Capital gains: taxing times

In the US, obtaining long-term (over one year) capital gains treatment is a key objective for investors from a tax perspective. The maximum rate applicable to such gains is 15 per cent, compared to 35 per cent for ordinary income, plus any applicable state income taxes, writes Jim Smulkowski, a partner at law firm Katten Muchin Rosenman.

Recognising capital gain from the sale of non-real estate and non-operating assets is even more attractive to passive foreign investors, who won't pay US tax. The favourable 15 per cent rate isn't available to corporations, which pay the same rate on capital gain and ordinary income, nor in general to pension funds and other tax-exempt investors, which pay no tax on their investment income.

Past change
The big news over the last couple of years has been that the 15 per cent rate has applied to most dividends received by US investors. They could recapitalise their investments and distribute the proceeds during the holding period. This wasn't previously the case, as dividends were normally taxed at the same rate as ordinary income. Typically, an investor would hold the shares for a couple of years and then sell.

A timely end
The maximum 15 per cent rate for long-term capital gain and dividends is scheduled to expire after 2010. This is also the only year in which the US estate tax rate (equivalent to the UK's inheritance tax) is cut to zero for those who can time their demise accordingly. The estates of any belated souls still breathing at midnight will again be subject to a 55 per cent rate starting in 2011. As it stands, the long-term capital gains rate will return to 20 per cent after 2010 and the dividend rate will be again taxed at ordinary income rates, which are also scheduled to concurrently increase to 39.6 per cent.

An end in sight
The end of the favourable long-term capital and dividend rates could be nearer after the US elections. If those inclined to raise taxes prevail, another issue will be whether "carry", payable to managers of PE, hedge and other funds, should be taxed at ordinary income rates. Carry is currently taxed according to proportion and character of the underlying investment income, which may be long-term capital gain. The proposals floating around Washington DC would impose tax at ordinary income rates on carry.