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Private equity funds (PEFs) eliminate entity-level taxation by using pass-through entities. They further minimize their investors’ tax liability by taking the position that profits distributed to both general partners (GPs) and limited partners (LPs) are passive portfolio investment income and taxed preferentially. The taxation of carried interest at low capital gains rates is likely the most infamous loophole. This article challenges such tax position and instead argues that the nature of PEF investment is active. PEFs seek to influence their portfolio companies to increase their value so that they actively manage the companies by acquiring at least 10% of their stock, which does not conceptually accord with portfolio investments. The proposed theory that PEFs are active is further supported by recent proposals on carried interest as well as cases and rulings holding that PEFs are involved in a “trade or business.”

This article also considers international tax implications of the new theory: it switches the primary tax jurisdiction to levy tax on PEFs’ crossborder income. This change may be justified for GPs who erode the tax base of a source country, but less justified for LPs because of their genuinely passive involvement, notwithstanding that LPs’ tax-exempt or nonresident status enables GPs’ abusive activities. Finally, determining the true nature of PEF investment and reforming PEF tax accordingly would increase worldwide revenue without significantly reducing the revenue of traditional residence countries, because the traditional residence countries, such as the United States, are also major source countries in the PEF industry.

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