Inequities
by the Editors
Post date: 08.04.07
Issue date: 08.06.07

Stephen Schwarzman, noted solipsist and private equity kingpin, was delivering a speech at the New York Stock Exchange last month when his cell phone rang. "There's a crisis going on," he said, then answered it. For the next few minutes, the audience was treated to a real-life case study in crisis management. Finally, Schwarzman returned to the podium and revealed the cause for his alarm. A terrorist attack? A market meltdown? A last-minute glitch in the iPhone? Not quite. Two senators had just introduced a bill requiring his firm--starting in 2012--to pay its fair share of taxes.

At the time, the Blackstone Group, which Schwarzman runs, was planning to raise some $4 billion in a public stock offering. (The actual amount came pretty close to that when the IPO happened in late June.) But, unlike most public companies--even those, such as investment banks, in essentially the same business--Blackstone would not have been subject to the corporate income tax on its profits. The loophole arises from a law that allows publicly traded partnerships to mostly avoid the 35 percent corporate tax so long as they generate the vast majority of their income from passive investments. (Partners pay only a 15 percent capital gains tax on profits remitted to them directly.)

Problem is, there is no English-language definition of the word "passive" that describes Blackstone's business model. The whole point of a private equity firm, after all, is to buy up undervalued companies and overhaul their operations. "Go and talk to the companies they buy," says Victor Fleischer, a tax expert at the University of Illinois. "They very much feel like [the ownership] is active." In weaker moments--like, say, its SEC filings--even Blackstone concedes as much.

The two senators, Democrat Max Baucus and Republican Chuck Grassley, want to fix this inequity by closing the loophole. Blackstone's defenders, meanwhile, trot out a fairness argument of their own. The logic, as summarized in a recent Wall Street Journal editorial, is that Blackstone makes its money from subsidiary companies. And, since those companies already pay corporate taxes on their own profits, it would be punitive to levy the tax a second time. Which might be true, if the subsidiary companies actually paid taxes. As it happens, Blackstone takes on so much debt when it buys them that their effective tax rate is negative (meaning they receive money from the government). Moreover, by the Journal's logic, GM shouldn't pay the corporate tax, either, since it has already paid taxes on the glass and steel that it fashions into cars. Blackstone's management presumably thinks it's engaging in a productive economic activity--capital allocation--when it buys up companies. It's hard to see why profits from this activity should go largely untaxed. Finally, much of Blackstone's revenue comes from the sale of subsidiary companies, not their operations. Other public companies have to pay corporate taxes on profits from such sales. Blackstone gets to pay a far lower rate.

"A hallmark of corporate status is access to the capital markets," Grassley noted when introducing the legislation, which is currently awaiting a committee vote. "It's unfair to allow a publicly traded company to act like a corporation but not pay corporate tax." He's exactly right. No one is forcing Blackstone and its ilk to raise money from the public. If they do, they should bear the responsibilities that go with it.

the Editors