (B) we will find ways

where people will grumble in paying taxes, but they will realize it

is the proper level and the proper way.

I just want to make clear, my intention in this committee is to

again find out what is right here. That is the goal we are trying

to pursue here and that is the reason for having this hearing and

subsequent hearings.

I do have some more questions, though. First, I might ask you,

Mr. Donohue, about maybe the Blackstone offering, and I guess

KKR is talking about going public, and others as well. I get the

sense that some of these firms think the window might be closing

a little bit so they are going to rush to move these offerings, maybe

to cash out at an appropriate time. But for whatever reason, they

are rushing to offer them in public offerings.

A couple of questions here. It is curious. Your private equity

firms, they are buy-out companies. They buy out publicly held companies, arguing that this is the way to help drive companies to be

more efficient and enhance performance, et cetera. On the other

hand, the managers are going public. That is a little interesting to

me.

Nevertheless, some say—those who argue in favor of the publicly

held partnerships going public—that now there is greater transVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00052 Fmt 6633 Sfmt 6633 53637.000 SFIN1 PsN: SFIN1
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parency to investors, that they are going to know what is going on,

because after all, as you know better than anyone in the room, at

least there is going to be the ’33 Act, or whatever, there are going

to be filings, 10(k)s, and so forth, quarterly reports and yearly reports.

So my question is about the confusion of what is actually going

public. Are investors who provide these shares purchasing the

share of a private equity fund or a hedge fund, or are they purchasing a share of the managers’ fees?

Mr. DONOHUE. I will start off by saying that one of the most important analyses that we do relates to that very question of what

is it that investors are purchasing. That is why we go through our

status analysis on whether or not what they are purchasing is actually an investment company or whether it is an interest in an ongoing enterprise.

We also do an analysis of whether or not the offering of firms

like Blackstone or Fortress represents the distribution indirectly of

any of the underlying funds, and the conclusion we reached was

that investors that were investing in Fortress and in Blackstone

were clearly obtaining an interest in an operating company, a firm

that manages other people’s monies, and the success of that organization will be related certainly to how successfully they do that on

behalf of other investors in those underlying funds, but will also be

related to how well they run their business.

The CHAIRMAN. Correct. But they are not purchasing a share in

the underlying funds. They are purchasing a share in the management.

Mr. DONOHUE. That is correct.

The CHAIRMAN. Not the underlying funds. So if Blackstone, Fortress, whomever goes public, the partnership goes public, the investors who are purchasing shares in that offering are investing in the

management fees, not investing in the underlying investments that

the managers operate.

Mr. DONOHUE. That is correct.

The CHAIRMAN. All right. Thank you.

Now, the next question. How much can an investor in these managers determine from the public filings? Can they determine the

amount of leverage in the public filings of the partnership going

public, the amount of leverage that the firm is undertaking? A lot

of these funds have a lot of leverage, as we well know.

Mr. DONOHUE. I would make a distinction here between the

amount of leverage that might be employed in underlying funds

that they manage and the amount of leverage that the company

itself has. Certainly the amount of leverage that Blackstone, Fortress, or similar companies might have, public companies, is determinable from the registration statement and filings.

The CHAIRMAN. But there is no way to determine the leverage in

underlying funds.

Mr. DONOHUE. No.

The CHAIRMAN. From the filing.

Mr. DONOHUE. Some may. I am not sure I could.

The CHAIRMAN. But basically they are not there.

Mr. DONOHUE. Yes.

44

The CHAIRMAN. I mean, the disclosure is not there with respect

to the underlying funds.

Mr. DONOHUE. That is true.

The CHAIRMAN. What is public, what is disclosed, is, again, the

managers’ operation, it is not the investment strategy or investments undertaken through underlying funds.

Mr. DONOHUE. That is correct.

The CHAIRMAN. All right. Thank you.

So can an investor figure out what assets are owned by the fund,

by the managers?

Mr. DONOHUE. As a general matter?

The CHAIRMAN. That is disclosed with the public filing, the partnership filing, public filing.

Mr. DONOHUE. From the public filings, it would be difficult unless it was material to the issuer of the securities, which would be

the operating company. It would be difficult. You would not be able

to determine that.

The CHAIRMAN. Does a person who invests in a publicly held

partnership have voting power over what the manager does or does

not do, as is typically the case with someone who buys a share of

corporate stock?

Mr. DONOHUE. They do have the rights that are accorded to them

under the organizational documents for that company and consistent with State law.

The CHAIRMAN. Correct. And what does the S(1) say on this

point, right on the front page? I have read it. What does it say?

Mr. DONOHUE. They do have rights to vote on certain things, but

because——

The CHAIRMAN. No, they do not.

Mr. DONOHUE. But because of the amount of ownership that they

have, it is very limited.

The CHAIRMAN. It is basically no right. I read that front page and

it is right there. I used to work at the SEC a long time ago and

was involved in a lot of filings. It is just very clear what it says.

There is no voting power, basically.

What rights does this person have that are similar to the rights

of a common stockholder?

Mr. DONOHUE. Well, they have the rights that are accorded them

under State law with respect to their ownership interest in those

companies.

The CHAIRMAN. Right. So what are the different rights, generally, that a person who buys one of these shares of a publicly

held partnership has compared with the person who buys stock of,

say, General Motors, or shares of General Motors?

Mr. DONOHUE. They have similar rights to their economic interests.

The CHAIRMAN. They do not have voting power.

Mr. DONOHUE. They have voting power, but remember, if Blackstone was in a corporate form and only 10 percent of the ownership

interest was being distributed to the public, the public would have

very limited rights to change anything because 90 percent of the

voting rights would be residing with some other party.

The CHAIRMAN. I know. But that is not the issue. I am sorry,

that is an obfuscation. That is a little smoke-and-mirrors. The

45

same would apply if the institution owned most of the shares of the

publicly held shares, too.

Mr. DONOHUE. That is correct.

The CHAIRMAN. So that is not a fair answer, to be honest with

you. I do not think that is a fair answer. The basic point is whether

someone has a controlling interest or a non-controlling interest in

a publicly held partnership, and they do not have the same voting

power that someone with a controlling interest would have when

holding shares of common stock in a company.

Mr. DONOHUE. Mr. Chairman, if I could make a point here with

respect to what the role is of the SEC with respect to public companies. Under the ’33 Act, the SEC’s role is to make sure there is adequate disclosure with respect to points similar to what you have

pointed out, and also make sure that there is no fraud or other

things going on.

The CHAIRMAN. Right. I appreciate that.

Mr. DONOHUE. So there was a point of time, I believe, back in

the 1990s when the Commission had taken action to move towards

one share/one vote, and it was overturned by the courts.

The CHAIRMAN. That is another issue. Thank you very much.

Senator Hatch?

Senator HATCH. Well, is it not true, Ms. Mitchell, that virtually

every investment that comes your way is done because you believe

in management?

Ms. MITCHELL. Absolutely.

Senator HATCH. Is it not true, Mr. Donohue, that almost everybody who invests in the stock market, if they have any brains, are

investing because of management?

Mr. DONOHUE. I would hesitate to agree that almost everyone.

Senator HATCH. To be that broad?

Mr. DONOHUE. But generally I would agree with you.

Senator HATCH. All right. I will let you slip off just a little bit

there.

How about it, Mr. Solomon?

Mr. SOLOMON. Clearly, the investors make their decision about

whom to invest with based on the track record of the managers.

Senator HATCH. Sure.

Now, Ms. Mitchell, do the people who invest with you have any

liability if something happens, if you go bankrupt?

Ms. MITCHELL. The limited partners?

Senator HATCH. Yes.

Ms. MITCHELL. No, they do not.

Senator HATCH. No. So they get limited liability for investing

with you. That is a tremendous benefit. Once they make the investment, they are off the hook, right, except for the investment?

Ms. MITCHELL. Right.

Senator HATCH. And if they are lucky enough to be part of that

20 percent that really hits it big, then they get the rewards from

that. Is that right?

Ms. MITCHELL. That is their goal.

Senator HATCH. All right.

Well, I think what I am saying is this. I believe everybody should

pay fair taxes, but I also believe that one of the things we ought

to consistently try to do up here on Capitol Hill is make it possible

46

for people to not only get a return on their investment, but for the

public at large and the country at large to benefit from those investments in a better economy.

Now, let us face it. There are some people in general partnerships who make a fortune every year because they are very good

managers, and there are some people up here on Capitol Hill who

do not like that, that they are making that much money.

On the other hand, it is amazing how, in this country, those who

reach that status of making a lot of money seem to come from the

bottom sometimes. Those who are millionaires today may not be tomorrow, but there will be a lot of new millionaires if we continue

to have the incentives to be able to invest and to use those investments wisely, which I believe you have done.

I think Mr. Gergen is right, too. Our tax code is so complex that

there is lot of unfairness in the code. It would be wonderful if we

could somehow or other make it fair for everybody. I think most of

my colleagues want to do exactly that.

On the other hand, the one thing I do not want to do is stifle

investment, stifle economic development, stifle economic opportunity, stifle the right of people to be able to invest with people like

you, Ms. Mitchell, who have been successful, who have spurred on

some of these smaller companies. You mentioned eBay, you mentioned Google.

Ms. MITCHELL. Right.

Senator HATCH. I deal in the intellectual property world all the

time, but I have to say that those are some of the most risky investments at the start. The dot-com bubble turned out to be exactly

that when it burst, and there were very few companies that really

made it big.

But there were companies that made it big because of, I guess,

good management and the ability of people to risk-assess their investments in spite of the fact that you are rolling the dice in some

of the start-up companies.

Ms. MITCHELL. Right.

Senator HATCH. I just want to personally thank all of you for

your testimony here today because it has been very, very important

to me personally, and I think to the public at large.

But I am very loathe to tax partnerships just because they make

a lot of money, and because the partners make a lot of money.

There is a lot of risk to it. And having tried some of these cases,

I have seen people’s whole lives just destroyed because the dice

they rolled did not come up right.

Ms. MITCHELL. Right.

Senator HATCH. And they made mistakes, or for some reason or

another the economy went down and their particular investors lost

their money and they wound up, some in jail, many in bankruptcy.

But those who do the job, I do not begrudge the money to them because that money is not generally squirreled away in mattresses.

What do you do with that money when you make big money? The

partners come back with more, do they not? Am I wrong?

Ms. MITCHELL. You raise your next fund and you invest it in

more start-ups to create more jobs.

Senator HATCH. Right. Well, that is the way our country has

been the greatest country in the world. I do not want to see us go

47

downhill just because we resent some people who make a lot of

money. Of course, I have to admit, we all do resent them from time

to time, do we not? [Laughter.]

Well, I just want to thank each and every one of you for your testimony. It has been very enlightening to me, and right across the

board every one of you have been very, very interesting.

Thank you, Mr. Chairman.

The CHAIRMAN. Thank you, Senator.

On a lighter side, I was just sitting here thinking, we can get the

opinion maybe of Professor Gergen, you know, there are a lot of

lobbyists in this town who have been hired on this issue. I wonder,

could they form a partnership——

[Laughter.]

The CHAIRMAN [continuing]. And convert their fees into carried

interest so some will get capital gains treatment? I am just curious.

I mean, there is an awful lot of money on this issue in town and

I am just curious if they could form a partnership to accomplish

that result.

Mr. GERGEN. Let me spin off of that. Not the lobbyists, but give

me a group of plaintiffs’ lawyers who have lawsuits where the damages will be capital gains. If we could get past the rules on

champerty, which I think we can, we can convert that into a limited partnership where their contingency fees become capital gains.

All we have to do is get past the rules on champerty that bar the

assignability/salability of a lawsuit. They are not as strong as you

might think.

The CHAIRMAN. Which raises an interesting question. Irrespective of whether it is proper policy or not, does it enable certain people to get greater after-tax income? That is, the current partnership rules with respect to carried interest. How many other entities

would be looking at this and saying, hey, why not us? Why should

we not convert to a partnership form in order to take advantage

of this phenomenon?

Senator HATCH. Well, I hope there will be a lot of them.

The CHAIRMAN. I am just asking the question. Is it easy or not

easy to do?

Mr. GERGEN. You would have to have an entity where you are

performing labor with capital from other people, where the yields

on the capital or capital gains are taxed at some other taxpreferred rate. So that would define the universe of possible companies.

The CHAIRMAN. All right. You are right.

Mr. GERGEN. How large that universe is, I just have not tried to

think. If I was in the business of making money instead of teaching, I might. [Laughter.]

The CHAIRMAN. Ms. Mitchell, I am just curious. You said that

there is a real down side for the general partner.

Ms. MITCHELL. Yes.

The CHAIRMAN. We all know the down side of limited partners

is, they lose their investment.

Ms. MITCHELL. Right.

The CHAIRMAN. Could you explain in a little more detail so we

can more fully understand what the down side is for the venture

capital firm?

48

Ms. MITCHELL. Yes. I will give you two quick examples. One is,

we could have a situation—as you will recall, we invest the money

in companies, we draw our management fees to cover our expenses,

then we have companies that go public or get acquired and we first

take all that capital and repay that to the investors.

So during the period of the fund, before I actually have earned

my carry, which is after all that capital is returned and all of the

fees are returned, I may actually have a taxable event on a gain

because there is an early gain in the fund, but yet I have not gotten the cash for it.

And it may turn out that the rest of the investments that I make

throughout the rest of the fund, because my partnership is formed

around a collection of companies, not an individual company, the

rest of my companies may lose money.

So at the end of the day, I simply return the capital and the

management fees to the investors and there is no capital gain. I

will have paid tax in earlier years because there was a gain in a

given year on a partnership taxed to me on a flow-through basis

that I will pay taxes on that I will never have a gain on to offset

against out of that fund.

The CHAIRMAN. But in the meantime do you earn a fee?

Ms. MITCHELL. Yes. That is taxed as ordinary income. Absolutely.

The CHAIRMAN. You have the manager’s fee independent of

carry?

Ms. MITCHELL. Yes. When we sat down with our limited partners

to negotiate, which we did, actually, most recently at the beginning

of this year, the objective of that fee was just—just—to cover our

operating expenses.

They really wanted us to have all of our up side in the carried

interest, not fees. They do not want us to make money and get

wealthy off of the fees, and that is not the intention of the fund

that we formed. Our up side, our hope that we are working hard

for, is the capital gains that happen down the road.

The CHAIRMAN. But on a net basis, you get your fees, you pay

tax on some early distributions.

Ms. MITCHELL. Yes.

The CHAIRMAN. On a net basis, I am just trying to get a feel for

how much of a down side is there, independent of carry.

Ms. MITCHELL. There is a second example I could give you where

I could lose real money. If, in fact, we have such a large winner

that early on—that early example I just gave you—and this is actually a real-life example, not from my fund, from another fund,

where it earned so much that actually the general partner got a

distribution of stock in this given company.

Again, the later results of the fund—and this is one of the first

investments of the fund. All the later results—this was, I believe,

a bubble fund—all the rest were losses. We have a contract clause

with our limited partners called a claw-back, and, if at the end of

the day I receive a distribution of stock, as in this example’s case,

and at the end of the day we did not make money, I have to give

that back to my limited partners because I did not, on the full portfolio, earn enough.

49

In this particular example, what happened with that, the stock

was dropping during a lock-up period. The value of the stock went

to almost zero. So the general partners actually had to write checks

to close out the partnership for this claw-back that, (A) they had

paid taxes on, and (B) no longer had an asset to liquidate in order

to both pay the taxes and pay the claw-back.

The CHAIRMAN. I appreciate that.

Senator Grassley?

Senator GRASSLEY. Thank you very much.

Professor Gergen, would you please comment on Senator Crapo’s

question that came very early in the hearing regarding the movement of investment funds offshore? Would it be so easy to avoid

U.S. tax by moving offshore? It is my understanding that U.S. citizens are taxed on their worldwide income no matter where they

live.

Mr. GERGEN. It is a very complicated question. To the extent we

are taxing it as compensation and not as capital gains, it is harder

to avoid U.S. tax without giving up your U.S. citizenship. But it is

not impossible. You can use various shielding devices.

On the other hand, to the extent we are taxing them as capital

gains or other returns, it is much easier to keep the funds offshore

and never pay U.S. tax on them. So if we are worried about that,

something that tries to tax these as compensation is less likely to

see funds shifting offshore, but you are still going to see some evasion. Hanging on to the U.S. tax base is very, very complex.

Senator GRASSLEY. My next question is about Senator Ensign. I

think he said something about his veterinarian business and the

sweat equity he had in it. I think he was trying to make the point

that we were going to tax that sweat equity.

What is your response to points like that about sole proprietorships and founders’ equity?

Mr. GERGEN. I actually was almost tempted when he said that—

I would like to go back and look and see what he did, because he

may not have complied with the law when he sold his veterinary

business. [Laughter.] I do not know. If he was in a corporation, we

are not going to tax the sweat equity. We treat it as a sale of corporate stock.

If it is a true sole proprietorship that he does not hold through

a corporation, some of the gain is likely to be ordinary income unless it was structured as a sale of assets good will.

Indeed, some of the more complicated rules in subchapter K

would prevent people from taking a sole proprietorship and turning

it into a partnership and be able to convert what would be ordinary

income on sale into capital gains. But that is when we were just

talking about the single person.

Coming back to the point about founders’ capital. If you give

them a credit for their capital contribution, to the extent they have

actually made a capital investment, we are not going to be taxing

returns on that as ordinary income.

Then I will give my example where A and B would start a company, they grow it in value to where it is worth $2 million. Only

that $2 million would be taxed as ordinary income, and that is only

if we taxed as ordinary income if they were holding it as a sole proprietorship on their own under the general rules of section 1211.

50

Any remaining returns on their capital, their founders’ capital,

would be taxed as capital gains as pro rata returns on their capital.

Senator GRASSLEY. Thank you.

Peter, I would like to ask you, but before I ask you the question,

I kind of recall lobbyists in Washington, and typically it seems to

me they have a weak hand when they tell me the reason we should

not close a tax loophole, not because it is going to hurt that lobbyist’s client, but it is going to hurt somebody else.

We are seeing right now, with the private equity and hedge fund

lobbyists, they are trying to say that the best reason not to have

managers of hedge funds and private equity pay the same rate as

everyone else is because it would hurt the pension funds.

We just had a story this morning, Bloomberg, a report that pension officials strongly disagree with the decision by Congress to

have hedge funds and private equity managers pay the same rate

as everyone else, that that is going to hurt workers’ retirement. So,

a few quotes: ‘‘‘This argument that this is about the interests of retired public employees is ludicrous,’ said Orin Kramer, who manages the State Pension Fund in New Jersey, ‘and places billions of

assets in private equity firms and hedge funds.’’’

Then there is Michael Musraca, who sits on a union pension

board that also invests billions in private equity, who said, ‘‘Suggesting that changing the tax status on carried interest would lead

to public sector pensions being jeopardized is taking a pretty extreme view of their importance.’’

So do you agree with the statements of these officials who manage and invest for pension funds, that Congress should look at the

merits of deciding these issues and not the impact on pension

funds, and, if there is an impact, it is going to be negligible?

Mr. ORSZAG. In general, yes. And let me just explain, briefly. To

the extent that the limited partners are tax-exempt entities, changing the tax treatment of the income flowing to the general partners

does not have any direct effect on them. The argument you would

have to make is that somehow the tax benefits of the general partner would be shared with the limited partners, and the evidence

in favor of that is at least unclear.

I want to also then come back to an earlier question. To the extent that the investors in these funds are taxable entities, and I am

just coming back to the question Mr. Kyl asked, the flip side of

higher tax for the general partner is a tax reduction or a tax break

for the limited partner. Those are mirror images of each other.

For tax-exempt investors, that latter part is not relevant because

they are tax-exempt. But for taxable investors, you need to look at

both sides of the equation.

Senator GRASSLEY. All right.

And my last question is both for Mr. Solomon and Mr. Donohue.

In their registration statements filed with the SEC, some management firms going public as partnerships assert that they are not

properly treated as investment companies under the Investment

Company Act of 1940 because they are performing asset management and investment advisory services and are not investing in securities.

At the same time, the rules of the tax code limit permitted income of publicly traded partnerships to certain types of passive inVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00060 Fmt 6633 Sfmt 6633 53637.000 SFIN1 PsN: SFIN1
51

come, including capital gains, dividends, interest, and other specified types of income.

Two questions, and I will ask them both at once. Do you perceive

any inconsistency in these positions, and might one view any potential inconsistency as regulatory arbitrage, as some commentators have called it, by taking opposing positions under different

regulatory regimes to get the best of both worlds?

Mr. SOLOMON. Focusing on my lane, which is the tax side, the

question is whether the income constitutes capital gain. That is the

specific question asked in the tax code.

To the extent that the income is ordinary income, it is treated

as such, and to the extent that it is capital gain, it is treated as

such. That is the analysis that one would do under the tax code to

make the determination under the particular section that you are

mentioning.

Senator GRASSLEY. Mr. Donohue?

Mr. DONOHUE. From our perspective, when we were doing the

analysis of whether or not the entities were investment companies,

we looked to the reality of the situation and we concurred with the

view of the company with respect to the character of what they

were doing and the ownership. They were not investing their own

assets, they were investing on behalf of others.

The fact that they had, some might view, a contrary view of what

their tax status should be, they had tax opinions from counsel that

were part of the registration statement with respect to whether or

not that was correct. From the disclosure point, that was in their

registration statement.

Senator GRASSLEY. All right.

Thank you, Mr. Chairman.

The CHAIRMAN. Senator Hatch?

Senator HATCH. Thank you, Mr. Chairman. I think that this has

been a very interesting hearing and a very interesting panel. I appreciate all of you being here. Thank you.

The CHAIRMAN. I just have a question. I apologize. This may

have been addressed. I have been absent for part of the hearing

and somewhat distracted sometimes on other matters.

I hear from those who oppose changing the tax treatment that

if, generally, the general partners have to pay ordinary income tax

on, say, the proportionate share of contributions, they get capital

gains on their proportionate share of the capital they contribute,

otherwise it is ordinary income for the services they perform and

so forth, that that will have a detrimental effect on the underlying

investments, that somehow the agreements—this is all so complicated, I do not understand it.

But somehow, in the contracts and the agreements, either among

the partners or with some of the subsidiaries that the general managers largely operate, that those contracts will have to be changed

or renegotiated. It even goes to pension funds and endowments.

Somehow, as a consequence, the rate of return for the pension

funds or the university endowments will not be as great because

somehow the general partner will have to take it out of the hides

of the endowment or the pension fund. So, I hear that argument,

and I just wonder if somebody could address it.

52

Mr. ORSZAG. I will take a crack at that. Let us take a case where

the investors, the limited partners are tax-exempt and the general

partner is a taxable entity. You could make two different arguments. One is that the tax benefit to the general partner is shared

with the limited partners, or you could say that the general partner

retains the full tax benefit.

In the case in which the general partner is retaining the full tax

benefit, there is no effect on the limited partners, and changing the

tax treatment of the general partner would not affect things at all.

To the extent that things are being shared, and there is offset

to the limited partners, then some of the arguments about entry

into being a general partner, et cetera, would also be attenuated.

That is to say, if you can lay off a lot of the tax change onto your

underlying investors, your net return is then changed less and your

incentives to participate in this kind of activity is basically the

same as it was before.

I think it is more likely that the general partner is retaining

more of the tax benefit in this case, in which case changing the tax

treatment to ordinary income would not really affect the limited

partners and underlying investors that much.

It may affect the incentives to be a general partner as opposed

to an executive at a financial services firm or a manager of a public

investment fund, but there seems to be plenty of people willing to

do those types of activities also.

The CHAIRMAN. Any other response to that question, anybody?

Mr. Gergen, do you have a view?

Mr. GERGEN. Well, it just depends on, as you were saying, the

elasticity of supply of these sort of management services. A lot of

us think it is very inelastic. You raise the tax rates slightly, you

are not going to affect the supply of it.

Then the question is to what extent these tax benefits are flowing to the people who invest, the capitalists. If they are not, you

are not going to affect their yields at all. So, my hunch is the same

as yours, but it is finally an empirical question.

Ms. MITCHELL. I strongly disagree with that statement. I think

you hit that at the very end of your comments, the incentive—you

know, if I am the sweat equity in a small company, or let us say

a large one—but in a small company, why would I spend my time

in an early speculative deal that I can lose money in when I could

alternatively get——

The CHAIRMAN. But do you lose money? That is not the point.

You own a large cash contribution.

Ms. MITCHELL. No. But again, in the example I gave you previously, we actually can lose money as part of our——

The CHAIRMAN. Can. But ordinarily, customarily, with the fees

that you get, management fees——

Ms. MITCHELL. It is not as rare as you would think.

The CHAIRMAN. All right.

Ms. MITCHELL. The issue really is, why would I do that? Why

would I want to spend—we sometimes found companies, as an example, and actually within our offices incubate it, write the business plan, attract the entrepreneurs ourselves.

Why would we do that versus, let us say, a later stage investment or an entirely different form of investing that has much less

53

risk associated with it, much less time and effort, much fewer intangible contributions we need to give in terms of trying to work

and make that happen? I think, naturally, you would find fewer

time, money, individuals.

I think that will be the issue. There will be a lot of capital available, looking for people who are willing to, in essence, speculate

their time over the 7, to 10, to 12 years it takes to hopefully be

successful, and you may not find them.

The CHAIRMAN. Well, I deeply appreciate all of the time that you

have dedicated to the hearing this morning. You have been very

forthright, very helpful, and I thank you very, very much. We will

obviously be looking at this for some time now, but, just, thanks.

I cannot thank you enough.

The hearing is adjourned.

[Whereupon, at 12:47 p.m., the hearing was concluded.]

(55)

CARRIED INTEREST, PART II

TUESDAY, JULY 31, 2007

U.S. SENATE, COMMITTEE ON FINANCE, Washington, DC.

The hearing was convened, pursuant to notice, at 10 a.m., in

room SD–215, Dirksen Senate Office Building, Hon. Max Baucus

(chairman of the committee) presiding.

Present: Senators Bingaman, Kerry, Lincoln, Wyden, Schumer,

Stabenow, Salazar, Grassley, Hatch, Lott, Snowe, Kyl, Crapo, Roberts, and Ensign.

OPENING STATEMENT OF HON. MAX BAUCUS, A U.S. SENATOR

FROM MONTANA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. The hearing will come to order.

The Apostle Paul wrote of this world, ‘‘Now we see through a

glass darkly.’’ We could say as much about the world of hedge

funds and private equity. The world of hedge funds and private equity is opaque.

Today we will hold our second hearing on carried interest. We

will try to shine a little more light through the glass on the operation of private equity funds, hedge funds, and real estate funds.

Private equity funds use a variety of strategies. They acquire

companies and take them private. They provide structured financing for deals. Because private equity funds are not transparent,

some misunderstand what private equity managers do. These hearings will try to help us see some more facts.

We see how private equity has a tremendous appetite for taking

companies private. A cup of coffee from Dunkin’ Donuts is produced

by a company held by private equity. Private equity funds have incredibly diverse holdings, from hotel chains to toy stores. The ability of private equity funds to grow and expand is impressive. These

are fantastic times for private equity.

Hedge funds serve an important role. They manage nearly $2

trillion in assets. Much of that money comes from pension funds,

foundations, endowments, and other nonprofit corporations.

The returns of some funds are stellar. Some funds create tremendous wealth for investors and managers alike. The strategies that

hedge funds use are not transparent. There is a reason for that.

Very bright managers spend a great deal of time creating strategies to generate these returns for their investors. They want to

keep those strategies secret. They would prefer that other managers not replicate their strategies.

56

But secrecy can also increase risk. We will try to see how risky

some hedge fund investments are. Take, for example, leverage, the

amount of debt that hedge funds take on to enhance their investing

capacity.

There is a lot of misinformation, or downright disinformation,

about how hedge funds use leverage to achieve investment goals.

I talk about disinformation because, in a meeting in this very

building, a hedge fund association implied that leverage in hedge

funds is 1:1, that is, they are borrowing about as much as they hold

in equity.

The reality is that hedge funds are generally leveraged at a minimum of 3:1, and more likely leveraged at least 10:1. That is, they

are borrowing 3 to 10 times what they hold in equity. The public

does not know the amount of leverage in any of these deals.

There is leverage at the fund level, and then depending on the

strategies employed, the securities themselves could be highly leveraged. I hope that we can have an honest discussion. I hope that

the many lobbyists employed by hedge funds in private equity will

not make the glass even darker than it already is.

A manager of a fund receives two types of income, a management

fee of around 2 percent of capital, and a carried interest of 20 percent of the profits. The management fee is generally taxed at the

ordinary income rate.

A carried interest is the interest that the manager has in the

profits of the investment partnership. The manager receives the interest when the fund is created, and the manager receives payment

on that interest only after the initial investment is returned to the

outside investors and the fund exceeds a certain level of profit.

As we discuss whether income from carried interest should be

treated as income from a service or receive the character determined at the partnership, there are also issues that could cloud the

view.

For example, many private equity fund managers convert portions of their management fees into additional carried interest.

Some managers aggressively convert management fees into carried

interest on a quarterly or annual basis.

Many hedge funds use Cayman Island or other off-shore corporations to bring in foreign and nonprofit investors. With the off-shore

part of the fund, the manager receives an incentive fee of 20 percent of the profits from the foreign sale of the fund. This fee is

taxed at the ordinary income rate. For the domestic part of the

fund, the manager has a 20 percent carried interest that is taxed

as capital gains income.

Economically, I do not see the difference between the incentive

fee and the profits interest. Both give the manager 20 percent of

the profits, whether off-shore or on-shore.

There is little difference between a large private equity firm and

a Wall Street investment bank. Both offer merger and acquisition

services. Both provide mezzanine financing for transactions. Both

offer a wide array of investment strategies for their clients. But

only one claims that the income from an active business is passive

and is subject to capital gains treatment.

Once again today, we have a balanced panel of actual managers

of alternative investment funds who can discuss how profits interVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00066 Fmt 6601 Sfmt 6601 53637.000 SFIN1 PsN: SFIN1
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est plays a role in their deals. For now, we may see through a glass

darkly. We will try to see face to face. For now we may know in

part, but we will try to know more completely. We can hope, perhaps with a little charity, maybe a little change, that our faith in

our tax system will abide.

Senator Grassley?

OPENING STATEMENT OF HON. CHUCK GRASSLEY,

A U.S. SENATOR FROM IOWA

Senator GRASSLEY. Yes. Mr. Chairman, thank you very much for

holding this hearing. Beyond the short remarks I am going to make

this morning, I have a long statement that is going to be included

in the record, please.

This is our second hearing on the tax treatment of carried interest. At the last hearing we had a balanced approach. We have the

same here today. This hearing, and the committee’s inquiry, is

about the distinction between capital income and labor income.

This issue arises frequently in partnerships when a person receives a carried interest or an interest in the partnership’s profits

in exchange for performing services for the partnership as opposed

to contributing capital.

This hearing is not about well-settled principles regarding capital

assets or the propriety of current capital gains rates. It is not an

attack on the investor class or capital formation. We are not questioning the tax treatment of the return on any partner’s invested

capital. That return is, and should continue to be, taxed at preferential capital gains rates.

This hearing is also not about a revenue grab for Congress. It is

not about whether alternative asset managers are good or bad for

society. We are not here to have a hearing on each industry and

to measure its value to society, and assign the tax rate accordingly.

This hearing is about our responsibility to ensure that the tax

code is operating fairly and consistently with the intent behind enacted policies. If it is not, then there is an unintended subsidy

being provided to some, while others pay for it with higher taxes.

There are a lot of sound, pro-growth tax policies that Congress

needs to advance to keep our economy strong. The individual capital gain preference is an obvious one. Like I have done before, I

will be working to get that policy extended.

Another policy is our corporate tax rate, which is the second

highest among OECD countries. We are standing still while our

trading partners are lowering their corporate tax rates.

Economists tell us to make our system more efficient by lowering

rates and broadening the base by eliminating preferences for specific industries. Well, we are looking at a potential base-broadening

here. But if we cannot even examine these kinds of issues in a deliberate, thoughtful way, then I am afraid that we are never going

to get into a position to talk about lowering rates and being competitive worldwide.

Folks on both sides of the aisle ought to roll up their sleeves,

move away from partisan talking points, and join Chairman Baucus and me in finding the facts. The carried interest issue is complicated, and some might say headache-inducing, but this comVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00067 Fmt 6601 Sfmt 6601 53637.000 SFIN1 PsN: SFIN1
58

mittee is responsible for getting the policy right, so we need to take

our aspirin and wade in.

Mr. Chairman, you may remember a TV series, ‘‘Dragnet,’’ and

the character, Sergeant Joe Friday and his partner Bill Gannon.

The CHAIRMAN. I do.

Senator GRASSLEY. Sergeant Joe Friday used to say, ‘‘Just the

facts, ma’am.’’ Like Joe Friday, we are here to get the facts. We

have not made up our minds yet. With that open mind, I look forward to today’s discussions.

I will also look to submit for the record my response to some of

the criticisms of our publicly traded partnership bill. The two arguments I respond to are: first, it singles out private equity and

hedge fund management firms and, second, it would result in an

unfair triple tax on private equity management firms that go public. I disagree with those arguments, but, rather than taking too

long to go through those detailed responses, that is what I have

asked to be put in the record.

Thank you, Mr. Chairman.

The CHAIRMAN. Thank you, Senator Grassley.

[The prepared statement of Senator Grassley appears in the appendix.]

The CHAIRMAN. Before I introduce the witnesses, Senator Roberts has asked me—maybe he wants to, himself, indicate what he

wants me to do. Senator Roberts?

Senator ROBERTS. I thank the chairman and I thank Sergeant

Friday. [Laughter.] Mr. Chairman, I have a personal commitment

to see if I can get this cast off my arm at 10:30—with a doctor, by

the way—so consequently I would like to submit my statement. I

would like to insert my statement at this part of the record, and

ask unanimous consent that I do so.

[The prepared statement of Senator Roberts appears in the appendix.]

Senator ROBERTS. I have several questions for the witnesses, if

I could submit them for the record. But like Douglas McArthur, I

shall return when I can.

The CHAIRMAN. They will be included. Thank you very much,

Senator. Good luck.

[The questions appear in the appendix.]

The CHAIRMAN. All right. Our panel is very distinguished. We

have a lot of panelists here. It is a great opportunity for us.

First, Professor Joseph Bankman, professor of law and business

from Stanford Law School; second, Charles Kingson, lecturer at the

University of Pennsylvania Law School and New York University

Law School, and former International Tax Counsel at the Treasury

in the 1970s; third, Professor Darryl Jones, professor of tax from

Stetson University Law School. Thank you.

Next, Mr. Adam Ifshin, president of DLC Management Corporation; fifth, John Frank, managing principal of Oaktree Capital

Management, LP; and next, Mr. Bruce Rosenblum, managing director of Carlyle Group and chairman of the board of the Private Equity Counsel; finally, Bill Stanfill, founding partner of Trailhead

Partners, LP, a venture capital fund.

Thank you all for coming. If you have longer statements than the

allotted 4 minutes, they will be included in the record. But I do

59

urge you to stay within your allotted times because we have a lot

to go over this morning.

Mr. Bankman?

STATEMENT OF JOSEPH BANKMAN, RALPH M. PARSONS PROFESSOR OF LAW AND BUSINESS, STANFORD LAW SCHOOL,

STANFORD, CA

Mr. BANKMAN. Thank you. May I ask, we cannot see the clock

over here. Is it possible to scoot it around this way?

The CHAIRMAN. We will turn it around just like that.

Mr. BANKMAN. There we go. All right.

The CHAIRMAN. Well, you have already taken 30. We will give

you an extra 30 seconds. [Laughter.]

Mr. BANKMAN. Thank you. Chairman Baucus, Senator Grassley,

members of the committee, thank you for inviting me to speak

today.

I support taxing carried interest as ordinary income. The change

will make the tax law more efficient by reducing economic distortion.

Students at Stanford and elsewhere who are interested in business become investment bankers, management consultants, and

they can become executives and pay tax at a maximum rate of 35

percent on their income. The same rate is true of students or anyone else who goes into virtually any other occupation you can imagine.

Alternatively, these students can become fund managers or other

profit participants and pay tax on their income, much of it, at a

maximum rate of 15 percent. This two-tiered tax system distorts

career choice and in so doing reduces rather than expands the size

of our economic pie. It is also unfair. Why should a surgeon, a

school teacher, or a CEO pay tax at twice the rate as a fund manager?

I would like to briefly respond to some of the arguments that

have been made in support of the present rule. We are told that

fund managers do a terribly important job, and of course that is

true, but so do members of the other occupations.

We are told that fund managers will work less if we tax them

at the same rates as everyone else. If that is true—and it is a big

if—the same reasoning applies to members of every other occupation. We are told that taxing fund managers might hurt investors

on the thought that investors indirectly benefit from the low tax

rate on fund managers.

The same reasoning would imply that we have the same low tax

rate on lawyers or anyone else who helps out investors. If Congress

wants to reduce the tax rate on investors, they do not have to

adopt a Rube Goldberg scheme where we first reduce the tax rates

on high-paid professionals and then hope that some of the benefit

goes to investors. Congress can simply reduce the tax rate on investors directly through accelerated depreciation or lower taxes on investment income.

We are told that we should keep this low tax rate on investors

because certain industries benefit. First of all, it is going to be an

inefficient way to benefit any industry for the reasons I just described. If you want to benefit an industry, you should do so diVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00069 Fmt 6601 Sfmt 6601 53637.000 SFIN1 PsN: SFIN1
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rectly and not benefit the professional income of some individuals

who work some of their time within a particular industry.

Moreover, I would hope that Congress decides not to try to benefit a particular industry. Our economy works best when we have

the same tax rates across all industries. If high tax rates are a

problem, we ought to reduce them across the board and maybe use

the revenue you gain from changing the law here to do so.

Fund managers have been compared to entrepreneurs, but the

two groups are really quite different. An entrepreneur may spend

a decade or more pursuing a single idea at little or no pay, betting

her and her family’s financial future. Fund managers receive handsome annual compensation and perform services connecting investors with companies and rendering certain advisory services.

If those services are successful, there is an additional payout in

the form of carry. That is similar to an incentive bonus that a CEO

might get. The CEO is taxed on that incentive bonus at ordinary

income rates in the year he receives it. Under the proposal Professor Gergen and I favor, the same would be true of the fund managers.

I do share one concern that some of the opponents of change in

this area have voiced. Changing the law here will require certainly

ancillary changes in subchapter K, and those changes may make

life difficult, at least temporarily, for some of the smaller partnerships. It is also true that in the smaller partnerships the profit participants do resemble entrepreneurs.

Eric Solomon, in the July 11 hearing, brought up the example of

the clothing store owner. I think you could find that same kind of

entrepreneurial resemblance in a partnership involving more significant activity in terms of asset size.

So while I favor changing the law here, I would urge the committee to consider applying the new rule only to the larger, or even

largest, partnerships. My sense is that might be a good balance of

equity and concern for compliance costs, and still get the committee

most of the revenue and equity advantages that that change would

bring.

The CHAIRMAN. Thank you very much. That was very succinct.

[The prepared statement of Mr. Bankman appears in the appendix.]

The CHAIRMAN. Mr. Kingson?

STATEMENT OF CHARLES KINGSON, ADJUNCT PROFESSOR,

NEW YORK UNIVERSITY LAW SCHOOL, NEW YORK, NY; AND

LECTURER IN LAW, UNIVERSITY OF PENNSYLVANIA LAW

SCHOOL, PHILADELPHIA, PA

Mr. KINGSON. These are my individual views. The issue is whether amounts received for managing capital assets should be treated

as selling capital assets. It is phrased as how to tax a carried interest, but it is not what tax law means by a carried interest at all.

A carried interest was something in oil and gas law, which Congress repealed and redefined as mortgage debt in 1969. Even when

it was in force, nobody said that you look through to the underlying

assets outside mineral interests. A court said, basically, you do not

have an economic interest in the assets just because your right to

payment is measured by profits, dividends, farm crops, or the like.

61

The question is then, what is the right analogy? You have people

running pooled brokerage accounts on a contingency. What they get

depends on what the client gets. The closest analogy I can see is

people who did this for a long time, and they are tort lawyers. They

have contingent fees. I mean, they get a percentage of how much

they recover for the client.

Two years ago, the Supreme Court ruled that a tort lawyer, who

got a percentage of the recovery that his client got, did not own the

claim even though State law gave him a lien on it. The court said

basically, he got a fee, and I think these are contingent fees. The

same distinction between selling property and furnishing services

obtains for artists as well as hedge fund managers, and it is again

based on risk. If I pay Andy Warhol for a picture of a soup can or

Marilyn Monroe, he is selling a painting. If, on the other hand, I

pay an artist to paint a portrait, he is performing a service—because he has no risk of loss in the property.

Now a partnership is supposed to change this, but it is not really

an economic partnership. A partnership is for richer or poorer, for

better or worse; but these guys are just in for richer and better.

They do not put up any credit, they do not put up any money, they

do not bear any losses. If they do not put up anything but services,

what they get is compensation.

What is more, they themselves do not even believe in the partnership. As the chairman said, basically, when foreign investors

come in they could, if partners, be deemed to be doing business

here. The managers then say, well, let us make it a performance

fee, and it is really the same deal.

Even if the managers are partners, the amounts they receive are

taxable as compensation if it is a capital interest. They say, no, it

is a profits interest. Well, a profits interest is like Professor Bankman’s clothing store. If I get 20 percent of the profits by being out

on the floor and selling the stuff, that is a profits interest. But I

do not share in the gain from sale of the building. Profits and capital interests distinguish between ordinary operations and appreciation in assets.

Hedge funds are all about appreciation in assets—that is their

business. But to claim capital gains on the ground because you own

the fund’s assets, and to then say, well, you never got a capital interest in those assets, that, to me, makes no sense.

My conclusions rest on looking at language, but that is what tax

law does. Tax law analyzes the meaning of words; and tax avoidance usually rests, as in this case, on distorting their meaning.

Supreme Court tax cases usually turn on the meaning of words

like ‘‘gift,’’ ‘‘dividend,’’ ‘‘debt,’’ and ‘‘sale.’’ Here, the difference between services and the transfer of property is one that is fundamental to tax law.

I mean, misconstruing it reverberates all through the code. Two

aspects are retirement plans and employment tax: characterization

of hedge fund fees as a sale of property may avoid over $180 million a year of Medicaid taxes. Another example, particularly with

the rise of intangibles and commerce over the Internet, is determining how and where Americans and foreigners earn their income. Internationally, under source rules, how you earn income determines where you earn it. Whether we tax foreigners may depend

62

on whether they are performing services in their own country or

selling intangibles in this country. Definitions apply to more than

one industry and for more than one country.

So, although this hearing is about raising taxes on a few people

who manage pooled brokerage accounts on a contingency basis, it

is really more than that. It is what fundamental concepts like

‘‘sale’’ and ‘‘services’’ mean in tax law. I do not think that my interpretation of services is changing the law. If what is received really

is compensation, this has been the law all along. This is not a

change: what has happened is that the law has not been enforced.

These people have gotten a free pass for so long, they think it is

a constitutional right.

If they dispute this, I would like to see it tested. I would really

like to see the Internal Revenue Service directed to audit these

people on the issue for all open years. I would like to hear it explained to a judge how, when someone is advising foreigners, he is

performing services and, when he is advising Americans, he is selling stock.

One other item. A significant portion of amounts received by

managers at private equity funds is attributable to their eliminating tax on an acquired corporation. Thus, in a very real sense,

what is being asked is reward under the tax code for fostering

avoidance of the tax code.

The CHAIRMAN. Thank you, Mr. Kingson, very much.

[The prepared statement of Mr. Kingson appears in the appendix.]

The CHAIRMAN. Mr. Jones?

STATEMENT OF DARRYL JONES, PROFESSOR, STETSON

UNIVERSITY COLLEGE OF LAW, GULFPORT, FL

Mr. JONES. Thank you, sir. I would like to start by saying that

taxation of carried interest is to the tax code what the Abu Graib

scandal was to the Iraq War. I am not speaking in hyperbole. I will

explain that in just a minute.

But the capital gains tax rate is justified in theory by a logical,

and even an elegant, theory. I hate teaching the mechanics of the

capital gains tax rate, but I love the theory. I think the theory is

unassailable. Students, too, hate the complexity of the number

crunching, but they love the theory. But an ugly, unchecked incident, though, can undermine even an elegant theory.

In the Iraq War, we went in with an elegant theory and we had

an ugly, unchecked incident or ugly incident that undermined a

theory. The same analogy applies to carried interest.

If carried interest continues to be taxed as capital gains, it will

severely undermine the elegant theory that I think Senator Grassley referred to that justifies the lower rates on invested capital.

Just yesterday, for example, the Washington Post published an

editorial calling for the repeal of the capital gains preference, citing

as evidence the abuse that is going on with the taxation of fund

manager compensation. So you can have an elegant theory and, if

you allow an abuse, you undermine the integrity of that theory.

The first hearing, Carried Interest I, suffered, I think, from a

conspicuous absence of critical discussion about the purpose of the

capital gains tax rate and whether that purpose is even furthered

63

by the application of those tax rates to the variable income fund

managers receive.

In his opening statement during Carried Interest I, Senator

Grassley stated that we justified the lower rate on capital gains as

a remedy against the double taxation of investment income and the

resulting benefits of economic growth.

On the other hand, certain testimony—that of Ms. Kate Mitchell

and Mr. Eric Solomon—suggested that capital gains tax rates are

justified to encourage taxpayers to assume greater risk than would

otherwise be rational and, without that risk assumption, society

would suffer from a lack of innovation.

Senator Grassley’s statement is accepted tax law doctrine; Ms.

Mitchell’s and Mr. Solomon’s are not. In neither case, though, do

the doctrines support capital gains taxation in this instance, that

is capital gains taxation of fund manager compensation.

Senator Grassley’s simple and universally accepted statement deserves further scrutiny. You have a taxpayer who earns $100 after

tax and then takes that money and purchases a piece of property

for $100 during a time when annual inflation is 6 percent. They

sell it next year or a year later for $106, and they get taxed on $6

of gain even though they really only have a nominal gain. They do

not really have an economic gain, the gain is merely inflationary.

The taxpayer would have been better off immediately consuming

the $100 in a selfish manner rather than investing that money in

some way that generated jobs or some other social benefit. Likewise, a taxpayer who did invest the $100 would be better off not

taking that investment out of some old technology. For example,

the taxpayer might have invested it in 8-track players when CDs

were all the rage. Instead of selling the 8-tracks and buying the

CDs, they would stay in 8-tracks because the tax cost would be an

economic barrier.

Implicit in Senator Grassley’s observation is that there are beneficial savings, referred to as ‘‘investment,’’ of previously taxed income. In the typical case, fund managers have never been taxed on

income subsequently invested in long-term assets such that we

should be concerned about the deleterious effect of taxation on

nominal, as opposed to real, economic gain.

Fund managers are untaxed human capital, what Ms. Mitchell

referred to as ‘‘sweat equity,’’ not previously taxed financial capital,

so the tax on human capital is a single tax and it will not discourage innovation that the managers claim will happen if we apply ordinary rates.

I see my time is up, so I will stop there. Thank you very much.

The CHAIRMAN. Thank you very much, Mr. Jones.

[The prepared statement of Mr. Jones appears in the appendix.]

The CHAIRMAN. Mr. Ifshin?

STATEMENT OF ADAM IFSHIN, PRESIDENT,

DLC MANAGEMENT CORPORATION, TARRYTOWN, NY

Mr. IFSHIN. Thank you, Chairman Baucus and Ranking Member

Grassley. My name is Adam Ifshin. I am the incoming chairman

of the International Council of Shopping Centers’ Economic Policy

Committee, and I am the co-founder and president of DLC ManageVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00073 Fmt 6601 Sfmt 6601 53637.000 SFIN1 PsN: SFIN1
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ment Corporation, an owner, developer, and redeveloper of shopping centers, headquartered in Tarrytown, NY.

I am appearing today on behalf of the ICSC, the global retail real

estate trade association for the shopping industry, the Real Estate

Round Table, and other real estate organizations whose members

will be significantly impacted by proposals to tax the return of all

carried interest as ordinary income.

Simply stated, I believe if such a policy is enacted it will be the

most sweeping and potentially most destructive tax increase on

real estate development, real estate investment, and value creation

in real estate since the modification of the passive loss rules of the

1986 Tax Reform Act.

I started DLC Management when I was 26 years old. I had no

money and the commercial real estate industry was struggling to

overcome the damage caused by the savings and loan crisis and the

aforementioned 1986 Tax Act.

Since starting from the ground floor, my company has grown to

become one of the Nation’s preeminent owners and mid-sized operators of retail shopping centers, with 70 such centers located across

25 States.

Over the past 16 years I have led DLC to focus on revitalizing

older existing properties in infield first-tier suburbs, cities, and

some small towns. DLC is dedicated to creating value, primarily

through redeveloping older, distressed properties in challenging environments which often include older suburbs and cities such as

Peekskill, NY, environmentally challenged brown field properties in

places like Levittown, PA, and inner city Baltimore.

We typically reinvest most of our capital gains in new projects

to make long-term investments in communities that would not otherwise see such revitalization. The differential in the tax rate between ordinary income and capital gains is an important driver in

our ability to recycle capital into new projects.

At ordinary rates, the return simply would not justify such risks

that we take in many cases. Imbedded in our business plan is the

concept that a material component of the return sharing is the general partner’s profit participation taxed at a capital gains rate.

Real estate development involves substantial risk, and the reward on the back end is what makes that risk worth taking. Capital gains treatment for the long-term commitments we make to the

investment is part of that reward. That assumes, of course, that

there will be a reward in the end.

Many real estate developments never get off the ground, others

fail or fall short of their investment goals. In all of these cases, the

general partner typically receives no compensation other than

nominal fees.

We take on significant risk every time we acquire a property.

The general partner is typically at risk personally on construction

loans, construction completion guarantees, and environment indemnities for all manner of real estate loans.

In sum, the general partner is taking risks beyond their investment in any given real estate project, and the carried interest is

earned in part for taking that entrepreneurial risk.

Many of our projects are not short-term in nature. Many of mine

have taken 5 to 10 years to reach full stabilization. If the carried

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interest were to be taxed at ordinary rates, the material shift in

the risk/reward trade-off for the developer would mean that fewer

developers would take such long-term risks and that those that did

would do it in higher-income, central business districts and fancier

suburbs.

The key for us is that the tax treatment allows us to take risks

that we would not otherwise take in places such as Newborg, NY,

Spring Valley, NY, and inner city Baltimore, where there is a fundamental under-served nature for the consumer. Our developments

typically lower the prices of basic commodities like milk and bread

for people who can least afford to pay.

According to IRS statistics, in 2005 46 percent of partnership tax

returns came from the real estate industry. The statistic is significant, as it clearly shows that carried interest applies to many more

businesses than just hedge funds and private equity firms with

which it is now being associated.

Thank you.

The CHAIRMAN. Thank you, Mr. Ifshin.

[The prepared statement of Mr. Ifshin appears in the appendix.]

The CHAIRMAN. Mr. Frank?

STATEMENT OF JOHN B. FRANK, MANAGING PRINCIPAL,

OAKTREE CAPITAL MANAGEMENT, LP, LOS ANGELES, CA

Mr. FRANK. Mr. Chairman, Senator Grassley, members of the

committee, I am here to address the proposed Publicly Traded

Partnership (PTP) legislation and the adverse impact it has had on

the mutual funds and other investment funds that invested in our

firm just this past May, on behalf of individual investors and retirement funds across the country.

Oaktree is a leading alternative investment manager. We man- age about $47 billion in 17 different strategies. Private equity is

part of that, but a reasonably small part, about 18 percent.

Each strategy that we manage focuses on a non-mainstream

asset class that some people might consider risky, but that we attempt to manage in a very conservative, risk-controlled way. No

one has ever lost any money invested in Oaktree, and we have a

very successful track record over a long period.

We are proud to manage money for 128 corporate pension plans,

the pension plans of 28 of the 50 States, including, I think, more

than half of the States represented on the panel, 225 colleges, universities, and charitable endowments.

As I indicated in May, just a couple of months ago, we sold about

16 percent of our equity to a group of mutual and other investment

funds. As a result, we are now a publicly traded partnership. There

is nothing unusual about our status as a publicly traded partnership and it does not push the envelope of any existing tax law.

In undertaking the offering and in becoming a publicly traded

partnership for tax purposes, we consciously subjected a substantial portion of our income to a corporate-level tax, whereas in the

past it had never been subject to such a tax because we were a

partnership, as are essentially all of our competitors.

When we made that decision, we had no way of anticipating that

the chairman’s bill and the ranking member’s bill relating to the

PTP legislation might be introduced.

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When we made the decision to make an offering, it was a close

call. We weighed the disadvantage of additional tax against the advantage that we thought we would obtain by creating liquidity for

our equity and a public valuation for our equity, an advantage that

we primarily sought in order to compensate and retain our employees.

Now, the proposed legislation, had it been enacted, might well

have caused us to change our view. In my judgment, it will cause

others to become less likely to go public, others in our industry.

I think that is a disadvantage, and it causes me to doubt the

merits of the legislation. I think it will result in less transparency

for our industry, it will result in less access to the investment opportunity represented by our industry, which has historically only

been available to the wealthy, and for those reasons I doubt the

merits of the legislation.

But if the committee deems it appropriate, nonetheless, to go forward with the legislation, notwithstanding those considerations,

then we very strongly urge that appropriate transition relief be

granted.

As was indicated in the chart which was attached to my testimony, our outside investors, these mutual funds that represent

money for individual Americans and their retirement funds, lost

over $100 million overnight when the proposed PTP legislation was

announced, and that was with a 5-year transition rule contemplated by the legislation.

When subsequent news reports indicated that that 5-year transi- tion period might be in jeopardy, the stock lost another $50 million

attributable to the portion held by the outside investors.

So we would urge the committee, if you move forward with the

legislation, to grant all of the publicly traded partnerships that

were in existence prior to the announcement and introduction of

the legislation, at least a 10-year grandfather provision.

The last time the committee addressed this issue in 1987, it

granted 10-year relief, which it later made permanent. In our case

we think it should be at least 10 years. We do not believe it will

provide any competitive advantage to the firms benefitted, either

in the competition for investment dollars or in the competition for

investments.

I see my time is up. I would be happy to answer any questions.

The CHAIRMAN. Thank you, Mr. Frank, very much.

[The prepared statement of Mr. Frank appears in the appendix.]

The CHAIRMAN. Mr. Rosenblum?

STATEMENT OF BRUCE ROSENBLUM, MANAGING DIRECTOR,

THE CARLYLE GROUP, WASHINGTON, DC; AND CHAIRMAN

OF THE BOARD, PRIVATE EQUITY COUNCIL, WASHINGTON,

DC

Mr. ROSENBLUM. Mr. Chairman, Ranking Member Grassley, and

members of the committee, thank you for inviting me to appear on

behalf of the Private Equity Council to present our views on taxation of partnership carried interest.

First, a few points about the private equity industry. It is not

just large firms like Carlyle. It includes hundreds of firms, large

and small, located in all parts of the United States. Even today’s

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largest firms were small start-ups as recently as 15 to 20 years

ago, and they are still owned in significant part by their founders.

Over the years, numerous companies, including such household

names as AutoZone, J. Crew, and MGM have been turned around

or improved by the focused strategies that characterize private equity investment.

Private equity has benefitted tens of millions of Americans

through superior investment returns delivered to pensions, endowments, and foundations, and carried interest ownership structures

are integral to the private equity business model.

Let us examine the arguments underlying proposals to raise

taxes on carried interest. First, we hear that private equity firms

are exploiting loopholes to avoid taxes on so-called compensation

for services.

But a carried interest is not compensation, it is a feature of an

ownership interest. It has been used for many years in many contexts. Its tax status is well settled, and it is anything but a loophole.

A second argument is that taxing carried interest allocations as

capital gains is inconsistent with the principles underlying differential long-term capital gains rates. It is clear that the companies we

own are capital assets and that the sale of those assets produces

capital gains, but some say that our share of those capital gains

should be recast as pay for performance.

This might make more sense if we were employees of the limited

partners of our funds, but quite the contrary, a private equity fund

is an enterprise established by its sponsor which sets investment

strategy and makes all business decisions.

The sponsor raises capital from limited partners, offering them

an interest with defined ownership rights, the first allocation of

profits until they have received a minimum return, and 80 percent

of the profits once this minimum has been achieved. The sponsor

retains an ownership interest that entitles it to the remaining profits. We are co-owners with our limited partners, not their employees.

Finally, some say that private equity firms should not be eligible

for capital gains treatment because we do not have capital at risk.

For starters, this is not accurate. Private equity firms contribute

substantial cash and intangibles to their funds and also retain the

residual risks of a general partner.

But leaving this aside, capital gains treatment has never been

tied to either the amount or proportion of capital at risk. It is tied

to whether one has an ownership interest in a capital asset.

Sole proprietors of small businesses may invest very little capital

and may generate most of their ownership value through personal

efforts, but when they sell their businesses the profit is capital

gain.

The founder of a technology company receives capital gains from

the sale of a substantial stock interest even if he or she contributed

only a tiny fraction of the company’s capital. These straightforward

rules apply even-handedly to everyone.

They reward entrepreneurial risk, whether that risk involves investing cash or investing years of time, effort, and vision. Strangely, the recent proposals on carried interest taxation would adopt a

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policy that only those with money to risk should qualify for capital

gains tax benefits.

A tax change of this magnitude is not without consequences. Private equity investment will not wither and die, but over time there

will be deals that will not get done, there will be entrepreneurs

that will not get funded, and turn-arounds that will not be undertaken, and it will likely mean lower returns for pensions and other

investors. I urge you to proceed carefully before risking this adverse impact on entrepreneurial activity that has been a positive

force for the U.S. economy.

Thank you, Mr. Chairman. I would be happy to answer questions.

The CHAIRMAN. Thank you, Mr. Rosenblum, very much.

[The prepared statement of Mr. Rosenblum appears in the appendix.]

The CHAIRMAN. Mr. Stanfill?

STATEMENT OF WILLIAM STANFILL, FOUNDING PARTNER,

TRAILHEAD VENTURES, LP, DENVER, CO

Mr. STANFILL. Chairman Baucus, Ranking Member Grassley,

members of the committee, my name is Bill Stanfill, a founding

partner of Trailhead Ventures, a private venture capital partnership focusing on information technology.

At the outset, I would like to make it clear that I speak not on

behalf of my firm, I certainly do not speak on behalf of the industry, rather, I speak as a private citizen who has been involved in

the venture capital business for 25 years.

In 1982 at the Centennial Funds of Denver, I was responsible for

a fund that invested in 30-some venture partnerships around the

country, which in turn invested in 600 to 700 venture-backed companies. These portfolio companies were scattered across the United

States from sea to shining sea, from Massachusetts to California.

I, too, have read Kate Mitchell’s testimony from the first hearing

about the wonderful things that we venture capitalists do. I think

it is an idealized view of our industry; a vision of the Wizard of Oz

comes to mind—before Toto pulled back the curtain. [Laughter.]

Ms. Mitchell and I simply come to different conclusions about the

tax treatment of our compensation.

It seems to me that all workers add value to a greater or lesser

extent. Randy Testa is a gifted teacher. He inspired and challenged

our son David and his 3rd grade classmates, enriching human capital as he went, yet the tax rate on my carried interest is less than

the tax rate on his salary.

There has been more than a hint of Chicken Little and the dire

predictions of the havoc that these tax changes will cause. In my

judgment, few, if any, of them will come to pass any more than the

end of the automobile industry which was predicted when seatbelts

and gas mileage were mandated.

I do not think many, if any, firms will move off-shore or that limited partners will stop investing. This change does not affect their

taxes. Most of them are non-taxable entities anyway.

I do not think losing the carried interest tax break would drive

other venture capitalists out of the field. We get ample compensation, financial and psychic, from the work that we do and the risks

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that we take—with other people’s money, by the way—in the form

of a share of the profits. I have been in the business for 25 years,

and the base compensation structure of 2 and 20 has survived all

the tax changes over that period of time.

How long will we tolerate the ever-widening gap between rich

and poor? Though my preference is for major tax reform, major tax

reform is not on your agenda. However, I do believe that it is fair,

equitable, and appropriate to work on the issue of tax equity where

we can. We should not do nothing because we cannot do everything.

I am especially disturbed by suggestions that we cannot afford to

provide health insurance for low-income children or first-rate medical care for our injured soldiers. I am disturbed that these and

other human priorities are unaddressed while we pretend that we

can afford to continue such tax breaks.

In conclusion, our earnings are compensation in my view and

should be taxed the same as compensation for everyone else in the

country. It is just not fair for teachers and firefighters to subsidize

a special interest tax break that costs billions of dollars a year.

We, and our representatives in Congress, have a choice. We can

change the tax code in favor of equity and fairness, or we can come

to the same conclusion reached by Walt Kelly. You remember Walt

Kelly and his mouthpiece, Pogo: ‘‘We have met the enemy, and he

is us.’’ Thank you.

[The prepared statement of Mr. Stanfill appears in the appendix.]

The CHAIRMAN. Thank you. This has been an interesting hearing.

We have had Sergeant Friday, we have the Wizard of Oz, and we

have Pogo here. [Laughter.] Things are looking up.

I would like to address a point that a lot of the private equity

people are raising and hedge fund people are raising, basically

that, if carried interest is taxed as ordinary income, that pension

funds and other investors in limited partnerships will suffer a

lower rate of return.

I would just go down the table here a little bit and ask people’s

reactions to that point, the degree to which that is actually going

to happen. I am wondering if, frankly, pension funds might go

shopping, looking for the best deal, because this is a competitive

business. There are a lot of hedge funds out there, a lot of private

equity firms.

But the private equity people raise the argument that, well, gee,

if they have to pay ordinary income on the carry, that they are

going to take it out on the pension funds. So there are lots of questions I want to address, but that is the one I want to address at

this moment.

Mr. Rosenblum, I will give you first crack.

Mr. ROSENBLUM. First of all, I do not want to engage in hyperbole or pretend that I have the crystal ball that sees all the consequences, but I think it is just simple economic common sense

that when a massive tax shift happens, there will be things that

ripple through the system.

I think you are absolutely right that this is a market-driven set

of terms between investors and sponsors of private equity firms,

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but in that environment the best private equity firms will be able

to look for ways to balance out these types of adverse changes.

Some people have also pointed out the obvious—I have read some

tax commentary—which is that an alternative to raising limited

partner investments to some degree may be to borrow funds and

just bear that interest cost, but retain more than 20 percent of the

profits in the fund.

So I think these things will work through the system, but it is

naive to think that it will not cause an economic change. I think

the proof of that is that there are many pension funds themselves

that have expressed concerns and believe that this will be the case.

The CHAIRMAN. Mr. Stanfill, your reaction to that question?

Mr. STANFILL. I cannot imagine that it would have a serious disruptive effect. I really do not have anything more to add to that.

The CHAIRMAN. All right. I am going to ask some of the academic

community.

Mr. Bankman?

Mr. BANKMAN. Subsidizing highly paid professionals is a really

inefficient way of helping out investors. Our economy works best

when we have the same rates across all industries. So pension

funds, like any other investor, would benefit from equal rates

across all industries and the elimination of preferences. And if high

rates are a problem, again, putting any additional revenue to work

at lowering rates for all industries would benefit investors.

The CHAIRMAN. Does anybody have a reaction to that basic question, the degree to which pension funds would be adversely affected

if—maybe even transitioning over a period of time—the carry was

taxed at ordinary rates? Anybody else want to take a crack at that?

Mr. Frank?

Mr. FRANK. Mr. Chairman, if I may, one thing I think the committee should be aware of in the spirit of how the hearings were

opened, let us just get to the facts. There has been a lot of discussion that assumes that the carry is synonymous with capital gains

income, and I just wanted to point out, at least in the case of our

firm, about two-thirds of the income that we generate is not capital

gains income, so the carry is not synonymous with a preferential

rate of tax, necessarily.

In terms of the impact that a change in law would have on the

pension plans that are our clients, I am sure that there are plenty

of people who would be very happy to manage the pension funds’

money.

The CHAIRMAN. Professor Bankman raised an interesting question, that maybe there is a difference between, on the one hand,

private equity and hedge funds, and perhaps maybe VC, real estate, on the other. It is the clothing goods store, the dry cleaning

store that two people start. One brother puts in the capital, the

other does the work.

On the surface, it seems to have an appealing argument that the

person who puts in the work should get a percentage of the gain

of the sale of the business when it is later sold. To what degree

does it make any sense to have some kind of differentiation according to size?

I think it is true, frankly, that this interpretation of the law by

the IRS, its genesis was back in the oil, gas, and other era when

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we did not have private equity and hedge. And maybe things have

changed a lot. Maybe it has something to do with size, something

to do with the character of the business. My time has expired, so

you are lucky the bell has rung. But that is a question in my mind

that I would like to address.

Senator Grassley?

Senator GRASSLEY. On the first question, I would like to ask the

entire panel yes or no, and then ask you, if you are not satisfied

with just saying ‘‘yes’’ or ‘‘no,’’ to supplement it with a written response.

I have read reports in the press that rather than change the tax

treatment of carried interest, some think it would be more fair and

equitable to raise the top marginal tax rate to 40 percent and the

capital gains rate back to 20 percent.

That would leave the fund managers with a 20 percent rate preference, while raising taxes on everyone else, including small business owners, households with two wage earners, investors who actually put their capital at risk, and retirees who depend on investment income.

So to the panel, would this make the tax system more fair and

equitable than changing the treatment of carried interest? Mr.

Bankman?

Mr. BANKMAN. No.

Senator GRASSLEY. Mr. Kingson?

Mr. KINGSON. No.

Senator GRASSLEY. Mr. Jones?

Mr. JONES. No.

Senator GRASSLEY. Mr. Ifshin?

Mr. IFSHIN. Yes.

Senator GRASSLEY. Mr. Frank?

Mr. FRANK. This is a complicated issue.

Senator GRASSLEY. Well, then answer in writing.

Mr. Rosenblum?

Mr. ROSENBLUM. No. I will supplement.

Senator GRASSLEY. Mr. Stanfill?

Mr. STANFILL. No.

Senator GRASSLEY. All right.

The CHAIRMAN. I might say, Senator Grassley, I would apologize

to you and I apologize to everybody here. I have to go to the floor

to manage the Children’s Health Insurance Program bill. But I

care deeply about this subject, trying to get the right answer here.

I do not want my departure to be interpreted as disinterest in this

subject. I really care about this.

Thank you, Senator Grassley.

Senator GRASSLEY. Thank you.

This one is to Professor Bankman about the publicly traded partnership bill. The Private Equity Council opposes our bill because

they say it unfairly singles out private equity firms and imposes a

triple tax. My response is that we have singled them out, and the

triple tax problem, if it exists for private equity firms, is a problem

that affects all corporations, and the tax code should not provide

preferences for financial buyers over strategic buyers when both

have access to public markets.

Which side of these arguments would you come down on?

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Mr. BANKMAN. I share your position, Senator. The line in the

sand that has been drawn says that actively managed, publicly

traded enterprises are taxed as corporations. If that is the line in

the sand, I think that we have a problem with organizations like

Blackstone not being taxed as corporations.

Like almost all academics, and probably like you, Senator, I

would support an abolition of the second-level tax on corporations

if we could manage it. But that is a mega-change that I would support for all corporations and not simply a small subset of actively

managed enterprises.

Senator GRASSLEY. All right.

On this question I am going to ask Professor Bankman, and I

think we will have time. I am going to ask him four questions, and

then I would ask Professor Jones and Mr. Kingson whether they

share the Professor’s views, or do you have other views.

Under Professor Gergen’s approach, and he testified a couple of

weeks ago, income from carried interest would be taxed at ordinary

rates when realized by partnerships. Four questions. Why is this

the right way to look at what is going on?

Mr. BANKMAN. I think it is similar to the incentive compensation

a CEO might get if she has done a great job. It is additional compensation for services. We would tax a CEO on that at ordinary income rates in the year that the income is received, and we are

doing the same thing here.

Senator GRASSLEY. All right.

Some view the proper treatment as a mix of ordinary income and

capital gains. If that is right, will the right answer not be somewhere between your proposal and the present law, and would that

be administrable?

Mr. BANKMAN. Peter Orszag, among others, expressed that belief.

It is true that under Peter Orszag’s theoretical framework, some of

the income recognized by fund managers would be capital gains.

On the other hand, that framework would tax fund managers in

the year they get a profits interest whether or not, and before, they

get any cash. In that sense it would accelerate tax liability and be

less favorable than the approach that Professor Gergen and I favor.

In addition, if the investments did not work out, it would stick

fund managers with a combination of ordinary income and probably unusable capital loss. In that respect, it, too, would be less favorable than the rule that I favor.

So on balance, I think the expected tax consequences of the simpler and much more administrable rule that Professor Gergen and

I favor are about the same as the ‘‘theoretically correct’’ rule that

Professor Orszag proposes.

Senator GRASSLEY. How do you respond to the claim that carried

interest is like founders’ equity? You say that it is ‘‘more sensible

to compare fund managers to the far greater portion of their cohorts who are taxed at ordinary income.’’ Who would that be?

Mr. BANKMAN. That would be any corporate executive, anybody

who goes into the business internally to a corporation, be it an investment banker, a management consultant, anyone who starts

their own business and lives off the profits, anyone who goes into

sales. More broadly speaking, it would be accountants or lawyers

who work for a business. Really, the list is almost endless.

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Senator GRASSLEY. I am not going to ask the fourth question because I think that I ought to ask Mr. Kingson and Mr. Jones if

they want to agree or disagree at this point.

Mr. KINGSON. On the first question, I agree with Professor

Bankman that it is compensation. It seems to me that it does not

really matter what you call it. When you say ‘‘carried interest,’’ I

assume you mean that you do not share expenses and that you do

not put up anything.

To me, contrary to what one of the other witnesses says, if you

do not put up any money and you get money, then you must be

performing services. Once you are performing services you can call

it a carried interest, but to me it just means there is no risk. No

risk, as recent computer regulations have indicated, that equates

with services.

Senator GRASSLEY. Mr. Jones, maybe a 10-second response.

Mr. JONES. Yes, sir. I agree with Professor Bankman and Mr.

Kingson’s discussion of the first question. There have been some

statements in the literature that the tax code already treats a carried interest under code section 707(a)(2)(a) as ordinary income,

that is, that 707(a)(2)(a) could be interpreted—reasonably, I should

add—as taxing service income at ordinary rates as if the service

partner were a stranger to the partnership.

Senator GRASSLEY. All right.

I call on Senator Bingaman. But Senators Lott, Kerry, Roberts,

Wyden are the next few, assuming everybody is here.

Senator Bingaman?

Senator BINGAMAN. Thank you very much.

Let me just ask a question that has been raised to me. If this

change in the law were to occur and, if we were to determine that

what has been carried interest taxed at capital gains rates or eligible for capital gains treatment if it is held long enough, that that

is now going to be taxed as ordinary income.

It is not possible for the folks operating private equity or hedge

funds to rewrite their contracts with their limited partners in such

a way as to continue to get the lower capital gains treatment on

the lion’s share of their own income. Professor Bankman, is that a

real prospect or not?

Mr. BANKMAN. I do not think it is. There have been a lot of socalled work-arounds that have been suggested. I think the only

work-arounds that are feasible will still result in substantial

amounts of ordinary income being recognized by fund managers.

Senator BINGAMAN. So you do not think that a general partner

could rewrite the contract to become a co-investor and get the benefits that any investor would get, the capital gains benefits to a

much greater extent than is currently the circumstance?

Mr. BANKMAN. I do not think they could do it without dramatically changing the economics of the deal. For example, they are not

going to want to give up their management fees, which you simply

do not get as a co-investor. So I think, while there have been workarounds proposed, on balance the bill will still raise substantial

amounts of revenue.

Senator BINGAMAN. All right.

Anybody else have a thought on that? Mr. Stanfill?

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Mr. STANFILL. It strikes me that we are capable, or to the extent

we are capable of investing in our own activity, we enjoy capital

gains rates on that investment just as our limited partners would.

So, I think that is my response.

Senator BINGAMAN. It just strikes me that you could have some

kind of contract which says we, the general partners, are going to

be co-investors in these various projects; we are going to get our

stock for 10 percent of what you, the limited partners, have to pay

for your stock in these ventures.

Mr. STANFILL. I have never seen that done in the venture capital

industry. I cannot imagine that our limited partners would not

push back on a provision like that.

Senator BINGAMAN. Mr. Rosenblum?

Mr. ROSENBLUM. Yes. Senator Bingaman, I do not know what all

the alternatives are, but I think one thing that gets lost in this discussion is that our current carried interests earn ownership interest. We form a venture and we finance it a certain way by raising

limited partner capital and giving out limited partner rights.

There are certainly alternative ways to structure a venture to

buy companies, and I mentioned earlier the possibility of borrowing

additional funds, which is an economic equivalent. So I do think it

is wrong to think the status quo will stay as it is forever and ever,

even if the tax treatment is radically changed.

Senator BINGAMAN. Let me ask a sort of more general question

that just may be for some of the academics here who understand

the tax code much better than I do. As I understand our current

tax code, the increase in the value of musical compositions is treated as capital gains. The increase in the value of literary compositions is treated as ordinary income. How is that explained?

Mr. BANKMAN. That is a good question. It is somewhat of an accident of history. We have more favorable treatment for, say, patents

than we do for literary compositions, and maybe it is that we are

a Nation of investors rather than artists, I do not know, Senator

Bingaman. It is a question I often put to students.

Senator BINGAMAN. All right.

Are there some changes that any of you would anticipate seeing

in the private equity markets if this tax change were made, the one

that Senators Baucus and Grassley have proposed? Are there some

obvious changes there? Mr. Rosenblum, did you have some change

that you think is certainly going to occur?

Mr. ROSENBLUM. I cannot say anything absolutely occurs, other

than the fact that people will look for change and that it will happen in some way or another. I mean, we are not going to rip up

our contracts with our limited partners. We have made a commitment to them. Even if the rules are changed in the middle of the

game, we are not going to walk away from that commitment.

But for the next generation of funds and other types of business

ventures, I am sure they will structured differently, or people will

at least try. Whether that ends up reducing the amount of tax revenue that at the end of the day is generated by this change or

whether it results in the limited partners sharing in some of that

tax paying, I think all of the above is a distinct possibility.

Senator BINGAMAN. All right. I think my time is up, Mr. Chairman. Thank you.

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Senator GRASSLEY. Thank you. I will pass over Senator Lott and

go to Senator Kerry.

Senator KERRY. Thank you very much, Mr. Chairman.

Mr. Kingson, it is my understanding that your testimony stated

that these funds do not take risks and they do not invest their own

capital. Is that accurate?

Mr. KINGSON. I said that the managers of the funds do not take

a risk.

Senator KERRY. Well, they often do. That is not accurate.

Mr. KINGSON. Well, no. But it is unrelated. Basically they want

the managers to put up their money so the managers will not

throw it away, but the managers may put up 1 or 2 percent of the

capital. To that extent, they will be treated, and it seems to me

they deserve, capital gains. But the discrepancy between 2 percent

and 20 percent, that is a pure profits interest, pure, really, compensation because they do not put up any money for that 20 percent. If they put up 2 percent, they will get 22 percent because

obviously——

Senator KERRY. Well, they do not get 22 percent if the deal goes

south.

Mr. KINGSON. No, but they do not risk anything either.

Senator KERRY. But that is not accurate. They risk a certain percentage. I mean, a lot of the deals that I have seen structured and

have been inquiring about, they are required to put up a certain

amount of money and they put it up in order to show good faith

to other people to attract their capital.

Mr. KINGSON. And to the extent that they put up their money,

I think they deserve capital gain.

Senator KERRY. Well, what is the difference then between some

fellow who goes out, or woman who goes out, has no money, and

goes to somebody—a friend, a banker, whoever—and says, look, I

want to start this store and I don’t have any money to invest, but

would you put it up, and you will get 60 percent of the business,

or 30 percent, or whatever it is, and I will keep the other piece of

it.

They are getting a certain piece of the business which, when they

start it, is not really a viable concern and is not a business, correct?

They go out, and every day they work it. They get up in the morning and they make the decision about whom to purchase from,

what to purchase, where to sell, how to sell, and they build the

business up off no money, non-recourse loan.

After 10 years, somebody comes along and says, I am going to

buy your business, and they sell their business. Whatever the percentage is of their ownership, they get it as an asset that has appreciated and they get capital gain.

Mr. KINGSON. Absolutely.

Senator KERRY. So what is the difference between that and somebody who happens to be sitting on top of a fund, who goes out and

says, well, we are going to put a small percentage of our money in

this and we are going to go raise some money and we are going

to buy this business, and it is failing, and we are going to turn this

business around by putting in a better management team, by working day to day. We are going to find a different strategy. We are

going to go out and appreciate this asset. At the end of appreVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00085 Fmt 6601 Sfmt 6601 53637.000 SFIN1 PsN: SFIN1
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ciating that asset, they sell it and they get it treated as an appreciated asset gain.

Mr. KINGSON. Well, first, if you start a business and the business has nothing, let us say it has $100 in it, you have a capital interest

and you pay $100 for that capital interest, you do not have any income. If you grow the business, that is fine. But this is not a business. This is investments. So investments, it is not a matter of putting in your effort to building a business, it is a matter of buying

and selling capital assets.

Senator KERRY. Well, we do that every day in the stock market.

You do not put any effort into it. You buy a stock. The stock is sold

after it is appreciated and you get capital gain.

Mr. KINGSON. That is exactly what I am saying, that if you put

money into it, if you buy the stock, then you deserve capital gains.

If you do not put money in it and just advise on it, you get ordinary

income.

Senator KERRY. But there are all kinds of value put into something. Take the example of a professor who leaves a college who

has a brilliant idea at MIT, and all he puts in is his intellectual

capital.

Mr. KINGSON. He puts in his intellectual capital, but people are

not considered to perform services for themselves. You do not get

paid. You do not have income when you drive the——

Senator KERRY. See, I think the distinction is a very slippery

slope.

Mr. KINGSON. I am sorry, Senator. I respect that. But it seems

to me that, if you do not put up any money in a business in

which—it is not a question of inventing something or getting good

will. For instance, if I were to say to Dow Jones that I can get a

premium——

Senator KERRY. Do you know something we do not know?

[Laughter.]

Mr. KINGSON [continuing]. That I can get a premium for you above the $60 that Murdoch is offering and that I want a percentage of that premium, I would think that, if I negotiated, unless I

got $2 above, $62, people would say, well, you negotiated it and you

advise it. They would not say I sold part of Dow Jones.

Senator KERRY. But there is also a mythology about that.

Senator GRASSLEY. Senator?

Senator KERRY. I know my time is up. We do not have time to

go into it, but I understand that within the hedge funds and elsewhere, a huge percentage of the income is already taxed at ordinary income rates because there is a flow-through and it is treated

according to whatever the particular business or income was. So

unless you appreciate this asset—you know, it seems to me, Mr.

Chairman, the thing we have to think about carefully in the committee are the downstream impacts of how you begin to treat this.

I can understand the impulse to try to sort of single something

out here, but the fact is, probably the more real question the committee ought to be considering is the overall tax rate at certain levels and what has happened to it. If you single out one piece and

say we are going to get our chunk here on some theory, that theory

may well have a lot of impact on how other deals are made and

how other capital is treated.

77

One of the things we have to be careful of, we have a pretty efficient—we always pride ourselves on it—capital formation structure

in this country, the most efficient in the world. I was here when

we did what we did in 1986 and 1989 and saw what happened with

the Resolution Trust Corporation and real estate and so forth. I

think you have to think carefully, particularly in this market with

what is happening with debt, how we are going to move.

Senator GRASSLEY. I think that is what this hearing is all about.

Senator KERRY. I understand. I am just trying to underscore it

in light of some of those concerns.

Senator GRASSLEY. Thank you.

Senator Wyden?

Senator WYDEN. Thank you, Mr. Chairman.

Mr. Rosenblum, you were asked earlier what would happen if the

Grassley legislation passed, and I am going to start with that because I think the one thing that is known for certain is that, the

day after that bill passes, scores of lawyers and accountants are

going to go to work to try to find new loopholes in a broken, outof-control tax code.

So it seems to me, instead of lurching from one convoluted tax

proposal to another, the country ought to get onto the topic of

broader tax reform. I want to start with you, Mr. Bankman.

Ronald Reagan supported getting rid of the capital gains differential altogether when there was a proposal with low marginal

rates, got rid of all the clutter and kept progressivity. I have introduced legislation that is identical to what Ronald Reagan proposed.

What is wrong with going back to those kinds of principles along

the lines of what Ronald Reagan advocated?

Mr. Bankman?

Mr. BANKMAN. Well, there were some signal achievements of the

1986 Tax Act that you are referring to. It widened the base, it lowered the rates, it simplified the law. Anything that does it would

be another signal achievement, so I would support that. Of course,

there are different ways of doing that. One way is to do something

similar to 1986. Then there are some more expansive proposals,

like progressive consumption tax. But either move would be an improvement over what we have now, in my opinion.

Senator WYDEN. Professor Kingson?

Mr. KINGSON. I agree with the Professor.

Senator WYDEN. I think you are supporting me, so I want to

make sure everybody can hear it.

Mr. KINGSON. Yes. I agree with Professor Bankman.

Senator WYDEN. All right.

Let me then turn to you, Mr. Frank, because I would like to get

somebody on the record who is working with these funds. I will tell

you, coming from a State that has large investments in private equity with our pension funds, I am looking at this very carefully.

