Carried Interest

Carried Interest

July 10, 2010

Carried Interest legislation that the US Congress came close to enacting in June — and will probably enact eventually — could affect some transactions in the renewable energy sector.

The legislation is supposed to ensure that managers of hedge funds and private equity funds who receive part of their compensation in the form of “carried interests” in the funds are taxed on the value at ordinary income rates when they sell the interests. Many wait to pay taxes today at lower capital gains rates when the interests are sold.

The problem is the legislation is drafted to cover partnerships generally and not just hedge funds and private equity funds.

More importantly, it would limit depreciation and other tax losses that certain partners in a partnership are allocated for use as shelter against income only from that partnership. If this principle were applied to wind, solar, geothermal and other renewable energy projects, it could reduce the value of tax subsidies on such projects.

Many renewable energy projects in the United States are owned by limited liability companies treated as partnerships. The bill does not create problems for any project that is owned by a single LLC or partnership. However, the depreciation limit could come into play if there are two or more tiers of LLCs treated as partnerships. An example is where a project is owned by an LLC partnership and one of the partners is itself an LLC partnership.

The change in tax character of the income and restrictions on use of depreciation apply to anyone holding an “investment services partnership interest.”

That’s a partnership interest where two things are true. One is that the partnership holds the types of assets that hedge funds or private equity funds hold typically — stock in corporations, interests in other partnerships, real estate held for rental or investment, commodities or options or derivative contracts. The other thing that must be true is that the partner must be engaged in managing, acquiring or disposing of assets belonging to the partnership that fall into those categories or arranging financing for them.

It is not uncommon in the renewable energy sector for a small developer to sell an interest in a project to a larger developer while the project is still under development. They form a partnership. Later, another investor is brought in to provide capital. The partnership of the small developer and larger developer becomes a partner in a new partnership with the investor and the project is contributed to the new partnership. The developer partnership keeps a substantial role in the ongoing development of the project.

It is unclear whether the developer partnership could be caught by the bill.

Some financing structures in use in the renewable energy sector where debt or tax equity is brought into an intermediate-tier entity that is a partnership or where “back-levered” or portfolio debt is borrowed at the sponsor level against the interest of the sponsor in a project owned by a partnership also have the potential to bring a partner under the bill.

Discussions are underway with the tax staffs in Congress about these issues.

The carried interest provision was attached to a “tax extenders” bill that fell victim to a Republican filibuster in the Senate in June. However, it is likely to be enacted sometime this year if Congress can manage to pass any new tax legislation. The reason is Congress has run out of ideas to increase revenue to offset any new tax benefits that it wants to create and new tax reductions must be balanced by tax increases elsewhere. Earlier opposition to the carried interest provision in the Senate has largely evaporated.

The proposal would apply to sales of covered partnership interests after 2010 and to losses allocated to partners holding covered partnership interests in tax years ending after 2010.

Congress has complained for years about how complicated the US tax code has become. Negotiations in the Senate, before the tax extenders bill failed, led to a compromise where only 50% of income from sale of a covered partnership interest would be taxed as ordinary income and the rest as capital gain, increasing to 65% in 2013. However, the share that would be taxed as ordinary income would be only 55% for interests held for at least seven years.

Keith Martin