Senate Democrats have introduced the latest version of their mammoth tax extenders and unemployment benefits extension legislation, further modifying provisions such as the taxation of carried interest of hedge fund managers and private equity firm partners and reducing the cost to under $110 billion in part by scaling back Medicaid aid to states.

However, the measure still failed to pass during a vote Thursday evening.

The carried interest tax aims to raise the taxes on hedge fund managers, private equity firm partners, venture capitalists and real estate investment partners, who often pay only 15 percent capital gains rate taxes rather than the ordinary income rates of up to 35 percent. However, they have lobbied heavily against the tax increase.

The latest modifications to the carried interest provisions include two technical corrections. The provision would prevent investment fund managers from paying taxes entirely at capital gains rates on investment management services income received as carried interest in an investment fund. To the extent that carried interest reflects a return on invested capital, the bill would continue to tax carried interest at capital gains tax rates.

The two technical corrections clarify (1) the application of the reduced recharacterization percentage on the disposition of an asset or investment services partnership interest held for at least five years, including the treatment of the Section 197 intangibles related to entities providing investment services, and (2) the application of the exemption from recharacterization under Section 751of the Tax Code.

In addition, the modification confirms that a partner will not have a carried interest subject to recharacterization if all distributions and all allocations of the partnership, and of any other partnership in which the partnership directly or indirectly holds an interest, are made pro rata on the basis of capital contributions of each partner. Finally, the modification provides that an interest in a partnership acquired with a loan or other advance made or guaranteed, directly or indirectly, by other partners or the partnership may be treated as a qualified capital interest to the extent the loan or advance was repaid before the date of enactment.

This provision, as modified, is estimated to raise $13.594 billion over 10 years. The original version of the provision was estimated to generate $18.685 billion over 10 years (see Senate Modifies Carried Interest Provision). Earlier this month, the Senate scaled back the provision, however, decreasing the amount of carried interest that would be re-characterized as ordinary income from 75 percent to 65 percent and increasing the amount treated as capital gains from 25 percent to 35 percent in taxable years beginning after Dec. 12, 2012. The change further decreased the amount of carried interest re-characterized as ordinary income to 55 percent and increased the amount treated as capital gains to 45 percent for a gain or loss attributable to the sale of an asset which is held for seven or more years.

Another change in the legislation is a provision eliminating the Advanced Earned Income Tax Credit. Currently, low- and moderate-income individuals may qualify for a refundable earned income tax credit. Individuals have the option of requesting advanced payments of the EITC throughout the year by having their payments of withheld income reduced by their employer.

The advanced EITC payment option, however, is not widely used and has a significant error rate by workers and employers, according to a summary of the changes provided by the office of Senate Finance Committee Chairman Max Baucus, D-Mont. The elimination of the advanceability feature will affect few individuals who are eligible for the benefit, according to the summary, and is estimated to raise $1.2 billion over 10 years.

“For several weeks now, the Senate has been working to pass this important bill,” said Baucus. “This week marks at least the eighth week that the Senate has spent most of the week on this bill to extend current law tax and safety net provisions.”

He noted that as of this week, 900,000 out-of-work Americans have stopped receiving unemployment insurance benefits because of the failure to enact the bill. 

Over those weeks, the Senate has cut the total size of the bill from $200 billion to $140 billion, then to $118 billion, then to $112 billion, and then to less than $110 billion.

“We cut spending on health care benefits to unemployed workers under the COBRA program,” said Baucus. “We cut spending on the $25 bonus payments to recipients of unemployment insurance. We cut spending on the relief to doctors in Medicare and TRICARE. We have now cut spending on the help to states for Medicaid by one third.  And we have provided additional offsets for the package. Since the first time that the Senate passed this bill, we have sought and found more than $75 billion in new offsets. The bill is now more than two-thirds paid for. We have revised the carried interest provisions in at least eight different ways to address concerns raised by Senators. We have modified the S corporation loophole-closer to limit its effect on firms with fewer than four partners. We heard senators express an interest in more spending cuts. And the substitute before us today comes forward with additional spending cuts. We have fought mightily to adjust this bill to address Senators’ concerns. But in fighting for this legislation, let’s not lose sight of what the real fight is about.”

He noted that the bill would create jobs, provide tax cuts for businesses, provide more small business loans and career training programs, as well as infrastructure investment. The bill also contains provisions to provide tax cuts for families paying for college, tax cuts for teachers, and tax cuts for Americans paying property taxes and sales taxes.  The bill would also extend eligibility for unemployment insurance through November, along with health care tax credits, and housing assistance for people who have lost their jobs.

Among the latest changes are several technical corrections in tax provisions applying to multinational companies that use foreign tax credits. One such provision would prevent a foreign subsidiary’s earnings from being reduced as a result of certain redemptions such that the earnings remain subject to U.S. tax when repatriated as a dividend. The modification would clarify that the provision applies if more than 50 percent of the dividend arising from the redemption would neither be subject to tax nor includible in the earnings of a controlled foreign corporation. The modification has no revenue effect.

Another technical correction involves a provision that would terminate the special rules for interest and dividends received from “80/20 companies.” The provision would eliminate the withholding and foreign tax credit benefit for domestic corporations that generate 80 percent or more of their active business income from foreign sources (known as “80/20 companies”) prospectively, subject to a grandfather rule that would continue to provide favorable withholding tax treatment to payments made by existing legitimate 80/20 companies. The modification would clarify that for purposes of applying the grandfather provision for periods prior to 2011, the 80/20 rules then in effect shall apply. This modification would have no revenue effect.

Another technical correction involves the source rules for income on guarantees. The provision would reverse a recent Tax Court decision to provide that guarantee payments made to foreign persons are treated like interest, rather than services, and therefore subject to U.S. withholding tax when paid by a U.S. person to a foreign person. The modification would clarify that the foreign source rule for guarantees parallels the United States source rules for guarantees. This modification too would have no revenue effect.

Another modification involves the extension of the temporary increase in the federal Medicaid matching rate. Under current law, the federal Medicaid matching rate is increased by 6.2 percentage points for all states, and by additional percentage points for states with high unemployment. These temporary increases were enacted in the Recovery Act in February 2009 in response to the increased Medicaid caseloads and decreasing state revenues resulting from the recession. The increase is scheduled to expire on Dec. 31, 2010. The previous substitute amendment from Baucus would have extended these increases for six months, through June 30, 2011. The latest modification will continue the additional federal assistance for six months, but would phase the level of assistance down. For January – March, 2011, the federal Medicaid matching rate would be increased by 3.2 percentage points for all states, and for April – June, 2011, the federal Medicaid matching rate would be increased by 1.2 percentage points for all states. For the same six-month period, states with high unemployment would continue to receive the additional percentage points, as they do under current law. This would ensure that states continue to receive increases throughout state fiscal year 2011. This modification would reduce the cost of the bill by $8 billion over 10 years.

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