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New York City has long held a reputation as America's financial center. The city is home to major exchanges, banks and some of the world's largest hedge funds. Indeed, the city's mayor Michael Bloomberg made a name for himself providing services for financial professionals. However, this may be changing as city finance officials have opted to abruptly reassess how they collect taxes from hedge funds.

I spoke with Alexis Gelinas, Attorney at New York based law firm Sadis & Goldberg LLP, about the shift and its potential impact.

As several alternative management companies went through November audits, accounting firms Ernst & Young and PriceWaterHouseCoopers were suddenly faced with changes in what expenses the New York City Department of Finance was going to allow funds to deduct.

Currently, management companies of hedge funds have operated in a tiered structure that gives management fees to the investment manager and an incentive allocation to the general partner. This allocation usually results from capital gains income, or other investment or trading income. Typically, hedge funds pay an unincorporated business tax on management fees but not incentive allocations. This structure was the result of explicit statute outlined by the Department over 15 years ago.

Within the existing structure, investment managers normally deduct the same expenses reported on their federal income tax as they do in calculating the income, subject to the 4% unincorporated business tax. Now, the City is putting a stop to that by disallowing these expense deductions.

The Department of Finance is opting to re-interpret the 15-year old statute and view previously allowed expense deductions as part of the incentive allocation for general partners.

According to Gelinas, this is not just a simple shift: "You could argue that the tax at issue is only 4% but you have to be concerned with what the City is saying, 'should this only be applied one way for one tax?' That doesn't follow. Why wouldn't it go this way for other income taxes in the city?"

The Department is leaning on Section 482 of the federal tax code for the interpretation, which gives federal tax collectors the right to reallocate income and losses between entities controlled by the same interests.

Gelinas notes, "They're trying to make the argument based on the IRS code which isn't replicated exactly in the city tax code. That makes it hard to believe that if it is suddenly applicable here, why not other income taxes or out of state partners based on the same theory."

The Department of Finance indicated that the shift is within its purview and has the support of Mayor Bloomberg. The Mayor's support is also a notable shift, as he previously blocked a similar attempt in 2010, when then Governor Patterson proposed a budget amendment that would tax nonresidents on any incentive allocations from funds located in New York State saying then, that it would drive funds out of New York. However, at the city level, no statutory change is required to make such a shift.

New York City finance officials recently announced that they are faced with a bigger budget deficit going into the next budget cycle than they previously thought. Recent tax code modifications at the State level also seem to support where the Department of Finance is headed.

Hedge funds have long argued that capital gains given to management companies come at a cost, and for the last 15 years statute has supported that stance. However, given that no statutory requirement is necessary for the Department of Finance to change the way it interprets the law, hedge funds may find themselves with little recourse.

Gelinas noted that funds have basically two options: "the most obvious reaction to this is to remove all operations out of New York City. If funds decide to do that, it's hard to understand what net revenue the city gains from them leaving. The other option is to significantly restructure how fees and incentive allocations are appropriated. Although with no indication of how broadly the Department intends to reinterpret, more information is needed before funds will be able to fully understand the total expenses associated with those options."

"It looked like this issue had been resolved 15 years ago and now it's back again. I don't think NYC wants that (moving) to be the result. But they are trying this out," Gelinas said.


Arlene Busch
312-498-9595 mobile
abusch@contegocapital.com<mailto:abusch@contegocapital.com>