Changes to the capital gains tax rate, the treatment of carried interest as capital gains, as well as anti-trust legislation designed to restrict acquisitions, has the venture capital community reeling.
The proposed changes in President Biden’s Build Back Better plan, which is set to have far reaching implications for an industry that derives much of its value from its fees, would move the long-term capital gains rate from 20 percent to 39.6 percent for Americans earning more than $1 million. It essentially closes the carried interest loophole for investors.
In April, the National Venture Capital Association, the industry’s lobbying arm, made their stance clear in its policy highlights within PitchBook’s Q1 2021 Venture Monitor.
“While expectations are that the Build Back Better package will run a deficit, some of the spending could be offset by increasing the corporate tax rate, raising taxes on ordinary income and capital gains (including carried interest),” said Bobby Franklin, president and chief executive of the NVCA.
He added that raising the rate of capital gains or carried interest is “counterproductive to encouraging the long-term investments necessary to realize the goals of the administration’s Build Back Better agenda.”
Nearly two months after those initial comments, the NVCA teamed up with Ernst & Young for a webinar called ‘Tax and Remote Work Considerations for VCs Post Pandemic,’ to express renewed concern.
“We are quite worried about where [the current legislation] is,” said Justin Field, senior vice-president of government affairs at NVCA during the webinar on May 20.
“It gets a little bit strange knowing how much they [Democrats] want to do in these areas,” he added. “They have a capital gains and carried interest tax increase the likes of which has never been seen.”
According to the panelists, July is the earliest discussion could begin on this bill and despite Congress needing to pass a continuing budget resolution to keep all government agencies up and running in September, it will require determination to pass these tax increases in before the end of the year.
That’s not all. Senators Amy Klobuchar, Democrat of Minnesota, and Josh Hawley, a Republican from Missouri, have each proposed anti-trust bills that would make it more difficult for large companies to make acquisitions. Jeff Farrah, general counsel for NVCA, has already signaled his opposition in a TechCrunch piece penned on May 19.
Hawley’s proposal would constitute a ban on all acquisitions by companies with at least $100 billion in market cap. Klobuchar’s would flip the burden of proof from the US government to companies, making acquisitions from a buyer with a market cap of $100 billion blocked until it gets approved.
The VC industry has largely argued that caps on mergers would restrict entrepreneurship, but such limits would only be applicable to a corner of the market. There has been much more industry foment around the historic change in taxes and carried interest treatment.
If the Build Back Better plan passes through the House and Senate, it would be the first time such a tax rate was imposed on investment managers in recent history, which, for NVCA, proves that this approach to industry reform is already a failure.
“The only time in the history of the US tax code we’ve seen over 30 percent as a capital gains rate was the 1970s where a Democratic Congress full of Watergate babies worked with Jimmy Carter to get that rate back to 28 percent,” Field said. “Talk about a lived experience and a failed experiment.”
Field’s comments touch on much of the industry’s anxiety over the current cultural trend of corporate responsibility and sustainability and how the private investment community should respond. But this is an ongoing debate, and the legislation is subject to change.
Raising the corporate tax rate from the current 21 to 28 percent for one, seems to be the Biden administration’s first priority in its fight to reign in the industry.
“We understand that if you take the rate much above 27, 28 percent, it stops raising revenue, because people don’t sell, they hang on,” Adam Francis, Washington council and principal at Ernst & Young said. “If the rate gets too high, you don’t get the same amount of revenue that you otherwise would.”
Such projections ignore the 35 percent corporate rate that was in place until former President Trump passed the 2017 Tax Cuts and Jobs Act. Others in the VC industry aren’t worried at all about the incoming threat of higher taxes.
But raising the corporate tax rate is seen as the first step to the more sensitive issue of addressing carried interest, which would more broadly impact the VC industry.
“The challenge we have is once the capital gains rate moves, then there’s going to be more pressure to say, ok, but what about carried interest,” Field said.
The panelists agreed that this is a Democratic Party-led effort, and there is still a “wide gulf,” between the progressives and the centrist wing of the party, according to Field. They also lead with razor-thin majorities.
But according to Francis, Democrats could use the budget reconciliation process to expedite consideration of this bill.
“Most importantly, that expedited process allows legislation to be processed in the Senate with a majority vote versus the regular 60 votes threshold that’s normally required,” Francis said.
The Democrats have already used up their budget resolution to process the Recovery Act legislation that passed at the beginning of the year. The Senate Parliamentarian has signaled they would allow for an additional budget resolution, if Democrats were so inclined to jam this legislation through this year.
Plus, waiting until next year would shine an additional spotlight on the effects of such tax increases during a midterm election year, as Democrats are in danger of losing their House and Senate majorities.
Another variable hangs in the distance. The federal debt limit, which is currently suspended for the sake of clearing aid bills earlier this year, “comes back online at the beginning of August,” Francis said. This, too, can be extended.
While these discussions have been happening for decades, the industry is beginning to take these threats for higher taxes seriously.
“Is it going to be difficult? Sure,” Francis said. “Are they going to let it fall off? I don’t think so.”
But these discussions around taxes, also call into question the value that VC and the wider private asset management industry provides to society, and the NVCA is fighting hard to show just how important this industry is.
“It’s not enough to spend the money,” Field said. “But if that money gets spent without catalyzing the private sector activity on the other side, the Build Back Better agenda is a failure.”