Dear Mr. Secretary:
We are writing to you regarding several recent initial public offerings (“IPOs") ofprivate equity and hedge funds. We believe that these IPOs raise serious tax questionsthat if left unaddressed have the potential to jeopardize the integrity of the tax code andthe corporate tax base over the long term. We write to request your views on this matter,to ask what actions Treasury intends to take, and for your views on legislation weintroduced to address this threat to the corporate tax base, if a change to statute provesnecessary.
The basic structure of these IPOs is that they are classified as publicly tradedpartnerships (“PTP") under section 7704(b) of the Internal Revenue Code (the “Code").A PTP is taxed as a corporation unless it satisfies the qualifying income exception undersection 7704(c), chiefly directed to passive-type income. Section 7704(c) requires thatfor any taxable year, 90 percent or more of the gross income must be “qualifyingincome." Qualifying income is defined in section 7704(d) to include: interest; dividends;rents; gain from sale of a capital asset held for production of income; and gain fromcommodities contracts.
These funds clearly state that they are engaged in an active trade or business. Forexample, one fund states in its public filing that “[w]e believe that we are engagedprimarily in the business of providing asset management and financial advisory servicesand not in the business of investing, reinvesting, or trading securities. We also believethat the primary source of income from each of our businesses is properly characterizedas income earned in exchange for the provision of services." In order to avoid failing the90 percent qualified income test, these PTPs rely on the income from carried interestsbeing treated as qualified income, and have created a subsidiary blocker corporation toabsorb all nonqualified income. To the extent that any funds are then transferred fromthe subsidiary blocker corporation to the parent PTP, this blocker corporation willconvert the nonqualified income into a payment of dividends (that is, qualifying income)to the PTP.
We believe that the PTP rules are being circumvented because the majority of theincome is from the active provision of services to the underlying funds and limitedpartner investors inthose funds. The current section 7704 was initiated by the House Ways and MeansCommittee in 1987. We believe it is beneficial to call to your attention some keyexcerpts from the Ways and Means Committee report on section 7704:
Reasons for Change. The recent proliferation of publicly traded partnerships hascome to the committee’s attention. The growth in such partnerships has causedconcern about long-term erosion of the corporate tax base. To the extent thatactivities would otherwise be conducted in corporate form, and earnings would besubject to two levels of tax (at the corporate and shareholder levels), the growth ofpublicly traded partnerships engaged in such activities tends to jeopardize thecorporate tax base.
...These changes [referring to the corporate minimum tax included in the 1986 Act]reflect an intent to preserve the corporate level tax. The committee is concernedthat the intent of these changes is being circumvented by the growth of publiclytraded partnerships that are taking advantage of an unintended opportunity fordisincorporation and elective integration of the corporate and shareholder levelsof tax.
Thus, it is clear in these passages and throughout the report that Congress’ policyconcern in enacting this statute was to protect the corporate tax base. Congress allowedfor a very narrow exception for PTPs that were invested in passive investments.
In certain circumstances, however, the committee believes that the tax-createdcompetitive advantage of publicly traded partnerships may be less significant. Ifthe publicly traded partnership’s income is from sources that are commonlyconsidered to be passive investments, then there is less reason to treat the publiclytraded partnership as a corporation, either because investors could earn suchincome directly (e.g., interest income), or because it is already subject tocorporate-level tax (in the case of dividends). Therefore, under the bill, anexception is provided to the treatment of publicly traded partnerships ascorporations in the case of partnerships whose income is principally from passivetypeinvestments.
Congress envisioned that a PTP could invest in outside corporations asinvestments and receive dividends and capital gains. It is a far cry to imagine that a PTP- which directly or indirectly gets its income from an asset management and financialservices business through carried interests and dividends from a wholly ownedcorporation that is actively engaged in a trade or business performed by a subsidiary -should also be included within the ambit of Congressional intent. We would note thatfrom the analysis that we have seen in some of the IPOs that it is unlikely that there willbe any significant corporate-level tax paid by the subsidiary blocker corporations.Justification for the view that a PTP generating its own income from performance feesstructured as carried interests and a wholly owned active trade or business (regardless ofits characterization) is not in keeping with Congressional intent is given supportthroughout the Ways and Means report. To highlight a key statement:In general, the purpose of distinguishing between passive-type income and otherincome is to distinguish those partnerships that are engaged in activitiescommonly considered as essentially no more than investments, and thoseactivities more typically conducted in corporate form that are in the nature ofactive business activities.
We ask that you please provide your analysis of the statute as it relates to therecent IPOs and your views on the potential effect on the corporate tax base. Further,please inform us of what guidance Treasury intends to issue to make investors orpotential investors aware of how Treasury will enforce the law. If you believe thatadditional statutory changes are necessary, please inform us of your recommendations inthis area. We also ask that you direct your staff to assist us by reviewing the legislationthat we have introduced to address this matter. Finally, we ask that you join us ininforming the Securities and Exchange Commission of the need to address the tax mattersraised by the Blackstone IPO so that we can preserve the integrity of the tax code andalso give clear guidance to potential investors and the public of the tax treatment.We would appreciate a prompt response in light of the recent increased volume ofPTP IPOs. Thank you for your time and courtesy on this important issue.
Sincerely,
Max Baucus, Chairman
Charles E. Grassley, Ranking Member
cc: The Honorable Charles B. Rangel, Chairman
Ways and Means CommitteeT
he Honorable James McCrery, Ranking Member
Ways and Means Committee
The Honorable Christopher Cox, Chairman
Securities and Exchange Commission
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June 14 2007
The Honorable Christopher Cox
Chairman
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Dear Mr. Chairman:
We are writing to you regarding the proposed Initial Public Offering (IPO) by TheBlackstone Group L.P. (“Blackstone"). The Finance Committee staff has met at lengthwith representatives of Blackstone and reviewed the relevant documents and filings.After careful consideration, we believe that these IPOs raise serious tax questionsthat if left unaddressed have the potential to jeopardize the integrity of the tax code andthe corporate tax base over the long term.
Today, we have written to the Secretary of Treasury to generally describe thismatter and have raised with him the question of whether Treasury will take action toaddress the tax concerns contained in the Blackstone IPO. Additionally, please findenclosed a copy of our letter to Secretary Paulson and legislation that we introducedtoday.
We trust that you will agree that investors and shareholders should haveconfidence of the tax treatment of any investments - particularly in a case where the taxtreatment is a critical component. Investors and shareholders will be in a more informedposition after Congress and the Treasury have had an opportunity to speak to the serioustax policy questions raised by the Blackstone IPO. Most importantly, the public willbenefit from a clear understanding and review of the tax policy issues presented.Thank you for your time and courtesy on this important matter.
Sincerely yours,
Max Baucus, Chairman
Charles E. Grassley, Ranking Member
Enclosures
