Wednesday, September 12, 2007

Carried Interest Taxation - Update

After reviewing my analysis, I clearly made a mistake in my calculations in my initial post. My only excuse is that I'm out of practice in pricing derivatives.

That said, the value of a 20% carried interest (assuming a 10 year life and between 10 and 100 percent volatility) would range from 7.99% to 18.24% of the initial value of the fund, assuming no liquidity discount (implied tax, at 35%, of 2.80% to 6.38%).

If the term were for 1 year (the minimum for long term capital gains treatment) the initial value would range from 1.36% to 7.97%, assuming no liquidity discount (implied tax, at 35%, of 0.48% to 2.79%).

The appropriate analysis is to take 20% (or whatever the carried interest percentage is) of the value of an at the money call (the option value of the appreciation of the fund). The exercise price is borrowed and returned almost immediately, and should not be reflected in the calculations.

Given the limitations of Black-Scholes (among other things, it assumes efficient markets, the ability to engage in hedging and the liquidity of the positions) and the fact that the carried interest is not liquid, a discount of at least 50% would be appropriate.

In other words, if tax policy were changed so that the initial option value of the carried interest were taxable, taxes could be less than 0.25% of the size of the fund ($2.5 million on a $1 billion fund).

I am now reading some coherent arguments AGAINST any change in tax policy as it relates to carried interest.

I am no longer certain what I think is the appropriate tax treatment for this issue.

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