It seems to me that the kind of thing that I am advocating which

picks up on what Ronald Reagan built for this country in terms of

tax reform still makes sense to someone in your shoes because you

have people who are willing to take risks. Risk and entrepreneurship is what built this country. But, if there was an approach that

in effect updated the 1986 Tax Reform Act, is that not something

78

that would still encourage the kind of investment that your folks

come to work every day to promote?

Mr. FRANK. Absolutely. No one can doubt that the tax code needs

to be reformed. We agree.

Senator WYDEN. I would like to give anybody else a chance,

maybe starting with you, Mr. Stanfill, because I think this is a

very hopeful coalition, Mr. Chairman. What we heard from Mr.

Frank, as the managing principal of a firm that every day focuses

on the issues in the Baucus-Grassley bill, is that he could support

what Professor Bankman and Professor Kingson are talking about.

I think that is the common ground that is good for this country.

I have been sort of running a lonely outpost here on the Senate Finance Committee for several years, trying to promote it. I am going

to see——

Mr. FRANK. Senator, may I make clear that we support comprehensive reform? We do not support the one-shot——

Senator WYDEN. I understand. I think that makes my case. That

is why, when Mr. Rosenblum said we are not sure what is going

to happen the next day after a Baucus-Grassley proposal passed,

I agree with you. I do not think anybody knows, other than what

I said is the certain reality. Tax lawyers and accountants all across

the land take out these codes which are taller than me, and I am

6-foot-4, and punch the next loophole into it.

What we have here with Mr. Frank and Professor Bankman is,

I think, a very promising opportunity to move forward in a direction that will promote growth, make us competitive in tough global

markets, and Mr. Frank’s people will come to work looking for investment opportunities and we will have a stronger, more vibrant

economy that is good for all of us.

Mr. Stanfill, the last word for you.

Mr. STANFILL. I agree with that, Senator. But I would also say,

short of that——

Senator WYDEN. Let us not stop short of that. Because if you stop

short, the lawyers and accountants go out and run the tables.

Mr. STANFILL. That has been our shared experience, sir.

Senator WYDEN. Very good.

Thank you, Mr. Chairman.

Senator GRASSLEY. Thank you.

Of the people who are here, Senator Salazar is next, then Senator Ensign, Senator Kyl, Senator Lincoln, and then Senator

Hatch.

So, Senator Salazar?

Senator SALAZAR. Thank you. Thank you very much, Senator

Grassley. I appreciate your interest in this issue and the leadership

of Chairman Baucus on this issue as well.

It is very interesting to sit up here and to watch the debate go

on between the panelists, because you have very different points of

view. I was just trying to count who would support a change in how

we tax carried interest, and I think we have four in favor and three

opposed.

So, somehow this group of political people up here who are not

tax experts and who are not in the business are somehow supposed

to figure out how we move forward, whether we move forward at

all.

79

So I did have a couple of questions. The first question is to the

non-academic folks, those of you who are in the business. Three of

you say no change. Bill Stanfill from Colorado, you say, yes, we

ought to go ahead and change and we ought to tax carried interest

at ordinary rates.

The chilling effect. People have said if we go ahead and we

change how we are taxing carried interest, what that is going to

do is put a chilling effect on the investment community that currently is involved. I would ask each of you to very briefly, in 30 seconds, tell me what you think that chilling effect would be, how dramatic it would be. How would you quantify it? Why do we not start

with you, Mr. Ifshin, and just move down the table this way.

Mr. IFSHIN. Senator, the chilling effect would occur in the following manner in our business from a consequences perspective.

Entrepreneurs in real estate are motivated to take risk, in part, because of the tax treatment that they receive on their carried interest. We are out looking to increase value, and while we are increasing that value we are creating jobs. We are creating both long-term

construction jobs, and then we are creating permanent jobs in the

properties that we build.

Senator SALAZAR. Do you have a sense, though—you reached

that conclusion conceptually. But what is a quantification in terms

of the impact that it would have in the investment area in your

case with respect to real estate development and redevelopment?

Mr. IFSHIN. In our case, our motivation to take that risk, which

very frequently involves the general partner personally guaranteeing a construction loan or guaranteeing the completion on a redevelopment loan, would be significantly removed because you are

talking about a dramatic——

Senator SALAZAR. So the motivation would be significantly removed. You and the industry do not have a quantification or a projection on what chilling effect that would have at this point?

Mr. IFSHIN. Not to my knowledge yet.

Senator SALAZAR. Mr. Frank?

Mr. FRANK. I think I would like to echo what Assistant Secretary

of Treasury Solomon said when he testified before the committee

a few weeks ago, which is the carried interest pervades the American economy. It has existed for decades. As the committee and the

Congress alters it, I think you need to be very conscious of the potential consequences, which I do not think anyone knows.

Senator SALAZAR. All right.

Mr. Rosenblum?

Mr. ROSENBLUM. I think it will reduce incentives for venture capital and private equity investing. That reduction in incentives is

most likely to be felt at the smaller firms or the riskier deals than

it is at the larger firms that have more room to maneuver. I think

it will give a lower cost of capital to foreign investment, both foreign private equity firms and foreign governments looking to invest

in this country. And as I said before, I think one way or another

it will result in a mix of some of the tax paying being taken back

through restructuring and some of it being passed on.

Senator SALAZAR. Mr. Stanfill?

Mr. STANFILL. Senator, I would reiterate that the 2 and 20 compensation system has survived 25 years of tax changes. But I think

80

the chilling effect, the only one I know of for certain, would be the

expectation of my children on the one hand, and perhaps the Outward Bound school in Colorado, which I support.

Senator SALAZAR. Thank you very much.

Let me ask a quick question of all of you. I just want maybe a

show of hands here. When I look at what is going to happen with

our tax code on down the road, I look at the Bush tax cuts that

are going to be expiring in 2010, I look at the spiraling deficit and

national debt that we have in this country, and I see a tax code

that I think everybody on this panel would talk about as being

overly complicated and nobody can understand.

So my thought on this initially as I approach this issue is that

we are taking a shot at one small area of the tax code, and maybe

what we need to do is to do something more comprehensive. The

President tried, with former Senator Breaux, Connie Mack, and

others in coming up with a commission and a comprehensive reform proposal. It did not work.

But following up on Senator Wyden’s comments, do you think

that that kind of comprehensive approach is something that we

ought to make a higher priority than the issue of carried interest

in this Finance Committee? If your answer is yes, raise your hand.

If you think we ought to go ahead and just keeping focusing on carried interest for the next several months, tell me that also. How

many of you would say yes to my question on the comprehensive

reform?

[A showing of hands.]

Senator SALAZAR. All right. I see two of the academics. So the

two at the end, Mr. Bankman and Mr. Kingson, you would say no?

Mr. BANKMAN. I love comprehensive reform, but I would not let

the best be the enemy of the good.

Senator SALAZAR. All right. Thank you. Thank you very much.

Thank you, Mr. Chairman.

Senator GRASSLEY. All right. Now it is Senator Ensign, then Senator Kyl.

Senator ENSIGN. Thank you, Senator Grassley.

A couple of comments, first. When we are looking at the whole

private equity issue, and, Mr. Bankman, when you were talking

earlier about equalizing the tax code and rates, the one thing that

I think at least I would share in common—I am not sure if this

is what you were alluding to—I would like to see corporate tax

rates lowered. The idea that we are thinking about raising some

because others are too high makes no sense.

We should be looking at lowering the other tax rates in the country. In this global marketplace that we are in today—I made this

point a couple of weeks ago in the hearing—I think it is important

that we are looking at ways to attract capital to the United States.

It has been said by several that some think that there will not

be any effect. There is going to be an effect. If you raise these rates,

there is going to be an effect. There is going to be change, whether

it is drastic, overnight. Some would argue that there would be,

some would argue there would not.

But there is going to be change. You only have to look across the

world and look for lessons, in that capital flows to the place of least

81

resistance, where it is the most welcomed, where it is going to provide the best return.

Part of that return is taxation. I made the observation that Ireland is a perfect example of that. It is called the Celtic Tiger for

a reason. One of their big policies that they changed, is they lowered the tax rates. The United States has the second highest corporate tax rate of any industrialized country.

For us to be raising others to personal income tax rates on this

idea of the carried interest and taxing partnerships, first of all, I

think it is very difficult to distinguish, at what level do you make

the change?

Mr. Bankman, in your testimony when you talked about, well,

for the small firms, at what level? Is there a gradual? Is there a

cliff? Do we make the tax code more complex? That is another

thing that makes us less competitive in the United States, is the

complexity of our tax code. I agree with Senator Wyden, we should

all be looking at overall tax reform instead of making one little

shot across the bow here because some people think that some

folks are making too much money.

It is very important in this global economy that we are providing

an avenue for capital to create jobs, or that capital will travel overseas. A lot of the folks who are investing in these private equity

firms, in hedge funds, in venture capitalists are not just Americans. They are the Chinese Government, they are investors from

Europe, they are investors from all over the world.

Well, it is very easy for them to just invest in other countries

where it is more attractive if we raise our rates, and that is one

of the points that needs to be made here.

The other point is, there is a difference between capital gains

and other income, for several reasons. One, and it has been talked

about because of the idea of inflation devaluing your asset over

time, but the second is that we want folks looking at long-term investments. A lot of the corporate income, a bonus for a public corporation today—we hear it all the time that public corporations,

that CEOs and corporate boards think way too much about shortterm investments.

The private equity markets look more on long-term investments.

The average, I think, is around 5 years for their investments. And

looking long-term is healthier for the economy. That is something

that cannot be overlooked, Senator Grassley, when we are thinking

about doing some of these changes to the tax laws.

The law of unintended consequences is the worst law that we

pass around here. It is something that no one sees. I fear, in this

particular situation, if we go forward, that is what is going to happen.

I am going to make a terrible prediction, what I think is going

to happen with this. I think next year that the Majority in the Senate and the House is going to tie this to the Alternative Minimum

Tax, and they are going to set it around a 25- or 26-percent rate,

and you all will feel like you got off, but they are still going to be

raising your taxes.

That is my prediction that I think is going to happen, because

they are going to be looking for revenue raises because there are

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sequence that I think will do damage to our capital markets in the

United States.

I wish I had time for questions. If I have time to stay around for

a second round, I would like to be able to ask some questions of

the panel. But I thought it was important to get some of those

statements on the record.

Thank you.

Senator GRASSLEY. Did you want Senator Hatch to go next? Senator Hatch?

Senator HATCH. Well, thank you, Senator Schumer and Senator

Grassley. I appreciate it. I think he is trying to get even for picking

on me last Sunday on television.

Senator SCHUMER. You handled yourself extremely well, Senator

Hatch.

Senator HATCH. We are good friends.

Mr. Rosenblum, you quoted an editorial in Pensions and Investments magazine that indicated that there would be pension funds,

endowments, foundations, and other tax-exempt investors who

would end up paying the extra tax from a change in how we tax

carried interest. Would you care to elaborate on this a little bit?

Mr. ROSENBLUM. Well, yes. We have discussed a little bit what

the consequences would mean of changing the effective tax cost of

doing business for private equity firms. As I have said, I think it

is hard to predict exactly how this plays out.

But one of the distinct possibilities is that over time, fund structures will get reworked, for one, and some level of activity in this

sector will be reduced. I think there will be a potentially significant

reduction.

Both of those things is likely to reduce the opportunities for pension funds that have been probably the single biggest category of

investors in private equity and have benefitted a great deal from

superior returns out of those investments.

I noted another article after this was submitted just this morning

with the head of the Washington State pension fund expressing

very similar concerns. I think the fact that this is coming from the

pension community as opposed to private equity sponsors is meaningful. I think we all see this as a potential consequence.

Senator HATCH. Well, here is another question for any of you

who care to answer. Mr. Rosenblum, I will start with you. Changing the taxation of carried interest would likely make the U.S. less

competitive, and the next generation of private equity entrepreneurs may set up shop in more hospitable locations overseas.

Now, do you see this as a real threat? Maybe we will just go across

the table.

Mr. BANKMAN. Well, the funds are already off-shore entities. In

order to get around this, you would actually have to have the managers of these funds effectively move off-shore, and that would really require something almost akin to giving up U.S. citizenship. So,

I do not see that as the next realistic alternative.

Senator HATCH. All right.

Mr. Kingson?

Mr. KINGSON. I had a client who was foreign and moved to Bermuda and could not stand it. [Laughter.]

Senator HATCH. All right.

83

Mr. Jones?

Mr. JONES. Yes. I agree with Professor Bankman. I think that so

long as the management expertise is domestic, then that is where

the money will flow.

Senator HATCH. All right.

Mr. IFSHIN. In the domestic real estate industry, we do not have

that option. The jobs we create are here and they are not outsourceable. To the extent that there is less development as a result

of a change, then the impact is going to be less job creation, less

value creation in our own domestic communities.

Senator HATCH. I see.

Mr. Frank?

Mr. FRANK. Senator, in my judgment it is a real concern. Already, 25 percent of our employees are located overseas. We see—

I think many investment managers like us see—a disproportionate

number of attractive investment opportunities overseas. I think

that legislation of this type could conceivably encourage investment

managers to concentrate their hiring overseas because it could be

beneficial to them and their employees to locate them overseas.

Senator HATCH. I see.

Mr. Rosenblum?

Mr. ROSENBLUM. I think the professors are missing the point. I

am not planning to move overseas, and I do not think my partners

in New York or Washington are planning to move overseas. But

capital is global. We are not the only private equity managers in

the universe. There are people who operate today out of foreign

countries. If the tax incentives for private equity operations flow

more to other countries and not the U.S., you will absolutely see

an increase in the foreign component of capital, and it will likely

be directed to foreign markets as well.

Senator HATCH. Mr. Stanfill?

Mr. STANFILL. Senator, I reside in the State immediately east of

yours and I cannot imagine leaving Colorado, if only because I can

visit the canyon lands of Utah.

Senator HATCH. You sound like a very reasonable person, is all

I can tell you. [Laughter.]

Mr. STANFILL. Well, I would add that the richness in both depth

and breadth of investment opportunity from Texas, Colorado, Utah,

to the West Coast will keep us home and investing happily in our

own backyard.

Senator HATCH. I just have a few more minutes.

Mr. Bankman, is it not true that investments in many different

industries commonly use carried interest and the partnership form

as a way of structuring investment vehicles, and that these industries include oil and gas, real estate, venture capital, timber, health

care, biotech, restaurants, cable television, cellular telephones, and

many others. How long have these structured existed? Has the current tax law been challenged or has it been a settled area of law

in these areas?

Mr. BANKMAN. I think, by and large, it is a reasonably settled

area of law. So what the committee is considering is whether it is

the right rule, not whether it is the actual rule.

Senator HATCH. All right. Thanks.

Senator GRASSLEY. Senator Schumer?

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Senator SCHUMER. Thank you. Thank you, Mr. Ranking Member.

I want to thank you and Senator Baucus for holding these hearings.

As you know, I have a particular interest in these issues because

this is an industry that is so important to New York. I look at this

the same way as, say, Senator Baucus would look at it if someone

were proposing a fundamental change in the way ranchers were

taxed. I look at it in the same way as if somebody wanted to do

away with tax credits for ethanol. I am sure the ranking member

would have a keen interest, as he should.

Senator GRASSLEY. Try me.

Senator SCHUMER. Yes, I know. I have. [Laughter.] I have. Every

Senator pays attention to the industries with big footprints in their

States, as they should. So, that is how I look at this issue.

It is not about keeping taxes low for wealthy hedge fund owners

or private equity partners. In fact, I have been very clear about

how I believe the country needs more revenues to pay for certain

priorities and that the wealthiest Americans, who have seen their

average tax rates decline in recent years, should be the first to pay

more.

Partners in hedge funds and private equity firms are counted

among the Nation’s wealthiest people, and their taxes probably

should go up. But I do not think it is right to target one particular

industry for higher taxes when other industries use the exact same

practices.

As I think about the interests of my State, I want to make sure

that New York partnerships are not singled out for different tax

treatment when many other partnerships around the country use

the exact same structure to pay lower taxes.

What possible tax policy justification could there be for taxing

one partnership’s carried interest differently than another’s? As we

touched on in the first hearing, oil and gas, real estate, venture

capital, timber, biotech, and restaurants are just a few of the businesses that commonly use carried interest.

If an oil and gas partnership in Texas or a venture capital firm

in California are using 2 and 20, how is that different from a private equity firm or a hedge fund in New York using 2 and 20? It

certainly seems that, as a matter of fundamental tax policy, it is

unfair to single out one type of partnership for different tax treatment than all the others when they are using the same structure.

I am also concerned about the effects that doing so could have

on New York’s economy. If an industry that predominated in New

York had a high tax and an industry with the same exact structure

in, say, Texas had a low tax, would capital flow from one to the

other?

There is an additional argument, this one to be made about revenues. One of the driving factors behind the effort to change the tax

treatment of carried interest is to raise the necessary funds to

make investments in education, health care, or pay for AMT relief

for the middle class. Under the new pay-go rules which this Congress has adopted and which I am proud of, you cannot just deal

with the AMT without finding the way to pay for it, for instance.

But simply raising taxes on private equity or hedge fund partners does not generate nearly enough. For example, I have seen esVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00094 Fmt 6601 Sfmt 6601 53637.000 SFIN1 PsN: SFIN1
85

timates saying that the Levin bill in the House would raise about

$4 to $6 billion, and that is about one-tenth the cost of fixing the

AMT for one year, which people estimate will be about $52 billion.

Most of us do not enjoy raising taxes, but, if we have to raise

taxes on the wealthiest Americans to pay for other priorities or

AMT relief, we should strongly consider doing it for everyone, not

just one industry.

Some have said that expanding this beyond investment partnerships will kill any bill. That is not my goal. My goal is two-fold:

increasing fairness and raising the maximum amount of revenues

in a way that does not distort our economy.

If the Finance Committee decides to move in this direction,

broadening the pool of those affected will improve fairness and

bring in more revenue at the same time, making it easier to meet

our pay-go requirements.

Now, my question. The fundamental issue here, or one of the

fundamental issues, and I think it is an interesting panel, I did not

hear any of you make an economic case for taxing financial services

partnerships differently from partnerships in other industries that

use identical structures or very similar structures.

So just to confirm, I want to go down the line one by one. Is

there any member of this panel who believes it would make economic sense, tax sense, to tax carried interest for investment partnerships differently than carried interest for oil and gas, or venture

capital, or real estate, or ethanol, or anything else?

Again, all of you may have different views on how the carry

should be taxed in the first place, but can any of you make the case

for when private equity and hedge fund partners should be taxed

differently from other partners? Let us just go down the line, and

then I will get some comments.

Do you think that there is a justification to treat them differently?

Mr. BANKMAN. No.

Senator SCHUMER. No.

Mr. Kingson?

Mr. KINGSON. No.

Senator SCHUMER. Mr. Jones?

Mr. JONES. No. And I think that once you do this, you will have

to change the proposed rules regarding all service partners.

Senator SCHUMER. All right.

Mr. Ifshin?

Mr. IFSHIN. No.

Senator SCHUMER. Mr. Frank?

Mr. FRANK. No.

Senator SCHUMER. Mr. Rosenblum?

Mr. ROSENBLUM. No.

Senator SCHUMER. Mr. Stanfill?

Mr. STANFILL. No.

Senator SCHUMER. All right.

Does anyone want to elaborate? Yes, Mr. Jones?

Mr. JONES. Yes. I mean, the Service has recently proposed regulations regarding the treatment of partners who receive a profit interest for services, and those regulations suggest that there would

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be no tax consequences, and in fact the profit interest could be

eventually realized as capital gains.

I think that if the Levin bill passes, it necessarily requires that

the proposed regulations would have to be redrafted so that all

service partners who get a profit interest for services eventually

recognize ordinary income. So I think you are absolutely right, it

would not be consistent.

Senator SCHUMER. Anyone else? Mr. Ifshin?

Mr. IFSHIN. To the extent that the carried interest has been

imbedded in the concept of real estate partnerships for in excess

of 50 years, Senator, in addressing the issue, clearly the maintenance of a differential to incentivize entrepreneurial risk-taking in

real estate is an important component for us to keep the type of

job creation we do and the development and value creation we do

in local communities.

Senator GRASSLEY. All right. Senator Roberts?

Senator SCHUMER. Thank you, Mr. Chairman.

Mr. STANFILL. I had just a brief remark. It strikes me, if the

probability of your suggestion is low, fairness and equity would dictate that you chip away at the margins.

Senator SCHUMER. But that is not from an economic or fairness

point of view, that is a practical, political point of view.

Mr. STANFILL. And fairness.

Senator SCHUMER. All right. Thank you.

Senator GRASSLEY. Senator Roberts?

