President Trump signed into law tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”) on December 22, 2017. The Tax Act implemented the most far-reaching changes to the Internal Revenue Code (the “Code”) since the Tax Reform Act of 1986. While the Tax Act lowered the corporate tax rate to 21%, other changes made by the Tax Act will also affect the after-tax profitability of private equity portfolio companies and impact how sponsors structure deals and conduct diligence for future transactions.

The Tax Act changes are a mix of permanent changes to the Code and others which are of limited duration. As with all things in Washington, D.C., the permanence (or temporary nature) of any provision is subject to the whims of Congress.

Relevant provisions of the Tax Act for private equity funds and their portfolio companies are highlighted below.

Portfolio Company Changes

  • Corporate Tax Rate Reduction: The Tax Act implemented a permanent reduction in the corporate tax rate from 35% to 21%, beginning in 2018. The alternative minimum tax for corporations is repealed.

  • 30% EBITDA/EBIT Limit on Interest Expense Deductions: The Tax Act generally limits the deductibility of interest expense (net of interest income) for corporations and partnerships to 30% of a business’s annual adjusted taxable income (“ATI”). ATI approximates, but does not necessarily equal, EBITDA through 2021 and EBIT for years thereafter, thereby creating an unexpected burden on capital expenditures after 2021. More specifically, ATI is taxable income computed without regard to (i) items not properly allocable to a trade or business, (ii) interest income, (iii) deductions for net operating losses (“NOLs”), (iv) the 20% deduction for qualified business income described below, and (v) prior to 2022, any deductions for depreciation, amortization or depletion. Many highly levered businesses may face an increased tax bill despite the lower tax rate as a result of this limitation. In particular, businesses that otherwise would not have had a tax bill if their interest expense were fully deductible may now owe federal income taxes. Businesses with gross receipts below US$25 million are exempt from the limitation. For partnerships, the limitation is applied at the partnership level. Taxpayers may carry forward disallowed interest deductions indefinitely, subject to certain rules applicable to partnerships, but such carried forward deductions would remain subject to the overall calculation of the limitation on deductibility. Section 382 of the Code, which limits the use of NOLs and other tax attributes following an ownership change, would also apply to unused interest deductions. Investment interest expense (typically not applicable to a portfolio company) is not subject to the new 30% limitation but remains subject to limitations under current law.

  • NOL Limitations: NOLs incurred in years beginning on or after January 1, 2018, will have an indefinite carryforward but importantly can no longer be carried back. Thus, a corporate target’s deal expenses no longer fuel pre-closing tax refunds beyond refunds of estimated payments for the year of a sale. Also for years beginning on or after January 1, 2018, NOL deductions are limited to 80% of taxable income, although pre-2018 NOLs carried forward into 2018 are not subject to the 80% limitation. Valuations of existing and potential portfolio companies should be made with an understanding of the particular years in which NOLs arose and can be utilized. Utilization of NOLs from all years continues to be subject to the ownership change limitations under Section 382 of the Code.

  • 100% Expensing: Changes to expensing rules generally benefit portfolio companies with high capital spending. The Tax Act allows immediate expensing of 100% of the cost of qualified property in the year it is placed in service (up from 50% currently) for property placed in service before 2023 (or in the case of certain property having a longer production period, 2024). This 100% expensing is phased out 20% per year beginning with property placed in service in 2023 (or in the case of longer-lived property, 2024). In addition, certain used property will now be treated as qualified property, but expenditures for intangible property and foreign use assets are not eligible for immediate expensing.

Fund and Investor Level Changes

  • Changes to Individual Rules that Affect Pass-Through Structures: In addition to a reduced top rate on individual ordinary income (37% through 2025, down from 39.6% in 2017), qualified business income from pass-through entities allocated to individuals is entitled to a 20% deduction through 2025. Combined with the 37% top individual rate, income qualifying for this deduction has an effective maximum federal income tax rate of 29.6%. For taxpayers above a defined income threshold (generally US$315,000 for joint returns), however, the deduction is limited to 50% of the wages paid by the business or 25% of the wages plus 2.5% of the tax basis of property held for use in the business.

  • Reduction in Deduction for State and Local Taxes: Individuals are now subject to a new US$10,000 cap on deductions of state and local income, sales and property taxes.

  • 3-Year Long-Term Capital Gains Holding Period for Carried Interest: The Tax Act generally imposes a new 3-year holding period requirement (up from 1 year) for service providers to receive long-term capital gain from carried interests granted with respect to real estate or investment businesses. This provision applies to an applicable partnership interest held by a taxpayer, which includes a partnership interest transferred to the taxpayer in connection with the performance of substantial services by the taxpayer in the trade or business of (i) raising or returning capital, (ii) investing in (or disposing of) specified assets (or identifying specified assets for investment or disposition), or (iii) developing specified assets. Specified assets include securities, certain financial assets, and real estate held for investment.

International Changes

  • Move Towards Territoriality: The Tax Act moves the U.S. closer to a territorial system (i.e., not taxing earnings earned outside the U.S.) by excluding 100% of the foreign-source portion of the dividends received by U.S. corporations from 10%-or-more owned foreign corporations, subject to a one-year holding period requirement.

  • One-Time Repatriation Tax: As part of the transition to a territorial system, the Tax Act subjects “U.S. shareholders” (generally, 10% shareholders) of a foreign corporation to a one-time immediate taxation on the foreign corporation’s previously untaxed foreign earnings, at an effective tax rate of generally 15.5% for earnings held in cash or cash equivalents and 8% for the remainder. The tax may be paid over a period of up to 8 years. For transactions occurring during this 8-year window, private equity sponsors should review whether a target company has elected to defer payments.

  • “GILTI” Tax With Respect to Offshore Intangibles: Despite the move toward a territorial system, the Tax Act imposes a tax on the “global intangible low-tax income,” or GILTI, of U.S. shareholders of controlled foreign corporations (“CFCs”). The tax is based on a portion of the income of all CFCs owned by a U.S. shareholder, which is determined based on each CFC’s income as reduced by a deemed return on each CFC’s tangible assets. Because U.S. corporate shareholders generally qualify for a 50% deduction for GILTI, those shareholders are taxed at an effective rate of 10.5% for GILTI. Beginning in 2026, the deduction is reduced to 37.5%.

  • FDII Export Incentive: The Tax Act allows a U.S. corporation a deduction for 37.5% of its “foreign-derived intangible income,” which generally includes certain intangible income attributable to sales of property to foreign persons for use outside the U.S. Certain restrictions apply for sales to related foreign persons. Beginning in 2026, the deduction is reduced to 21.875%.

  • BEAT Base Erosion Tax: The Tax Act imposes a new “base erosion anti-abuse tax” on certain domestic corporations when the gross receipts of the domestic corporation and its corporate group exceed US$500 million and the domestic corporation makes meaningful payments to related foreign persons. The BEAT is a minimum tax and is based on the amount by which a corporation’s income tax liability determined without base-erosion payments exceeds its regular income tax liability. The tax is generally 5% beginning in 2018, 10% beginning in 2019, and 12.5% beginning in 2026.

  • Expansion of Scope of CFC Regime: The “Subpart F” provisions of the Code, which limit the deferral of taxation of income earned abroad by CFCs, are retained by the Tax Act and modified in three noteworthy ways that can broaden their reach: 1) the definition of “U.S. shareholder,” which is part of the trigger for CFC status, is changed from ownership of 10% of a foreign corporation’s voting power to 10% of the voting power or value, 2) the 30-day holding period requirement for CFC status is repealed, and 3) related-party attribution rules used for determining CFC status are more expansive.