There Are Two Private Equity Tax Loopholes Romney’s Opponents Are Just Waiting To Jump On

There’s a new Romney-Gekko 2012 ad out, and it brings a whole new angle to the attacks lobbed at Mitt Romney through private equity.

Instead of making a blanket statement about the industry’s practice as a whole, this ad (by Americans United For Change) gets specific, focusing on money Romney has stored in the Cayman Islands and the taxes (or lack there-of) he pays on them. Get ready for this to turn into a debate about the private equity industry’s tax practices/loopholes as a whole, especially after Romney releases his own tax returns on Tuesday.

Here’s the commercial in brief:

The scene opens and you’re on a beautiful, relaxing beach (think: Corona commercial). Two planes fly across the sky carrying banners that say, “Welcome to the Cayman Islands, Home to Mitt’s Millions… Cuz paying taxes is for poor people. Romney-Gekko 2012.”

On the beach below, two men in suits (one with a very Romney-esque haircut) sip beers (1% Ale) in chairs. Perfection.

There are two private equity tax practices/incentives that are vulnerable to attacks like this, the tax on carried interest profits and the tax deduction on corporate debt interest. The most vulnerable one of the two is the 15% tax rate on carried interest profits.

Carried interest profits are the chunk of cash (usually about 20%-25%) left over after investors get their returns and management fees are all paid out. Private equity firms and hedge funds use it as compensation, and people have been saying that taxing it at a rate of 15% is too low for years. Now though, with the Mitt Romney issue at play, the chatter is getting much louder.

Let’s put it this way: You know its bad when even Rupert Murdoch is saying carried interest tax policy is a racket.

Luckily, though, the carried interest tax rate issue isn’t the end-all, be-all tax policy in the private equity industry. That honour goes to the tax deductibility of corporate debt interest.

Here’s what William D. Cohan had to say about it in his Bloomberg column this weekend:

Since corporate debt is the mother’s milk of a leveraged buyout, there would be no private-equity/LBO industry without this huge tax benefit. Indeed, anyone who has used an Excel spreadsheet to model a leveraged-buyout — you know who you are! — knows that the magic of the entire industry depends almost solely on the interest-expense provision in the tax code.

Cohan argued that since the American people cover the tax subsidy that allows the private equity industry to exist, the industry should, at the very least, pay the normal 35% rate on its carried interest profits.

In his Term Sheet newsletter this morning, Fortune’s Dan Primack touched on this issue as well. Unlike Cohan, he didn’t call on his PE industry readers to pay the full 35%, but he did say that they should show some flexibility on this issue:

And I know that you, as an industry, aren’t going to concede your loophole without a fight. So perhaps it’s time for compromise. Go for a hybrid. Argue that carried interest is neither capital gains nor ordinary income. You may still lose the fight legislatively, but it will at least demonstrate that you’re trying to be reasonable – something that might help if Congress begins looking at the tax-deductibility of corporate debt interest (the tax break that private equity truly cannot survive without).

Primack also had a few other pieces of public relations advice for the industry: get your CEOs out talking, be open about your deals, get your limited partners on main street to talk you up, and scrap this whole ‘job creator thing’ (it’s OK that it’s not your job to create jobs).

It’s all good advice for an industry that has found itself in need of some serious defence, and if the competitive tone of this election is any indication, we haven’t seen anything yet.

Check out the Americans United For Change ad below: