On December 15, 2017, what is anticipated to be the final GOP tax reform bill (the “Bill”) was released in the form of House Report 115-466, a Conference Report for H.R. 1 (the Tax Cuts and Jobs Act).
As of this writing, the Bill has been passed by the House and Senate and is expected to be signed into law by President Trump. The Bill would have profound effects on the United States tax system, many of which are relevant to investment funds, their managers, and their investors. Although the entirety of the Bill is beyond the scope of this discussion, we have summarized below some of the key provisions relevant to investment funds.
I. Revisions Impacting Fund Managers
The carried interest regime is retained in the Bill. However, the Bill imposes a three-year holding period to achieve long-term capital gain treatment for partnership interests received in exchange for services.
The Bill also requires fund managers transferring their partnership interests to a related party to recognize any gain attributable to assets held for less than three years as short-term capital gain. It is unclear whether this applies to routine transactions that would otherwise be non-taxable (e.g., estate planning transfers or grants of carried interest to new professionals). Fund managers may want to wait for additional guidance before transferring their partnership interests to family members or estate planning vehicles, or making new profits interest grants.
Although not a component of the Bill, the IRS issued guidance on December 15, 2017, that confirmed that if a “partnership representative” elects to “push out” to its partners the liability for an imputed underpayment related to an audit adjustment, any partner that is itself a partnership can similarly make an election to push out such liability to its partners. That is, the election can be made through tiers of partnerships, thus allowing the liability for an underpayment to be imposed on the final partner in a tiered partnership structure. This will provide fund managers additional flexibility to properly allocate liabilities for audit adjustments to the partners that benefited from any underpayment.
II. Provisions Impacting Investments/Portfolio Companies
The Bill contains a number of changes affecting the way U.S. corporations and pass-through entities calculate their tax liability, which are likely to have a significant impact on funds’ investments and the value of tax attributes. These changes should be taken into account for purposes of pricing and structuring transactions.
Reduced Corporate Tax Rate
The corporate income tax rate is reduced to 21% from 35%, effective for tax years beginning on or after January 1, 2018.
Repeal of Corporate Alternative Minimum Tax (“AMT”)
The 20% corporate AMT is repealed. Any AMT credit carryforward can be used to offset regular tax liability, and up to 50% of any balance is refundable (increased to 100% for tax years beginning on or after January 1, 2022).
Under current law, corporations are provided a deduction with respect to dividends received from other taxable domestic corporations (the dividends-received deduction). The deduction generally is equal to 70% of the dividends, increased to 80% in the case of dividends received from a corporation that is 20% or more owned by the corporate taxpayer, and 100% in the case of dividends received from a corporation that is a member of the affiliated group of the corporate taxpayer.
The Bill would reduce (i) the general dividends-received deduction from 70% to 50%, and (ii) the dividends-received deduction applicable to “20% owned corporations” from 80% to 65%.
Reduced Pass-Through Tax Rate
A 20% deduction applies to “qualified business income” earned through certain pass-through entities such as partnerships, S corporations, and sole proprietorships. Generally, qualified business income is defined as all domestic business income (including certain dividends from REITs and cooperatives) but does not include investment income, investment interest income, short- and long-term capital gains, commodities gains, or foreign currency gains.
There are special phase-outs that apply where the wage income paid by such business to its owners exceeds certain levels. Generally, the phase-out begins for owners of such pass-through businesses at $157,000 for individual filers and $315,000 for joint filers (indexed for inflation), with a complete phase-out where such levels are exceeded by $50,000 and $100,000, respectively. An alternative/higher limitation calculation applies for pass-through entities (i) that pay significant wages to employees and (ii) with significant capital investment in tangible property but few employees, as is the case for many real estate companies.
Deemed Repatriation and Territorial Tax System
A one-time mandatory tax applies to U.S. corporations’ overseas assets (8% for illiquid assets and 15.5% for cash and cash equivalents).
The Bill also allows for a 100% deduction for foreign-source dividends received from “specified 10-percent owned foreign corporations” subject to a one-year holding period, exempting U.S. corporations from U.S. taxes on most of their future foreign profits. Also of note is that the Bill substantially modifies the taxation of foreign controlled entities and the current “Subpart F income” rules (discussed below).
The Bill allows taxpayers to immediately write-off, or expense, 100% of the cost of property acquired and placed in service through 2022. Starting in 2023, the Bill reduces the rate by 20% per year. For certain property with longer production periods, the reduction in the expensing rate will begin in 2024. Of particular note is the fact that, unlike under current law, these new rules allow write-offs for not just “new” property, but for “used” property as well. These provisions will clearly help reduce the effective tax rate of manufacturing and other machinery- and equipment-intensive businesses.
Interest Expense Limitation
Businesses’ ability to deduct interest expense is limited to 30% of adjusted taxable income determined (i) without regard to depreciation, amortization, or depletion for tax years beginning on or after January 1, 2018, through December 31, 2021, and (ii) decreased by those items (causing the limit to apply to EBIT) for tax years beginning on or after January 1, 2022. Disallowed interest expense deductions can be carried forward indefinitely.
This limitation will most likely affect buyout and mezzanine funds, and could negatively affect returns of portfolio companies. In addition, the limit on deductibility of interest may result in private equity funds using preferred equity, rather than debt, to raise capital.
Base Erosion Anti-Avoidance Tax (the “BEAT”)
The Bill imposes the BEAT to prevent earnings stripping. Many U.S. funds with foreign investors and affiliates manage their U.S. tax liability by maximizing deductible payments from the U.S. to their foreign owners and affiliates including, for example, interest on debt borrowed from affiliates. The BEAT is an alternative tax that is imposed at a 5% rate in 2018, 10% through 2025, and 12.5% thereafter, and each of these rates is increased by 1% for banks and securities dealers. Generally, this alternative tax rate is imposed on a modified taxable income base that starts with a taxpayer’s regular taxable income and adds back deductible payments made to foreign affiliates (affiliate is generally defined as an owner of 25% or more of the U.S. taxpayer). This alternative tax is then compared to the taxpayer’s regular tax liability, and the taxpayer pays the higher of the regular or base erosion tax. Banks and securities dealers fought for and were able to get an exception to the modified taxable income addback calculation for payments relating to derivative/hedging transactions.
Taxpayers’ ability to use NOLs will be limited to 80% of annual income, with no carryback and an indefinite carryforward.
Changes to the Scope of Controlled Foreign Corporation (“CFC”) Rules
U.S. entities are treated as constructively owning stock in a foreign corporation held by the U.S. entity’s foreign owners. Under current law, only stock held by an entity’s U.S. owners is attributed downward.
A U.S. person holding 10% or more of the vote or value of a foreign corporation is treated as a “U.S. shareholder” for purposes of testing CFC status. Prior to this revision, only voting power was considered.
The CFC test will no longer require a foreign corporation to be controlled by U.S. shareholders for an uninterrupted period of 30 days.
The CFC changes limit taxpayers’ ability to avoid the rules through careful planning, heighten the risk that the CFC rules are triggered through temporary and/or inadvertent structural changes, and are likely to increase the circumstances under which investment funds’ foreign portfolio companies are treated as CFCs, giving rise to potential “phantom income” inclusions to U.S. taxable investors, and resulting in additional reporting and compliance burdens.
III. Revisions Impacting Investors
New Individual Tax Rates
The Bill provides for a temporary rate structure with seven tax brackets, reducing the top marginal rate to 37% from 39.6%. A number of other changes apply, including the elimination of state and local tax deductions above $10,000.
Non-U.S. Partners’ Gain on Sale of Partnership Interests
Non-U.S. investors will recognize, as effectively connected income, gain from the sale of a partnership interest (or interest in an LLC taxed as a partnership) in proportion to the partnership’s U.S. business assets, with the tax being initially collected through a 10% withholding tax (similar to FIRPTA).
This provision codifies the IRS’s historic position, which was successfully challenged this summer in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. No. 3 (July 13, 2017). Funds with foreign investors and offshore blocker corporations investing in U.S. pass-through businesses should consider investing through U.S. blocker corporations; fortunately, the reduced corporate tax rate will mitigate the tax inefficiency of investing through a U.S. blocker. This particular provision is discussed in more detail in a recent O’Melveny & Myers Client Alert available at https://www.omm.com/resources/alerts-and-publications/alerts/client-alert-us-tax-reform-legislation-to-impact-secondaries-transactions/.
No Elimination of “Super Tax-Exempt” Status
The Bill did not include the House proposal to subject state pension plans and other state and local governmental entities to tax on their unrelated business taxable income (“UBTI”).
Investment-by-Investment Determination of UBTI
Tax-exempt investors must determine their UBTI separately for each unrelated trade or business, preventing losses from one UBTI activity of a tax-exempt investor from offsetting income from a different UBTI activity. Tax-exempt investors’ inability to net UBTI income against losses from other UBTI-producing businesses is likely to further incentivize the tax-exempt investors subject to the UBTI rules to invest through blocker corporations.