Cleary Gottlieb: Camp Bill Hits IPOs, Public Firms

Michael L. Ryan and Derek Wallace

Although much of the controversy surrounding Rep. Dave Camp’s tax proposal has centered on its treatment of carry, another part of the bill could have an even greater impact on many in the private equity industry.

In a severe blow to public PE firms and those considering IPOs, the Camp bill would entirely repeal the tax rule allowing publicly-traded PE firms to be taxed as partnerships. Instead, corporate income tax would be imposed on these firms for the first time, and distributions to their equity holders would be taxed as dividends.

These two provisions would dramatically change the economics of being publicly held, and in turn significantly reduce the potential value of ownership stakes in PE firms. As it stands, the Camp bill would apply even to already-public firms such as Apollo, Blackstone, Carlyle, Fortress, KKR and Och-Ziff.

Current tax rules don’t impose corporate tax on publicly traded partnerships (PTPs), as long as at least 90% of their income comes from capital gains, dividends, interest, and similar sources. All public US PE firms qualify for this treatment.

Under the Camp bill, private equity PTPs would instead be taxed as corporations, paying tax at rates currently set at 35%.1

The effect of imposing corporate tax on PTPs would be severe. Today, a public PE firm that earns $100 of net income will have $100 to distribute to its equity holders, who will then pay tax on it. Under the PTP provisions in the Camp bill, after paying 35% corporate tax, the PE firm would have only $65 to distribute. That $65 distribution would be subject to tax again in the hands of equity holders as a dividend.

Imposing corporate income tax on public PE firms would significantly diminish their attractiveness as investments.. Retail investors would be especially hard hit, since they don’t enjoy the favorable rules for dividend taxation that institutions do. Moreover, retail investors generally can’t access private equity investments, so investing in public PE firms is their only way to invest in the sector.

The effect of the Camp proposal would be to tax affected PTPs quite differently than other broadly-distributed investment pools, such as traditional mutual funds and ETFs.2 These vehicles are largely excluded from corporate tax under a different tax provision (for “regulated investment companies”, or RICs) that the Camp bill would leave in place. PE firms generally can’t use the RIC rules, because the management fees they earn as part of their business are impermissible for RICs.

Beyond disadvantaging many PTPs compared to other investment vehicles, the Camp bill would impose differing treatment even among PTPs.

Most PTPs investing in natural resources (such as energy master limited partnerships) would continue to be taxed as partnerships under the Camp bill. As a result, publicly-held vehicles that invest in natural resources would be tax-favored, compared to those investing in every other sector of the economy. Tax policy ordinarily seeks to avoid creating tax-driven distinctions among investment types absent a strong policy need, and the proposal gave no rationale for its differing treatment.

Although the Camp proposal is not likely to become law any time soon, it’s notable as an echo of earlier legislative proposals to tax U.S. PE firms as corporations.

But in one respect, the Camp bill is even more severe than prior proposals – it contains no “grandfathering” of existing institutions from its effect.

Each of the earlier proposals for PTP taxation provided PE firms with at least some grandfathering – generally for existing public firms and those that had begun an IPO process. In contrast, the Camp bill would apply starting in 2017 to every public PE firm, even long-public firms that had done IPOs in reliance on existing law.

Of course, prior efforts to impose corporate tax on public PE partnerships have foundered, and the Camp proposal is unlikely to be enacted in its current form. Even if something resembling the Camp bill is ultimately passed, history suggests that the final legislation will contain some degree of grandfathering. Tax legislation ordinarily seeks to avoid disrupting settled expectations, which historically has meant that relief was most likely to be extended to those farthest along in reliance on existing law.

Although the Camp bill should not be seen as likely to become law, it needs to be viewed as one relevant indicator of Congressional tax thinking. And while its PTP provision may not have as obvious an effect on the industry as its carry provision, the long-term value implications for some firms could be almost as significant.

Michael L. Ryan is a partner and Derek Wallace an associate at Cleary Gottlieb.

1A separate provision of the Camp bill would reduce the corporate tax rate to 25% by 2019, but this change isn’t tied to the PTP provisions.

2A separate provision of the Camp bill would also disqualify much PE income from qualifying PTP treatment, thus potentially denying PE firms PTP status even if the more sweeping ban fails.