Senator ROBERTS. I had thought that people would hush to let

me give my medical report, Sergeant Friday. Free at last! Free at

last! My cast is gone. I am supposed to squeeze this little ball. It

is a globe, which means I can serve on the Foreign Affairs Committee and be like everybody else in this body, either be a General

or a Secretary of State. So, I am squeezing away. [Laughter.]

I would like to associate myself with the remarks by Senator

Hatch, and also by Senator Ensign, who pretty well asked most of

my questions. But in Senatorial fashion, I will ask them again.

I share the concerns raised, especially by Senator Hatch, on the

university endowments and the pension funds, which I think is

something that we really have not thought of.

Mr. Ifshin, you noted in your testimony that, because of your

company investments, hundreds of jobs have been created and communities have been revitalized. We desperately need that in our

rural areas as well as our urban areas.

I am concerned that during this debate we talk about this as a

Wall Street issue, and I thank you for pointing out this is also a

Main Street issue that affects communities and pensioners and individuals all across the country.

So my question is—and I know what you are going to say—would

anyone else care to comment on the impact that these types of entrepreneurial investments have on Main Street? What is the benefit to communities in terms of job creation investments in local

economies? Would these investments continue to be made at the

level they are made now if taxes on carried interest were to increase? The answer, of course, is no.

So we will start with Mr. Bankman and just go right across.

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Mr. BANKMAN. Well, I think investors are better served with

breaks that get to them directly rather than a preferential rate on

one class of highly-paid professionals. So if we want the biggest

economy, I think that all investors, including Main Street, would

be better served by lower rates overall.

Mr. KINGSON. I agree.

Mr. JONES. I think that the subsidy, if that is how we want to

classify this, is poorly dispersed and it could be better spent directly in the inner city, for example. I do not think that giving fund

managers a significant tax break has any significant impact on

blighted areas in the inner city. I just do not believe that.

Mr. IFSHIN. And we clearly disagree, because that is a major

component of what we do. To the extent that we are full-time real

estate entrepreneurs, real estate capital flows historically flow to

primary first-tier major metropolitan areas, with the exception of

those portions of those areas that are blighted or distressed.

So to the extent that the carry incentivizes entrepreneurial—the

tax treatment of the carry as it is currently constructed incentivizes entrepreneurial risk-taking, whether it is my firm redoing a

center in Carbondale, IL that had a derelict and empty Kmart for

5 years and turning it into a Dick’s Sporting Goods, or us going

into inner city Baltimore and taking a center that had been foreclosed and was falling apart and investing millions of dollars in it

to create not only retail, but a major health clinic for the community, then that incentivization is crucially important both in the

inner city and in rural communities because those are the places

where capital typically does not naturally flow by market forces.

Senator ROBERTS. We are going to have to invite you to Greensburg, KS, the town that blew away. Maybe we can make some investments out there.

Please?

Mr. FRANK. Senator, I do not think anyone can seriously doubt

the positive impact on the Nation of the various investment firms

in the country as a group, both in terms of the investments they

make in revitalizing businesses around the country and in terms

of the returns they generate for the beneficiaries, their investors

who are typically retirement funds, pension plans, charitable endowments, and whatnot. The appropriate taxation of carried interest, obviously, is a different issue. It is a complicated issue. It is

why we are having hearings today, and I share your views on the

substance of that.

Mr. ROSENBLUM. Well, thank you, Senator. I think private equity

investing affects and benefits Main Street in several ways, first

through the revitalization of companies, and while the job growth

statistics are not comprehensive or definitive, what there is suggests that private equity companies do grow jobs at a faster rate

than other companies.

I think also that, while Senator Schumer pointed out there is a

large concentration of private equity firms in New York, there are

private equity firms in every State of the Union, and they are not

just large firms. They may have $5 million to invest and they may

be a critical part of supporting local and regional businesses.

Finally, as has been mentioned before, Main Street benefits

when tens of millions of pension participants receive better returns

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out of private equity investments, when universities and foundations receive those returns. So, it really does permeate throughout

the country.

Mr. STANFILL. Well, essentially I agree with Professor Bankman,

Senator.

Senator ROBERTS. All right. Thank you very much. My time has

expired. But could we not level the playing field that has been

talked about if Congress were to lower the corporate tax rate as

other countries have done? If a level playing field is what we are

really after here, that would be my suggestion, Mr. Chairman.

Thank you for your time.

Senator GRASSLEY. All right. Thank you.

Now Senator Hatch has one question, and then I will have three

or four questions, but they will not take very long and then we will

be done.

Senator HATCH. Let me just ask Mr. Ifshin: several witnesses

here today have discussed the idea of a hurdle rate. It seems to me

that in your business of turning around aging shopping centers, the

hurdle rate may be a key determining factor of whether a deal gets

done or not.

Can you tell us how your industry, or you in particular, view

hurdle rates and how they play into the decisions made by your industry and your firm, specifically, and how the proposal to charge

the taxation of carried interest might affect hurdle rates?

Mr. IFSHIN. Well, in most private real estate partnerships that

I am aware of—and I can certainly speak to how we structure ours,

and this is a place where real estate partnerships frequently differ

from other forums—the limited partners, the cash equity investors,

typically receive an annual compounded preferred return and their

return of capital prior to the general partner receiving anything

that is allocated to their profits interest or their carried interest,

whatever you prefer to call it.

In most real estate transactions, that hurdle rate may range between anywhere from, call it 8 percent on the low end, to 14 or 15

percent on the high end. So in essence, the general partner’s profit

participation is subordinated to that hurdle rate. So there is no

guarantee that there is going to be any compensation there whatsoever, that there is going to be any profit there.

In fact, there are many terrific real estate developments that

have occurred that have never met their hurdle rates because of

various things such as interest rate fluctuations, construction cost

overruns, failure to meet your leasing or your sales projections.

So the hurdle rate is a key component in a real estate entrepreneur deciding whether or not to undertake a development, a redevelopment, or an acquisition. So the key thing to understand is

that, if the real estate entrepreneur does not believe that they are

going to significantly exceed that hurdle rate, such that the remuneration, the profit that they receive at the end when they sell the

development, justifies the risk that they may have to take—which

in a new development or redevelopment may include risk beyond

the capital they have invested in the form of some guarantees to

their lenders—then that deal may never occur.

If the concept of how much of that carried interest that entrepreneur is going to get to keep shrinks because the taxation rate

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moves to ordinary income from the current capital gains treatment,

then you are creating a significant disincentive, because then the

deal would have to exceed the hurdle rate by so much more for the

developer, the real estate entrepreneur to have a motivation to undertake those risks.

In essence, that is very similar to the founder’s equity scenario.

Every single project that we undertake is, in essence, an individual

business that we are starting from scratch and we are taking startup risks from scratch. Until such time as that performs and we pay

our investors their hurdle rate and their return of capital, we have

not made anything. So, that is the analogy I would like to leave

you with as it relates to hurdle rates.

Senator HATCH. Thank you.

Thank you, Mr. Chairman.

Senator GRASSLEY. All right. A couple of questions. Actually,

maybe just one question for Mr. Rosenblum, Mr. Frank, and Mr.

Stanfill.

Fund management firms that have gone public have stated to

the Securities and Exchange Commission and to their investors

that their income, including carried interest, is from the provision

of services rather than owning investments.

Do you view your business as owning investments with financing

provided by others or as managing the investment owned by others? If you view it as owning investments, how do you explain the

seemingly opposite statements made by firms that have gone public?

Mr. Rosenblum, Mr. Frank, and Mr. Stanfill?

Mr. ROSENBLUM. Well, I think we view ourselves as owning ventures, partnerships, funds that engage in private equity investing.

We provide services certainly to those funds. We get paid management fees for those services, as well as having an ownership interest in those funds.

We, for security’s purposes, act as the investment advisor to

those funds in the sense that we are the ones who direct which investments to seek out, how to run those businesses, et cetera. I

think what you are referring to is the Investment Company Act requirements about engaging in that kind of active business.

I do not see any inconsistency with that level of activity on behalf of funds, as a general partner of those funds, and the fact that

we own a piece of those funds and that our ownership interest produces some capital gains.

Senator GRASSLEY. Mr. Frank?

Mr. FRANK. Senator, I just wanted to reinforce that. It has been

suggested, I know, that perhaps there is some inconsistency, that

a firm like ours is not an investment company for purposes of the

Investment Company Act, and yet it is engaged in certain activities

which qualify as passive income for purposes of the PTP rules.

As I believe the witness from the Securities and Exchange Commission indicated, and as I think was consistent with the testimony

of the Treasury Secretary, this seemingly apparent inconsistency,

in fact, is not inconsistent at all.

It is an example of our Nation’s laws using similar words and totally different contexts for different purposes. They are interpreted

90

differently, and this is by no means the only example of that in the

law.

Senator GRASSLEY. Mr. Stanfill?

Mr. STANFILL. Senator, it has always been my mind-set that I

manage a portfolio of private companies on behalf of my investors.

I receive compensation for that in management fees and carried interest, and I see no inconsistency in taxing both of those at ordinary tax rates.

Senator GRASSLEY. All right.

And my last question is a little different, to Mr. Rosenblum. I

have heard that at least half of all private equity firms convert

management fees into carried interest. This technique is described

in various tax treatises on carried interest.

Some managers convert their fees on an annual or quarterly

basis. Does this conversion not indicate that at least some of the

carried interest is really for services? Why should the service income be entitled to capital gains treatment?

Mr. ROSENBLUM. First of all, Senator Grassley, I do not believe

that there are many private equity firms that convert management

fees into carry. I should say at the outset that at my firm the arrangements are very straightforward.

For every fund that we have, we have a management fee and a

fixed rate. It runs for the life of the fund. We have a retained profits interest at a fixed rate that runs for the life of the fund, and

that is all there is to it. I am aware of techniques that are used

by some firms, and I have no idea whether it is 50 percent, 20 percent, or 10 percent, that are more complicated than that, but I

would not call them conversions.

What they do, essentially, is define that over time the level of

management fee changes, gets reduced as capital is invested, and

that the general partner participates in a portion—usually a small,

additional portion—of that invested capital with a contingent profits interest. I think it is a more complicated version of what has

been described simplistically here as 2 and 20, but I am not sure

that it differs much in its basic features.

Senator GRASSLEY. All right.

For Senator Baucus, me, and the committee, we appreciate very

much your participation. We thank you for it. This is an ongoing

discussion that we will have until some of us make our minds up

whether or not this is compensation or whether it is capital gains.

Thank you very much.

[Whereupon, at 11:55 a.m., the hearing was concluded.]

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CARRIED INTEREST, PART III

THURSDAY, SEPTEMBER 6, 2007

U.S. SENATE, COMMITTEE ON FINANCE, Washington, DC.

The hearing was convened, pursuant to notice, at 10:05 a.m., in

room SD–215, Dirksen Senate Office Building, Hon. Max Baucus

(chairman of the committee) presiding.

Present: Senators Rockefeller, Stabenow, Cantwell, Salazar,

Grassley, Smith, Crapo, and Ensign.

OPENING STATEMENT OF HON. MAX BAUCUS, A U.S. SENATOR

FROM MONTANA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. The hearing will come to order.

Thomas Carlisle said, ‘‘No man sees far; most see no farther than

their noses.’’ This committee has the responsibility to see as far as

we can, however—far beyond our noses. Before we choose a path,

we would do well to look down the path. We must understand how

our decisions will affect taxpayers and the economy months and

years down the road. That is why we hold hearings.

In July, we held two hearings on carried interest. Today’s hearing follows up on our hearing of July 31st. At that hearing, one of

the witnesses argued that increased tax liability for private equity

managers will be paid by pensioners. Today, we look into that

claim.

We have held these hearings on carried interest to consider

whether the current tax treatment of carried interest is fair. Is carried interest compensation for services? If so, then fairness would

point to application of ordinary income tax rates. If carried interest

is not compensation for services, then capital gains treatment is

probably appropriate.

Today’s hearing is not about whether or not carried interest is

compensation for services. Today I would ask all of you to set aside

this important debate and ask, what if? If carried interest were

taxed at the ordinary income rate, how would that affect pension

funds?

We need to address two basic questions. First, to what extent

would an increase in tax liability for fund managers be passed

through to investors? Second, to what extent would this passthrough affect retirees in pension plans?

As to the first question, how much would an increase in tax liability pass through to investors? The effect, if any, would depend

in large part on how dependent pension funds are on private equity

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investments. In fact, most pension funds have a modest level of investment in private equity and hedge funds.

A survey of large pension plans by the newspaper, Pensions and

Investment, showed that 36 percent of those pension plans had

hedge fund investments. That means 64 percent of those large pension plans had no hedge fund investments.

The folks at Money Market Directories estimated that, as of July

2006, American pension plans held about $350 billion in alternative investments, including private equity and hedge funds. That

is a lot of money. But in July of 2006, the same date, American defined benefit pension plans had more than $5 trillion in assets, so

they held less than 7 percent of their total pension assets in alternative investments. Two surveys of American public pension funds

found an even lower percentage, about 4.5 percent of assets, held

in alternative investments.

On the other hand, in 2006, about 10 percent of hedge fund capital came from U.S. pension plans. This data says to me that hedge

funds and private equity funds may need pension funds more than

pension funds need private equity or hedge funds. That means that

hedge funds and private equity funds may not have the economic

power simply to pass through increased costs to pension funds. All

that is not to say, however, that these alternative investments cannot play an important role in pension security.

Turning to the second question, assuming there is a pass-through

of significance of cost, how would that affect retirees and how

would that affect pension plans? Most pension funds that invest in

private equity are defined benefit plans.

Defined benefit plans promise their retirees a fixed benefit, and

the sponsors of defined benefit plans have to make sure that they

have enough money to pay that benefit. Thus, additional fees

passed through to private pension funds would generally flow

through to the sponsors of defined benefit plans—that is, the employers, not the retirees—so it is the employers who have the obligation to pay these benefits.

The situation for public pension funds is somewhat different.

Public employees generally pay part of the cost of retirement benefits and increased costs could be borne, in part, by employees. For

public plans, the employer is really the taxpayer. Taxpayers support the public retirement system, so taxpayers would bear most of

any additional costs that get passed through. Some public plans

pay additional benefits if investment earnings exceed specific levels, so a reduction in return could affect retirees.

I am very pleased that we have experts here, people who know

their stuff. Thanks very much for coming to our hearing so we can

better understand the role of private equity and hedge fund investments in financing pension plans, and for helping us to see how a

change in taxation of these arrangements might affect pension

plans.

This is an important subject. It is also a very fascinating one, intellectually very interesting, and I look forward to seeing what we

can learn from today’s panel.

Now I would like to turn to Senator Grassley.

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OPENING STATEMENT OF HON. CHUCK GRASSLEY,

A U.S. SENATOR FROM IOWA

Senator GRASSLEY. Thank you, Senator Baucus.

Earlier this year, Chairman Baucus and I asked the Government

Accountability Office to look into pension plan investments and

hedge funds. Since making that request, we have been studying the

tax treatment of carried interest. One argument against making

any changes is based upon what Senator Baucus spent so much

time raising the questions about—legitimately so—the concern of

higher taxes on fund managers if it is going to be passed on to

make pension funds’ returns somewhat less.

In response, Chairman Baucus and I intend to update our request, asking the Government Accountability Office to examine

pension plan investments, hedge funds, and other alternative investment funds like private equity funds. So I am glad for today’s

hearing because, as has been made very clear, we need some facts

on this.

Immediate reports and some of our preliminary findings indicate

that pension plans only invest a small percentage of their portfolio

in private equity and hedge funds. There are some outliers, however. That is that there are some pension plans that have an

alarming amount of the plan’s assets invested in these risky investments and in funds that are not registered with the SEC. This

ought to give all of us some pause. I hope our witnesses today will

inform the committee about the decision-making and due diligence

process associated with pension investments in private equity and

hedge funds.

This includes the thought process that is required of those representatives of pension funds who serve in a fiduciary capacity. The

economics of the decision to invest plan assets in particular investments must also be considered. Balancing risk and return and the

costs associated with an investment in one financial instrument

over another is an aspect that cannot be overlooked. Investment

decisions are generally based upon net returns. Net returns means

the gross earnings, less fees and expenses.

Economics 101 tells me that, if the expected rate of return of an

investment is diminished, I would consider moving my investment

elsewhere. Let me be clear. I understand that, when two sophisticated investors get together, these sophisticated investors enter

into complex business and legal negotiations involving multiple

economic variables. It may be difficult to discern whether a change

in one variable will change the outcome of the negotiations, but a

change in one variable will surely have an impact on the overall

negotiation process.

So I am going to ask the panel to describe the negotiations that

take place between a pension fund and, for example, a private equity fund manager. I want to emphasize that I do not believe that

pension plans should be prohibited from investing in private equity

and hedge funds. Strong argument can be made that these investments round out a well-diversified and well-balanced investment

portfolio. In addition, the capital that is provided through pension

investments could have a positive effect on the economy.

I do, however, think that the plan fiduciaries must tread lightly

when assessing the risk and return and the costs associated with

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those types of investments. Plan participants’ retirement security

obviously depends on it, and this hearing is all about finding out

whether that is going to be reduced in some way.

I fear the day that a pension plan would go under because a

hedge fund or sectors of the private equity industry have trouble.

As we examine the taxation of carried interest with these concerns

in mind, it is appropriate to ask the question then, to what extent

will a change in the way carried interest is taxed adversely affect

pension plan participants? That is what this hearing is all about.

Thank you.

The CHAIRMAN. Thank you, Senator, very much.

I would now like to introduce the panel. First, Alan Auerbach,

director, Center for Tax Policy and Public Finance at the University of California. Mr. Auerbach will discuss how the market will

affect fund managers’ ability to pass on tax increases to investors.

Second, Russell Read, the chief investment officer with the California Public Employees’ Retirement System, otherwise known as

CALPERS. Mr. Read will explain how and why CALPERS invests

in private equity and hedge funds, and how fees affect investment

decisions in negotiations.

Third, Donald Trone, president of the Foundation for Fiduciary

Studies. Mr. Trone will discuss how an increase in fees affects decision-making under risks and the Prudent Man investment rule.

Thanks, everyone, for coming. If you have longer statements

than the allotted 5 minutes, they’ll be admitted in the record. But

since there are only three witnesses today, I think this could be a

pretty productive hearing.

Thanks, Dr. Auerbach, very much.

STATEMENT OF DR. ALAN J. AUERBACH, ROBERT D. BURCH

PROFESSOR OF LAW AND ECONOMICS AND DIRECTOR, ROBERT D. BURCH CENTER FOR TAX POLICY AND PUBLIC FINANCE, DEPARTMENT OF ECONOMICS, UNIVERSITY OF

CALIFORNIA, BERKELEY, BERKELEY, CA

Dr. AUERBACH. Thank you very much, Mr. Chairman, and other

members of the committee. I am really pleased to be here to talk

about this issue. As you and Senator Grassley said in your opening

remarks, a reason for being interested in this is the impact that

taxation of carried interest might have on the returns of pension

funds and their beneficiaries.

The proposal to tax carried interest, as was already mentioned,

has one important motivation: a lot of people view carried interest

as compensation, and so it seems logical to many proponents that

taxing carried interest as ordinary income would make more sense

than as capital gains. I will return to that issue, briefly.

I cannot help but mention a second concern that a lot of people

have, that the managers of the funds that would be affected are

among the most highly paid individuals in the economy. Many are

disturbed that such high-income individuals face such low tax rates

on what appears to be ordinary compensation.

But on the other hand, there are concerns about the prospect of

taxing carried interest as ordinary income. One, which was already

mentioned, is the possibility that these taxes, while assessed on

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high-income fund managers, may ultimately be borne, at least in

part, by pension funds and their beneficiaries.

Second, I know that issues have been raised in previous hearings—and I think these are serious issues to consider—about potential problems of tax avoidance, in terms of restructuring of compensation or financial arrangements so as to avoid, at least in part,

some of the taxes that are increased.

To the extent that serious possibilities of avoidance are present,

that ought to temper one’s enthusiasm about the measures, not

necessarily because they would not be good things to do in principle, but because they may be difficult to do in practice. But I will

leave that concern aside for others to consider at other times.

It is difficult to formulate precise predictions regarding the economic effects of increased taxation of carried interest because there

is a lot of uncertainty here. Also, the data concerning these activities are not as good or as complete as in other situations that

economists study. But I can come to three conclusions.

First, assuming that the tax increase can be effectively enforced—that is, leaving aside the issues of tax avoidance—taxing

income from carried interest as ordinary income would be equivalent for the affected funds to roughly a 10- to 20-basis point increase in annual costs. That is as if the funds affected had a 10-

to 20-basis point increase in their operating costs each year.

Now, a key question is how the burden of this increase would be

split between fund managers or other employees of the funds themselves and their investors.

There are a lot of considerations that need to be taken into account when deciding the share of taxes that would be borne directly by the managers and the share that would be shifted to investors, including how responsive the level of activity is in the market, the degree to which the market is a competitive one, and the

degree to which there are alternative investments available to the

investors—the extent to which, if costs are increased by providers,

investors can go somewhere else.

After looking at each of these factors, I conclude that at least

some of the costs would be passed on to pension fund investors, although it is hard to say how much. It is going to be true, given the

small share of investments of pension fund investors in affected

funds, that the costs to their overall portfolios would be on the

order of less than one basis point annually in terms of annual returns.

Finally, I have to remark that the problem of carried interest is

one of a larger class of problems that arise from the favorable tax

treatment of long-term capital gains. There are alternative ways to

favor capital investment and saving without having that large differential, and removing the differential would alleviate problems

such as affect carried interest and other investments as well.

Thank you.

The CHAIRMAN. Thank you, Dr. Auerbach, very much.

[The prepared statement of Dr. Auerbach appears in the appendix.]

The CHAIRMAN. Mr. Trone, you are next. Well, I introduced Mr.

Read. Mr. Read, why don’t you go next?

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STATEMENT OF RUSSELL READ, CHIEF INVESTMENT OFFICER, CALIFORNIA PUBLIC EMPLOYEES’ RETIREMENT SYSTEM, SACRAMENTO, CA

Mr. READ. Terrific. Thank you, Chairman Baucus, Ranking Member Grassley, and members of the committee. It is a pleasure to be

here today.

I am Russell Read, chief investment officer of the California Public Employees’ Retirement System. I am here on behalf of 1.5 million California public employees and their families who depend on

us for retirement security, and also for the taxpayers who help to

fund our system. Our State constitution directs the California Public Employees’ Retirement System to act as a trustee to maximize

investment returns and minimize contributions required to workers

and public employees.

Our investment returns pay 75 cents of every pension dollar. The

rest is split between the employer and the employee. CALPERS is

governed by a 13-member board and is fully funded for retirement

benefits. It has nearly one-quarter of a trillion dollars in total assets. More than $17 billion of these assets are currently invested

in private equity, representing approximately a 7-percent allocation. This may seem small, but we believe it is incrementally significant, particularly in terms of the impact that it has on the returns of the overall fund.

Our Alternative Investment Management program, or AIM program, which manages our private equity allocation, began in 1990.

Since then, it has consistently out-performed its public equity

benchmarks in all relevant periods and added billions of dollars of

incremental returns. Those returns mean that we do not need to

raise taxes in that equivalent amount, so we believe this is a very

significant amount.

The AIM program’s most recent 1-year return was 28 percent.

Moreover, we are increasing both our allocation percentage and

dollars committed in general to private equity investments because

of not only the high historical returns, but also the high prospective

returns, because private equity also helps us to reduce our risk in

the portfolio because of diversification, and because private equity

offers us certain opportunities that we cannot access easily through

the public markets.

For example, our board is considering one potential investment

of many billions of private equity dollars in infrastructure projects

that are seriously under-funded and long overdue, both here and

abroad. We have also committed $700 million to a new private equity initiative aimed at generating attractive returns, while helping

to improve U.S. health care delivery. We have invested another $600 million also in private equity to

finance clean technology alternatives in order to help us to meet

the challenges of climate change and peak oil prices. Through private equity, we have deployed approximately $23 billion in the U.S.

economy and $28 billion globally, including over $6 billion in current commitments to venture capital, creating businesses and jobs

that otherwise would simply not exist.

Our private equity investments also include hundreds of millions

of dollars in under-served California markets that have been overlooked by traditional sources of investment capital. It is through

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these programs, such as the California Investment Initiative, the

Clean Technology Initiative, and the Health Care Investment Initiative, that we have the biggest and most positive impact on the

environment and on health care.

CALPERS is a limited partner in several hundred private equity

partnerships, and more than 5,000 companies have received fresh

capital through our efforts. My written testimony provides the details of how these partnerships work, including fees.

Essentially, each private equity investment has its own unique

terms and conditions, which we heavily negotiate with each general

partner. The level of fees charged by a general partner is but one

consideration of our analysis in negotiations for all of our private

equity investments.

Our objective is to pick the very best general partners and negotiate the strongest possible alignment of interests with them in

order to achieve the best possible performance, net of all fees. A

delicate balance exists for an investor like CALPERS to be successful. We need to achieve access to the very best private equity investments, while at the same time negotiating appropriate financial incentives for the general partners.

In short, our experience with private equity investment has been

highly positive since we began investing nearly 2 decades ago. If

done well, we believe private equity investment can be of great

benefit to all institutional investors, including public pension funds,

and provide fresh capital and benefits to the American economy.

We are pleased that the committee is giving this important issue

full consideration and the deliberation that it deserves.

I thank you for the opportunity to address the committee and

would be happy to address any questions.

The CHAIRMAN. Thank you, Mr. Read, very much.

[The prepared statement of Mr. Read appears in the appendix.]

The CHAIRMAN. Mr. Trone?

STATEMENT OF DONALD B. TRONE, PRESIDENT,

FOUNDATION FOR FIDUCIARY STUDIES, CORAOPOLIS, PA

Mr. TRONE. Mr. Chairman, members of the Senate Finance Committee, there are more than 5 million men and women who serve

as investment fiduciaries, who serve as trustees and members of

investment committees of retirement plans, foundations, endowments, and personal trusts. In turn, these 5 million investment

stewards are responsible for managing the majority of our Nation’s

liquid investable wealth.

As critical as their function is to the fiscal health of this Nation,

we still do not have a single Federal or State agency that is providing education and training to the 5 million. Nowhere is this

problem more pronounced than when we begin to examine the absence of sound fiduciary practices by many retirement plan sponsors when they make investments into hedge funds and private equity.

Good morning. My name is Donald Trone, and I am the president

of the Foundation for Fiduciary Studies and the founder of

Fiduciary360. I have more than 20 years of experience in writing,

lecturing, and preaching about the subject of investment fiduciary

responsibility.

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I appreciate the opportunity to appear before you today and, as

requested, my testimony will address the investment fiduciary

issues associated with the use of hedge funds and private equity,

including the likely impact a proposed change in the tax treatment

of carried interest received by hedge funds and private equity managers may have on the decision-making process of an investment

fiduciary.

To address the latter first and to cut to the chase, a tax on hedge

funds and private equity fund managers likely will have no more

impact on the inappropriate use of these investment strategies

than a hike in the capital gains tax would have had on investors

during the dot-com bubble.

Unfortunately, in many cases where investment fiduciaries have

invested in hedge funds and private equity, speculative hubris has

supplanted procedural prudence. Most investment fiduciary legislation is based on the flexible doctrine that gives consideration to incorporating changes in the types of asset classes, asset strategies,

and financial products made available to investors. At the root of

this doctrine is the concept of a process standard and the requirement that the investment fiduciary demonstrate their procedural

prudence.

No asset class is ever inherently imprudent. It is the way it is

built and how it is used that determines whether the prudence

standard has been met. While even the most aggressive and unconventional investment strategies, such as those employed by hedge

and private equity funds, can meet the standard if arrived at

through a sound process, the most conservative traditional asset

classes may be inadequate if a sound process is not implemented.

Our Foundation for Fiduciary Studies has identified 22 practices

that provide the details of a fiduciary’s prudent investment process,

and a listing of those practices is contained in Enclosure 1. Three

of the more significant practices are the requirements that the fiduciary demonstrate the due diligence process that was followed in

the evaluation, selection, and monitoring of each investment option.

There are numerous factors that should be considered which are

determined by facts and circumstances, such as size of the portfolio, the investment expertise of the fiduciary, the liquidity of the

investment option, the degree to which the investment option is diversified, the degree of regulatory oversight, and the ability of the

fiduciary to perform appropriate due diligence.

Now, compare the due diligence process just outlined to the process described in a recent Wall Street Journal article entitled, ‘‘Venture Firms vs. Investors.’’ A full copy of that article is provided in

my written testimony.

The reporter describes how some investment fiduciaries are

strong-armed by venture firms into investing into unproven funds

in order to remain within the good graces of the venture firms.

Quoting from the article, ‘‘These investors—including big university

endowments, foundations, and pension funds—worry that, if they

don’t comply, they could damage their relations with the venturecapital firms and possibly lose out on the chance to get into the

firms’ more typical funds, which invest in small start-ups.’’

The investment fiduciary also has a duty to control and account

for all investment-related fees and expenses, including the duty to

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identify all parties that have been compensated from these fees,

and a duty to demonstrate that an assessment was made as to

whether each party is receiving compensation that is fair and reasonable for the level of services being rendered.

The well-publicized exorbitant fees that investment fiduciaries

are willing to pay for access to hedge funds and private equity provide convincing evidence that we are witnessing yet another investment bubble. All bubbles have the same characteristics, best summarized as ‘‘the too’s’’: too much product is brought to market too

soon, it is not being properly vetted, and it is too expensive.

Specific to the impact a proposed tax on hedge funds and private

equity managers would have on the fiduciaries’ decision-making

process, a tax hike would have the impact of reducing the investment’s return, as well as reducing the attractiveness of the investment’s expected risk/return profile.

Unfortunately, even knowledgeable and responsible investment

fiduciaries often are not capable of accurately modeling a hedge

fund’s risk/return profile because of the lack of portfolio transparency and the absence of an audited track record.

In theory, a tax hike would have the effect of making hedge

funds and private equity investments less attractive in a prudently

diversified portfolio. In reality, the current unbridled exuberance

for these investment strategies means that a tax increase will have

little to no effect.

Thank you.

The CHAIRMAN. Thank you, Mr. Trone, very much.

[The prepared statement of Mr. Trone appears in the appendix.]

The CHAIRMAN. Let us start with you, Dr. Auerbach. If I heard

you correctly, you say that basically 7 percent of pension fund assets are invested in alternative investments. Is that correct?

Dr. AUERBACH. As was mentioned in the opening statements,

there are different ways of measuring this percentage, but I think

it is likely under 10 percent; maybe 7 percent, maybe 4 percent. It

is a small number. It is growing because the size of the industry

is growing, but I think 7 percent is in the ballpark, yes.

The CHAIRMAN. And you also said, if I heard you correctly, that

the net effect of taxing carried interest—that is, the carry part—

as ordinary income would be a reduction in investors’ return of

about one basis point.

Dr. AUERBACH. Or less.

The CHAIRMAN. Or less.

Dr. AUERBACH. Yes.

The CHAIRMAN. And one basis point is 1/100th of a percent.

Dr. AUERBACH. That is correct.

The CHAIRMAN. Or less.

Dr. AUERBACH. That is right.

The CHAIRMAN. Which is to say it is barely an asterisk on a total

basis.

Dr. AUERBACH. Well, it is being multiplied by a large number.

The CHAIRMAN. I mean, to the investor, though.

Dr. AUERBACH. The pension fund sector is trillions of dollars. Annual returns being reduced by one basis point, to you or me would

not be very much money. To them, it is more money, but not as

a share of their investment returns.

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The CHAIRMAN. But at least to the employee, if we are talking

about public.

Dr. AUERBACH. It would be a very small effect.

The CHAIRMAN. I mean, less than 1/100th of a percent.

Dr. AUERBACH. It would be a small effect.

The CHAIRMAN. Right.

Let me ask you, Mr. Read. I appreciate very much all of

CALPERS’s investments in alternative investments. I think that is

creative. It is good for a lot of reasons.

What effect would changing the character of the taxation from

capital to ordinary income have on your activities and what

CALPERS does in investing in private equity?

Mr. READ. Well, we would be very pleased if the answer were one

basis point. That would be a terrific outcome. From our perspective,

it is really hard to know. It is a very complex negotiation that actually occurs. We are looking for the best after-fee returns.

But we know that, historically, there has not been a material

change in terms as tax rates have shifted. This is but one factor

of many that would enter into our negotiations. The competitive

landscape, the amount of capital in the asset class, the number of

people who are looking for the best private equity managers, those

are all important factors, determining the terms of our engagement.

From our perspective, the most important thing is to have an appropriate alignment of interests. So, all in all, it is difficult for us

to know exactly what the effect would be of a change in taxation

on carried interest, but we do not have a view whether, right now,

that would be significant or not based on the complexities.

The CHAIRMAN. You do not have a view right now? That is interesting. If that is the case, and since you are so involved in this

area, it kind of sounds like it would not have a great effect. If you

do not know what the effect would be, it sounds like it would not

be very great.

Mr. READ. Not knowing what the effect would be really is not

knowing what the effect would be. [Laughter.] Our hope is that it

would be small, but it is hard to know. We would certainly have

to see.

The CHAIRMAN. I am just a little curious. Why do you not know?

I know you do not know precisely and specifically, but, since you

are so involved in this area, I would think you would have some

off-the-top-of-your-head gut response.

Mr. READ. The reason why it is more difficult for us to actually

know what the effect would be, is that this is a highly evolving industry and a highly evolving set of negotiations. The negotiations

between an investor and the private equity firms changes dramatically over the course of the year, for a number of reasons. This

would simply be another factor among many. So, that is why it is

hard for us to know exactly.

The CHAIRMAN. When you are looking at alternative investments—I am just asking for my own information here—it kind of

sounds like you have more options available to you than, say, private equity does to them. That is, you have lots of differing alternatives. You are very diversified in many different investments, I

am supposing. Is that correct?

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Mr. READ. Absolutely. One of the important things for our success is having access to great investors, both inside the organization and outside the organization. One thing that has been important about the private equity industry is that it has represented

some very creative capital. So when we talk about the hundreds of

partnerships that we have invested in, that we have done due diligence on, it has represented some of the most creative investment

minds, we believe, possible.

The CHAIRMAN. Right. But I am just trying to get at, I am wondering—again, I do not know—you may, all things being equal,

have a little more bargaining advantage when bargaining with private equity or hedge than they do with you in the sense that you

have many more choices. They have, relative to you, fewer choices.

Mr. READ. Although it might seem that way, I will sort of extrapolate, not only to private equity, but also to hedge funds. We

are an important investor. We represent billions of dollars in capital. But our ability to dictate terms is very limited. It is part of

the negotiation. I think there are four important areas that we

view as subject to the negotiation. They involve questions of suitability, they involve questions of transparency, liquidity, and fees.

So all four of those are wrapped into our negotiations. I would say

it is a fairly even bargaining position. We are probably on——

The CHAIRMAN. My time is expiring. But among the four, are

those evenly weighted, roughly, or are they disproportionately

weighted?

Mr. READ. I would say we have certain thresholds for transparency and for liquidity, which are absolute requirements for us.

Fees are certainly negotiated. We have a number of different programs, as you pointed out, so private equity for us is actually a big

area.

The CHAIRMAN. Sure.

Mr. READ. It is many types of investments. We help set up some

of the private equity firms ourselves. Our Health Care Investment

Initiative, as an example, is something which we helped to set up.

So we are kind of maybe not in a unique position, but we are both

investors as limited partners, but we also have an ownership interest in about a half a dozen private equity firms.

The CHAIRMAN. CALPERS has a great reputation for being very

creative, very successful. Thanks very much.

Senator Grassley?

Senator GRASSLEY. Mr. Read, I want to state four questions to

you all at once, taking off from Professor Auerbach’s testifying that

special characteristics of the private equity industry suggest that

at least some of the fund managers’ higher tax costs would be

passed on to pension plans.

Describe negotiations that take place between CALPERS and

fund managers generally. What factors enter into negotiations of

the carried interest percentage and fee structure in the various alternative asset funds? If Congress were to change the taxation of

carried interest, would you expect fund managers to seek changes

in their fee structures to make up the extra tax cost?

Then, did the fee structures change in any of your alternative assets’ investments in response to changes that we have had in rate

differentials? Like, in 1986 we had 28 percent for both capital gains

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and ordinary income, and then capital gains went down to 20 percent, and now 15 percent.

Mr. READ. Taking the last question first, we have taken a look

at what the effect has been on changes in taxation on our negotiations, and also on fees. In the past, there has not been a discernible

relationship. There is an important caveat, which is, many of the

changes since 1990, since we entered into the private equity space,

have been favorable tax changes in terms of more favorable taxation rates for capital gains.

As we go the other way towards something which is less favorable, it is hard to state with confidence that there would be no

change in our negotiations. In fact, my personal expectation is that

this will be a factor. How large a factor it will be is a really open

question, very difficult to know. Again, I would be very pleased if

it were a one basis point sort of adjustment in our returns.

What goes into our negotiations, though, is a more complex mix.

I should describe what actually transpires. We look for the very

best managers. There are really three things that we are looking

for: great past performance, a great existing team, and a great investment thesis going forward. So, all three of those have to be in

place.

Once we identify a team that is compelling, that we have confidence that they will deliver terrific investment returns in a particular sector of private equity, we then begin the negotiating process. Again, the factors that are important to us include transparency and liquidity. Fees are part of it, but it is really the afterfee return that we are most interested in. So we have to make an

assessment. We make an assessment of what the after-fee return

will be.

One of the important things about the way that this sector is

compensated is, most compensation is given in terms of incentive

compensation, which is performance-driven. So there have been big

fees that have been paid. We, ourselves, have paid, certainly, big

fees to our private equity partners, but it has been related to real

success. So, if they do not perform, if they do not deliver the returns, they do not generally get paid terribly well.

So the fact that the high fees are associated with high performance is a real positive. It leads to a very different view of fees than

we have in most other areas, namely we tend to pay the most fees

at the time that we get the best returns, so that is a very positive

characteristic.

The other thing that is important is that there is a wide dispersion of returns associated with different private equity managers.

Now, this is actually greater in the private equity area than in

many other asset classes. So, for instance, having access to the top

quartile of managers is very significant. We are actually not as interested in private equity as a general asset class, just being exposed to private equity. What we are interested in is having access

to the best of the private equity industry.

What this means, also, is that they tend to be among the players

who command the highest level of fees. So this is different, again,

I think, than some other asset classes in many of the public equity

markets and fixed income markets. Having access to those markets

is of preeminent importance.

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Here, having access to the best managers is what is most important, so they do tend to command the best terms. I think it gets

back to one of Chairman Baucus’s points, which is, you would think

that we would have the upper hand in these negotiations, but because we are seeking to negotiate with the finest private equity

managers, it is a fairly even negotiation. We do not find it straightforward to simply dictate terms.

If Congress were to change the taxation of carried interest, I

would personally expect that, again, that would come up in the negotiations. How it would manifest itself would be very peculiar on

every situation. For instance, for those private equity situations,

the managers that we helped to create, we do not believe it would

have any effect whatsoever; on others, we think it could be significant. So it is sort of a rich and complex area.

The CHAIRMAN. Thank you, Senator.

Senator Stabenow, you are next.

Senator STABENOW. Thank you, Mr. Chairman.

Thank you to each of the witnesses. In listening to all three of

you, we are basically hearing, Dr. Auerbach, you said in your testimony, we are looking at 1 to 2 basis points at most of difference.

Mr. Trone, you are saying, as a practical matter, because of the

exuberance in the market and what is happening—and I am concerned about the bubble that you talked about—that there would

be little to no effect.

Mr. Read, you are saying you do not know, but on the other

hand, indicating—obviously you are negotiating point by point, but

with the managers you deal with you just indicated there would be

no effect. I am not sure you are willing to say that. So it looks to

me like, from the perspective of the panel, we are not seeing a

great concern about moving in some direction as relates to more

tax equity.

I do not know if anybody would want to disagree with that, but

it appears to be what we are hearing. I am wondering a couple of

things. And Mr. Read, not to pick on you, because you have been

getting the bulk of the questions, I know the chairman has gotten

two different letters from the National Conference on Public Employee Retirement Systems, the first one saying that members were

concerned, and then the second one that we have, while some of

the members feel that the bills could affect public plans, the majority of the members do not share that opinion.

Is that your analysis as well, in working with the National Association, that the majority of the members with public employee

plans do not share the opinion that it would have a negative effect?

Mr. READ. I think my view is that we believe that tax policy can

have a very significant effect. In particular, in negotiations it can

be significant. We have not taken a position, nor do we anticipate

taking a position, as a public pension plan, particularly an artifact

of the State of California. We are very reticent to weigh in on Federal tax policy. There are lots of very important issues for you to

weigh, and we take that as our starting point.

