Asia-based private equity and hedge fund managers subject to US tax may be charged a higher tax rate on the share of profits they receive for outperformance, if a proposal by congressional Democrats becomes reality.

Some US tax lawyers say they have been receiving inquiries from alternative asset management clients in Asia about the tax implications of the bill.

The 'carried interest loophole' is one item on a list of tax breaks that Democrats want to see revoked. Democratic members are keen to raise more revenue for the US government, after the annual budget deficit hit $680 billion for the fiscal year that ended in September. 

Since 2007 Democrats have pushed for alternative managers' income to be subject to standard income tax rates rather than the lower capital gains tax rate. They recently raised the subject again, now that a US law-making committee is preparing to cut a budget deal by December 13 to avoid another government shutdown and potential US default.

Private equity (PE) general partners that receive a share of a fund’s profits exceeding a predetermined hurdle rate and hedge fund managers that earn performance fees have traditionally been charged 20% in long-term CGT if they are subject to US taxation. But congressional democrats argue that such profits should be charged at the 39.6% top tax rate for ordinary income.

If the bill were signed into law, it could affect any fund managers that are US citizens, deemed as US residents or hold a US green card, says Kurt Rademacher, director of international tax practice at law firm Butler Snow in London.

The bill would need to be passed by the Democratic-controlled Senate as well as the Republican-controlled House of Representatives, he notes, and would then have to be signed by President Obama. “I expect a potential Congressional battle on this issue as early as January 2014,” says Rademacher.

Unlike under the Foreign Account Tax Compliance Act (Fatca), tax on carried interest earned by PE or hedge fund managers would be applicable to managers with US person status, but the tax would be applied even on non-US-sourced fund income. (Fatca only concerns US-sourced income that is earned by non-American owners of investment funds.)

One popular structure used by PE managers to benefit from the lower 20% CGT is the 'pass-through entity'. This vehicle means the income the fund generates can 'pass through' from that vehicle and get allocated directly among all general partners managing the fund.

Industry players have mixed views on whether the Democrats are likely to get their way in the debate.

Meanwhile, they say alternative managers in Asia – due to their smaller AUM and scale of operations – are more concerned about rules that affect the trading entity (as opposed to the individuals managing the fund). The entity is affected by regulations such as Europe's Alternative Investment Fund Managers Directive and the US's Dodd Frank Act and Fatca.

Asia-based managers are more concerned about determining how their ability to generate returns to investors would be affected by these regulations, say tax consultants. Managers' main worries are about whether such new requirements will translate into additional costs and, ultimately, a higher expense ratio for the fund.

But managers with US citizenship or a green card seeking to avoid a higher tax rate on carried interest could start thinking about how their income is being treated under US tax law, says Jeb Altonaga, head of Northern Trust hedge fund services for Asia Pacific.

“For an Asia-based manager, if he is a US citizen and is a partner that has ownership in a pass-through entity, he should be thinking, under the US tax return that he files, how is he claiming the income incurred to him from this partnership,” says Altonaga. “Is it under regular income? Or is it income from dividend, interests and capital gains?”

If the latter, the manager could be affected by the current proposal for changing tax rate.