The UK is also addressing carried interest.  Their approach is simply to raise the capital gains rate to 28%; as in the US, the private equity firms are threatening to expatriate.  They won’t.

In its inaugural stab at reining in one of the highest deficits in the world, the U.K.’s new coalition government said it would raise capital gains tax, which taxes profit made by individuals on property and assets, by 10% to 28% with effect from Wednesday. The tax is payable on profit above GBP10,000 a year.

But the rise wasn’t as large as feared by many private equity executives who have to pay CGT on the carried interest, or the share of profits that fund managers receive as part of their compensation.

“It is a big increase but it could have been a lot worse–many were expecting a hike to 40% or even 50%,” said Caspar Noble, a partner in the tax group at Ernst & Young.

via UK Budget Unlikely to Drive Private Equity Bosses Away – WSJ.com.

The carried interest legislation, which is attached the the tax extenders bill, is still alive in the Senate (I think).  The latest language, an amendment to the bill offered by Baucus, is available here.

The latest version would tax carried interest as 75% ordinary income and 25% capital gain.  If the underlying assets of the partnership have been held for 5 years or longer, allocations would be treated as 50% ordinary income and 50% capital gain.  The favorable rate for 5 year assets especially helps venture capital firms and some private equity and real estate firms.

The private equity industry has been aggressively fighting to change the bill’s treatment of a sale of a partnership interest (proposed section 710(b)), which they call an enterprise value tax.  The latest version of the bill would extend a 50/50 blended rate to the portion of the sales proceeds attributable to goodwill.  I’ll try to post more about this later.

CV as of April 22, 2010.

Sovereign wealth funds enjoy an exemption from tax under §892 of the tax code. This anachronistic provision offers an unconditional tax exemption when a foreign sovereign earns income from noncommercial activities in the United States. The Treasury regulations accompanying §892 define noncommercial activity broadly, encompassing both traditional portfolio investing and more aggressive, strategic equity investments. The tax exemption, which was first enacted in 1917, reflects an expansive view of the international law doctrine of sovereign immunity that the United States (and other countries) discarded fifty years ago in other contexts.  Because §892 was not written with sovereign wealth funds in mind, the policy rationale for this generous tax treatment has not been closely examined in the academic literature.

This Article provides a framework for analyzing the taxation of sovereign wealth.  I start from a baseline norm of “sovereign tax neutrality,” which departs from the current regime under §892 by treating the investment income of foreign sovereigns no better and no worse than foreign private investors’ income and by favoring no one nation over another. Whether we should depart from this norm depends on several factors, including what external costs and benefits are created by sovereign wealth investment, whether tax or other regulatory instruments are superior methods of attracting investment or addressing harms, and which domestic political institutions are best suited to implement foreign policy. I then consider whether we should impose an excise tax that would discourage sovereign wealth fund investments in U.S. companies. This tax might be designed to complement nontax economic and foreign policy goals by discouraging investments by funds that fail to comply with best practices for transparency and accountability.

The case for repealing the existing tax subsidy is strong. We should tax sovereign wealth funds as if they were private foreign corporations; there is no compelling reason to subsidize sovereign wealth. At the same time, my analysis suggests that policymakers should be cautious about going any further: An excise tax may not be the optimal regulatory instrument for managing the special risks posed by sovereign wealth funds.

Download full paper: Taxing Sovereign Wealth