So the NCPERS letter that you are referring to, we know was

retracted. That was important. We were not consulted on that particular letter. NCPERS’s official position is, at this point, equivaVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00113 Fmt 6601 Sfmt 6601 53637.000 SFIN1 PsN: SFIN1
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lent to ours, which is that tax policy, we think, is very important

and also should not be in the realm for us as a public policy issue.

Senator STABENOW. If I might just follow up, we have been talking about impact overall as it relates to availability of capital in

private equity firms. And certainly coming from the State of Michigan, there are many positive things that are happening, and we

welcome investment and appreciate the partnerships that are taking place. But from the perspective of public retirement systems,

it seems to me there is a different kind of equity question.

That is, you have firefighters, police officers, school cafeteria

workers, and public employees who are paying into a retirement

system, and they have been taxed at regular income tax rates, and

then there is a question whether or not the fund managers who

defer their payments would pay something less than that, 15 percent capital gains rather than 25 percent, or 30 percent, and so on

in addition to the question of very large bonuses. Clearly, folks

have done very, very well under the system.

Does anyone want to speak to that? Mr. Read, from your standpoint, you represent those folks. You represent their pension plans,

people who are paying regular income tax rates and counting on

and looking for equity in the tax system to work for them as average Americans. Any comments about the question of equity in that?

Mr. Trone, you might, as well. I do not know if you would have any

comments on that.

Mr. Read?

Mr. READ. Sure. What you raise are very important questions.

For me, it is a more narrow focus, which is providing the best possible returns and diversification for the plan that our members will

be most benefitted for as providing the best returns for their retirement security. So I think the concerns you have raised are important, and we view it as inherently out of our purview.

Senator STABENOW. All right.

Mr. READ. The purview that we have is much more narrowly focused. So, we will simply take whatever decisions and policies you

determine and we will take that as our starting point.

Senator STABENOW. I appreciate that. I know my time is up, but

Mr. Trone, you wanted to say something. If you might just quickly

respond. I know my time is up, Mr. Chairman.

Mr. TRONE. What I would add to that is, when you started reading off the list of firefighters, police, sanitation workers, and teachers, we need to also understand, they comprise half the membership of the investment committees that we are talking about.

So when we talk about the need to train and educate the 5 million investment fiduciaries, that includes firefighters, teachers, police who are now making these investment decisions to invest in

these private equity and hedge funds, and they lack the training

and understanding of the fiduciary practices and prudence associated with that.

Senator STABENOW. Thank you.

The CHAIRMAN. Thank you, Senator.

Senator Crapo?

Senator CRAPO. Thank you very much.

At a time when many of us are raising concerns about the competitiveness of the United States in global capital markets, it seems

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to me that the last thing we want to do is to create a disincentive

by increasing taxes and encouraging the movement of business

away from the United States to London and other capital markets.

Just yesterday, the U.S. Chamber of Commerce released a first

phase of a two-part study of the impact of increasing carried interest taxes on the U.S. economy. The purpose of the study was to better understand how carried interest affects the economy as a whole,

and how different sectors and industries may be impacted by this

proposed tax increase.

This study concluded that carried interest is an element of partnership finance in every sector of the U.S. economy engaged in capital formation. Increasing the tax rate on carried interest would

lead to changes in the structure of partnership agreements, and incremental tax collections would be small.

To the extent that the tax increase could not be avoided by restructuring, the study concluded that the costs would be borne by

all the members of the investment process, including general partners, limited partners, and their beneficiaries, as well as owners

and employees of portfolio companies.

Increasing carried interest taxes, the study concluded, would reduce the amount of long-term capital available to the U.S. economy

and undermine investment, innovation, entrepreneurial activity,

productivity and growth, and, accordingly, the ability of U.S. companies to compete in the global markets.

This study reinforces testimony that this committee heard earlier

from Treasury Assistant Secretary for Tax Policy Eric Solomon,

who concluded that the current taxation of carried interest encourages the pooling of capital, ideas, and skills in a manner that promotes entrepreneurship and risk-taking.

I guess my first question is to you, Dr. Auerbach. Do you agree

with those general conclusions of this study?

Dr. AUERBACH. Yes, I do.

Senator CRAPO. In your testimony, you stated that it was difficult to predict the actual costs that the impact of this tax would

produce, and then you gave us your best prediction. Have you

looked at the predictions of others, and, if so, could you give me a

range of the kinds of predictions that are out there from other

economists and analysts?

Dr. AUERBACH. I am not aware of quantitative predictions. The

predictions that you mentioned are of a qualitative nature, that is,

these are the kinds of effects that would occur, and I agree with

those. In my testimony I tried to nail down, to the extent possible,

what the quantitative effect would be.

The thing I have the most confidence about is the size of the effect. The increase in costs for all these affected funds is on the

order of 10 to 20 basis points annually. The hard question is the

extent to which those increases in costs could be avoided through

restructuring of arrangements and, if not avoided, the extent to

which they could be passed on to investors.

Of course, the passing on involves a lot of other changes in behavior, such as a reduction in activity, which is one of the concerns

you mentioned in the report, and lower returns available to investors because there would be less competition in the industry. That

is a lot harder to predict. This is the kind of thing one has to conVerDate 11-MAY-2000 15:06 Dec 17, 2009 Jkt 000000 PO 00000 Frm 00115 Fmt 6601 Sfmt 6601 53637.000 SFIN1 PsN: SFIN1
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front whenever a tax increase is considered. We think that all tax

increases are going to have deleterious effects on the economy, but

the money has to come from somewhere.

The question is whether these particular taxes are less advisable

than others. There are two things to weigh here. On the one hand,

these seem to be logical taxes to raise because the income in question really does seem to be compensation, and it also is income of

very high-income individuals, which perhaps makes it more appropriate for taxation.

But on the other hand, because of the avoidance possibilities and

because of the fact that there is a lot of productive activity going

on in these sectors, one has to be concerned. So, it is a difficult policy question.

Senator CRAPO. In terms of the question of how many dollars will

this proposed tax increase actually produce for the economy, or for

the Treasury, are you aware of the Knoll study?

Dr. AUERBACH. No, I am not.

Senator CRAPO. All right. That is one that was quoted in the U.S.

Chamber of Commerce’s report, which indicated that they predicted

about $3.2 billion would be raised, assuming that there was not

any restructuring. But you are not familiar with that?

Dr. AUERBACH. I am afraid I cannot comment on that.

Senator CRAPO. All right.

My time is just about up. I want to just ask you one question,

Mr. Trone. You indicated in your testimony that, in theory, a tax

hike would have the deleterious effect of making hedge funds and

private equity investments less attractive. I assume that that theory you are talking about there is the same kind of thing that the

U.S. Chamber of Commerce was talking about in terms of the predicted response to this proposed tax increase.

But in any event, if I understand your testimony correctly, are

you basically saying that there is so much exuberance out there

that the managers of these various funds engaged in these entrepreneurial activities are not acting rationally? Is that your testimony?

Mr. TRONE. A large number, yes. I would like to add to that, Mr.

Read is a great counterbalance to my testimony today. CALPERS

is an example of an excellent investment fiduciary that is making

prudent investment decisions into these asset classes. But they are

atypical, as opposed to the typical investment fiduciary.

Senator CRAPO. All right. Thank you. I see my time has expired.

Thank you.

The CHAIRMAN. Thank you, Senator.

Next, Senator Ensign.

Senator ENSIGN. Thank you, Mr. Chairman.

In your testimony, gentleman from CALPERS, you talked about,

when you are looking at negotiating, one of the things that attracts

you to a particular private equity fund is the talent level. Is that

correct? And you also said in there that one of the things that attracts some of the most brilliant minds to these private equity

funds is the return, the amount of money that they can make. Does

it seem logical, at least, that if you raise their taxes, you decrease

the amount of money they can make?

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Mr. READ. The answer is, of course, it is a concern. This has been

a particularly important sector for us in that it has attracted some

of the finest investment minds in the business.

Senator ENSIGN. Right. The point I wanted to make—because I

think all of you have said this—is that it is impossible to predict

exactly what the policies will do or the consequences of the policies

that Senator Baucus and Senator Grassley are proposing, what effect they are going to have on the markets, what effect they are

going to have in the economy. It is impossible to tell that.

The CHAIRMAN. I might remind the Senator, neither Senator

Grassley nor I have proposed anything.

Senator ENSIGN. As far as what has been publicized and been attributed to you. I apologize.

The CHAIRMAN. There is no bill, no legislation. These are just

questions. Nothing has been proposed.

Senator ENSIGN. All right. I will say, Congressman Levin’s proposal in the House of Representatives, which there is a proposal on

that.

The bottom line is that the consequences could be fairly significant, and we do not know that. Because some of the things that

are happening with the private equity funds and the hedge funds,

they have actually generated a lot of positive economic consequences out there. It would seem to me—and this is one of the

things that I have been talking about—we ought to tread lightly

in this.

On its surface, Dr. Auerbach, you talked about compensation. On

its surface, yes, all right, that makes sense. It is fees. It looks like

income, it should be treated like income. But you also said in your

testimony, what about sweat equity? You talked about ideas. Those

are treated as capital gains. How do you tax the private equity and

the carried interest on private equity and not tax the idea of one

partner and their sweat equity? Why is that not just income? He

has not risked any kind of capital, he has just risked his sweat equity. Could you address that?

Dr. AUERBACH. Well, yes. As I said in my testimony, trying to be

guided solely by consistent treatment, that is, saying this looks like

compensation so it should be taxed as compensation, is not really

enough because there are so many inconsistencies in the tax code,

as, for example, entrepreneurs who start companies whose returns

are taxed as capital gains. You are never going to get fully consistent treatment.

I also said in my testimony that I thought that we could probably

get rid of the entire capital gains differential and solve both of

those problems if we made offsetting changes to the tax code that

did not damage the economy the way an increase in the capital

gains rate alone would do.

There are other measures we can use to spur capital formation

and the other objectives that a lower long-term rate is supposed to

accomplish without having a lower long-term rate. If we did not

have a lower long-term rate, that would pretty much take care of

the issue of carried interest, as well as some of the other inconsistencies that we experience.

Senator ENSIGN. Getting back, because that obviously is a separate issue and a lot of us would like to work on overall tax reform

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and simplifying our tax code, which I believe would make us a lot

more competitive in the world, but, if we are just dealing with this

issue that we have before us today, it did not make sense on your

one basis point.

What did not make sense to me is, if CALPERS has invested the

kinds of dollars that they have invested, and just using an article

that was in Bloomberg talking about the Blackstone Group, raising

their taxes, in the chairman’s opinion it would lower their market

cap by about 40 percent. Well, if their market cap drops by 40 percent, even if he is a little bit off, it would seem to have a little more

of an effect than the one basis point that you are talking about

with investors like CALPERS.

Dr. AUERBACH. There are a couple of things going on here. First

of all, if you had a tax increase and some of it were borne by Blackstone or other companies, even if the tax increase is small on an

annual basis, if the investors see that that company is going to be

yielding a lower return for a long time, then all of it will be immediately impounded in the value of the company. So you might see

a larger one-time decline in the value of the company, even if it

really plays out as a small decline in the rate of return over time.

Second, you can have a large impact on individual companies,

hedge funds, private equity funds, and so forth, but it only matters

to pension funds to the extent that pension funds are actually holding them. So if pension funds are holding 5, or even 10 percent of

their assets in this form, then any effect on these individual investments has to be divided by 10 or 20 in figuring out what the effect

on the overall returns of the pension fund would be.

Senator ENSIGN. Well, my time has expired. I appreciate it. Mr.

Chairman, maybe in writing I could get from CALPERS, and, if

any of you want to put it in writing as well, if you think it would

be good for your investors if the private equity funds that you are

invested in go down by 30, 40 percent in market cap.

The CHAIRMAN. Thank you, Senator.

Senator Cantwell?

Senator CANTWELL. Thank you, Mr. Chairman.

Mr. Read, I think the CALPERS experience has been similar to

what the Washington State Investment Board has experienced in

the past, so thank you for your testimony and insights.

We all know that private equity has outperformed the public equities. Are you concerned about the impact of credit and the credit

crunch and the impact that that might have on those investments

in the future?

Mr. READ. The answer is yes, but there is also a complex interplay that is going on. We have seen, for instance, a tightening of

credit, which has been more difficult for some of our private equity

partners and hedge funds. It has also allowed us to succeed in

other transactions because we are not a leveraged player in general, so we have been able to succeed in other areas because of a

change in the cost of capital and in credit.

So what ends up happening is, something that hurts us on one

side can benefit us with some of our other investments. So, we do

have a concern about changes in credit and cost of credit, but it is

both bad and good.

109

Senator CANTWELL. I know that is not the subject of today’s

hearing, but how do you think that they should best plan for that

as it relates to these changes in policy? I mean, do you think they

should consider it a more risky environment?

Mr. READ. What we have noticed, and what we have been particularly impressed by in the private equity community, is their

creativity, much more so than in any of the other sectors, many of

the traditional sectors. They have an eye both in terms of geography and in terms of structuring for identifying some of the most

attractive investment opportunities.

So one of the interesting points to us, and why we view them as

key partners for us, is that we believe they have a very good sense

for credit and the amount of credit that they can take and maintain. But also, it is something that, if that becomes more expensive,

they will contract and they will move into other ways to make

money.

Senator CANTWELL. Thank you.

Dr. Auerbach, thank you for elaborating on your last dialogue

with Senator Ensign about your testimony and your focus on longterm capital gains.

Since this is all a very delicate balance here, I do not think there

is any policy discussion that we do not have in this committee that

is not a pull-the-string-here-and-get-an-effect-there challenge for

us. How would you suggest that this committee might approach

dealing with carried forward interest and the larger issues of our

tax problem as it relates to entrepreneurship? How would you suggest we best tackle that in a way that would be constructive?

Dr. AUERBACH. If you are thinking about entrepreneurship in

particular, there are two approaches one can take. One is a lower

long-term capital gains rate. Another approach would be a much

more targeted approach, such as the 1993 capital gains exclusion

for new small business equity, or the section 1244 provision for

more liberal treatment of losses for small companies.

Entrepreneurship is very important in the economy, but it accounts for a very small share of the capital gains that are realized

in any given year. So a long-term capital gains differential is a

pretty blunt instrument to be using to encourage entrepreneurship.

If spurring entrepreneurship is the objective, then measures targeted more closely toward entrepreneurship would be much more

efficient methods of encouraging that activity.

Senator CANTWELL. And I do not mean to be obtuse, but when

you say ‘‘entrepreneurship,’’ what are you referring to?

Dr. AUERBACH. Private equity, if you like. New companies, fastgrowing sectors of the economy as opposed to the more mature

bread-and-butter sections of the economy: smaller businesses,

newer businesses, emerging industries.

Senator CANTWELL. In an information age, is access to capital

not even more critical than in an industrial age as it relates to

spurring more entrepreneurship?

Dr. AUERBACH. Sure.

Senator CANTWELL. So would you say it is more important today

that we get this tax policy right as it relates to spurring entrepreneurship?

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Dr. AUERBACH. I think there are many reasons why it is more

important today. It is more important for that reason. It is also

more important, given the fiscal challenges that we face, to whatever extent that we find that we need to raise taxes in the future.

I know that is something that is easier for a witness to mention

than a member.

The CHAIRMAN. Thank you, Senator, very much. We have very

limited time left before the vote, so I am going to have to truncate

things a little bit.

Senator CANTWELL. I thank the chairman for the hearing.

The CHAIRMAN. Thank you. Thank you, Senator.

Senator Smith?

Senator SMITH. Mr. Read, we are the little State between you

and Washington. Oregon’s Public Employee Retirement System has

roughly $7 billion in private equities. What does California have?

Mr. READ. We have in our system about $17 billion currently invested, and a little over $30 billion in commitments.

Senator SMITH. And yet, if you have that much more than Oregon and you say you are on an equal basis when you negotiate

these arrangements with these firms, what would that do for Oregon? Is $7 billion enough to make them equal?

Mr. READ. Seven billion is a big number. You are on a pretty

good basis, you will be happy to know.

Senator SMITH. How much, when you negotiate these arrangements—and I assume you deal with a number of these firms,

Blackstone and others—do they allocate to management fees which

are ordinary income as to taxation, and how much usually to carried interest that gets capital gains treatment?

Mr. READ. It depends on the specific private equity deal/program.

But you can think of management fees as being roughly between

1 and 2 percent, so it is a fixed management fee. An incentive fee

generally hovers in the range of 20 percent. That can be more or

less, again, depending upon conditions. It is 20 percent of the upside past certain performance thresholds.

Senator SMITH. All right.

Do those fluctuate depending on the deal that they may be coming to you with, an entrepreneurial deal with a lot of risk versus

less risk?

Mr. READ. Absolutely. They differ by firm, they differ by program, our involvement in creating the program or not creating the

program. So there is a high level of negotiation that is done. So,

when we talk about this program, literally we have hundreds of

private equity partnerships that we are invested in, each one of

which is negotiated very differently.

Senator SMITH. If carried interest and management fees are the

same as to taxation, then what is your best guess as to what would

happen to the entrepreneurial opportunities that you have taken

advantage of?

Mr. READ. What makes it difficult for us, is that we know on

some of the programs it will have no effect, on others it will have

a great effect. That is what makes it sort of complex for us. What

is the net effect in our returns? It is very difficult to know, given

the moving parts and given the differences in the relationships. We

know it will have some effect. I would be more than pleased if it

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were simply one basis point. We are certain it will probably be

more. But it would be one of many factors.

Senator SMITH. Can you tell me, the more risky the opportunity

is, does the carried interest, as a percentage, go up?

Mr. READ. I would say it is less a function of the risk than on

the prospective return. For instance, if you have a team with a

great track record that is intact with a great investment thesis

going forward, that is going to command generally a greater incentive fee that will seem more attractive to investors and they will

be able to command better terms.

Senator SMITH. Mr. Chairman, I know you and I have to make

a vote. I am certainly here because I am trying to keep an open

mind on this. But it seems to me we are brought to this hearing

because of the extravagant lifestyle of one person in Blackstone

and the publicity that that got, and we may be looking at using a

sledgehammer on an issue that may be more delicate in terms of

its consequences than we realize. So I will keep my mind open, but

I am trying to understand how this will impact Oregon’s public employees, because I do not think that this is a small consequence.

That is my hunch. Thank you.

The CHAIRMAN. Thank you very much, Senator.

We have a couple of minutes here, yet. Mr. Read, you mentioned

that currently some managers’ compensation is taxed as ordinary

income and some is not. Does the current tax treatment affect negotiations? That is, when you negotiate, some managers’ fees are

carried interest, some services. You talked to lots of different firms.

What effect does the tax treatment of one versus the other, fees

versus capital gains, have in your negotiations?

Mr. READ. The key for us is, we are trying to come up with estimates of what the returns will be to us when everything else is accounted for, the net return. So this is part of the negotiations that

we are focused on, what our expectations are of the net returns, all

the factors that will go into it, the particular sector, the importance

of the investment thesis. So you might say that the tax issue is not

directly important to us, but it is indirectly important to us because

it is directly important to the private equity firm.

The CHAIRMAN. What about Dr. Auerbach’s point that they could

just restructure their management fees, restructure their compensation if, say, it is taxed as ordinary income?

Mr. READ. We expect that they probably would react by changing

the structure of their incentive fees, or certainly could. Again, our

focus is going to be on that. What does this mean in terms of the

net expectations of returns and opportunities? So it will indirectly

affect us because it will be of central importance to the private equity firms and we will react to it afterwards.

The CHAIRMAN. If I understood you correctly, the lack of historical changes in fees when tax rates have changed—that is, I do not

know. I do not know how much the gain was passed on to you, or

when compensation is treated, what capital gains rates went into

effect so the tax burden on managers is less and how much of that

gain was passed on to companies like yours, or plans like yours.

Mr. READ. We have taken a look at that particular issue. In the

past, it is absolutely true that we believe that there has been no

discernible change in the past on our negotiations and fee levels

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based upon those changes in tax rates. That being said, there is a

directional importance here. Would we have the expectation that,

if there is an increase in tax rates, will it be a factor? I would actually expect that it would be a factor to a greater or lesser degree.

But certainly based on history, there is not historical evidence to

support that.

The CHAIRMAN. Basically, the conclusion is, everybody wants

more.

Mr. READ. Unfortunately, that is true, including us. [Laughter.]

The CHAIRMAN. When I started to ask that question, I thought

that would be your answer.

Thank you very much. I am sure there will be additional questions provided by members of the committee, and I would ask you

to please respond to those. But thank you all, very, very much. We

have progressed several steps forward. I do not know how many

more steps we have to take, but this has been very constructive

and helpful. Thank you very much.

[Whereupon, at 11:20 a.m., the hearing was concluded.]

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