Private equity players in Canada are hoping that strong election talk in the U.S. of boosting taxes on fund managers’ incomes doesn’t find a receptive audience in this country.

The debate over raising taxes on what is known as “carried interest” is front and centre in the U.S. political arena as Democratic presidential hopefuls Hillary Clinton, Barack Obama and John Edwards have all come out in favour of closing what Clinton calls “a tax loophole.”

Earlier this summer, the former first lady said in a campaign statement: “It offends our values as a nation when an investment manager making $50 million can pay a lower tax rate on her earned income than a teacher making $50,000 pays on her income.”

Typically, private equity managers have some of their own money in the funds they run and earn 20% of the profits. Those profits are taxed as capital gains, rather than traditional income. In Canada, that means managers pay tax at a rate of 23% instead of about twice that amount, depending on their home province.

Canadian private equity players say changing the tax treatment of income would reflect a fundamental misunderstanding of the business and would end up suffocating the industry. But it’s possible that what happens in the U.S. could spill over into Canada, says Trevor Maunder, a partner with Toronto-based Artemis Investment Management Inc.

Private equity managers are given preferential tax treatment because it’s far riskier to earn income on the investments they make than receiving a regular paycheque from an employer, says Rick Nathan, managing director at Toronto-based Kensington Capital Partners Ltd. and president of the Canada’s Venture Capital and Private Equity Association.

“It’s very important for Canada to have a strong private equity sector,” he says. “People talk about the debate about hollowing out companies and having too many foreign takeovers of Canadian companies. But we need to make sure we have strong Canadian investments and strong Canadian buyers for Canadian businesses.

“The last thing you want to do is put in a tax framework that weakens our domestic players,” Nathan adds. “That’s the key message people should be thinking about: do you want to have strong Canadian investors or don’t you?”

Private equity taxation has become a hot-button topic in the U.S. because the industry has a much higher profile there. The largest private equity funds in Canada wouldn’t even crack the top 20 in the U.S., he says.

“There’s, perhaps, not a lot of understanding of the nature of the business in Canada — because it’s private,” he says.

The impact of a potential tax change for private equity managers could have the effect of dampening a growing market, says Kirk Falconer, director of research at Thomson Financial Canada.

“I’m hoping the talk doesn’t gain much traction because private equity is a new option for Canadian businesses,” he says. “It’s a new and emerging capital market in Canada that has the potential to deliver very important value added. Why apply a tax that will snuff that out?”

Nathan notes that the amount of private equity invested in Canada has increased dramatically, to approximately US$64.1 billion as of Sept. 30, from about US$12.2 billion a year earlier. The pending Bell Canada takeover amounts to $47.2 billion of the total. Excluding that large transaction, the total as of Sept. 30 was US$16.9 billion, which still represents a respectable increase in a short time period.

Artemis Investment’s Maunder says he wants his managers to earn an income that they feel is “comfortable.”

“The last thing I want is them worrying about feeding their children and putting a roof over their heads,” he says.

But, if tax changes do eventually come, Maunder says managers will just have to take their lumps.

“They don’t have a choice. I don’t think there’s any strategy to mitigate it. If you could make another $100 tomorrow — and even if you were taxed at 99% — aren’t you better off making that extra $100?” he says.

Jeff Norton, president and CEO of the $4.7-billion Manitoba Teachers Retirement Allowances Fund, says any tax increase that would reduce the after-tax profits of its managers would be a negative development for its plan and its 26,000 beneficiaries.

He fears a tax hike could cause managers to take a larger share of the profits to make up the difference.

@page_break@“There could be a ripple effect. It could increase the overall taxes in an investment that we share,” Norton says. IE