As you may be aware, on November 2 the House of Representatives introduced a comprehensive tax reform bill that could affect private equity sponsors, investors and portfolio companies. On November 9, the Senate Finance Committee unveiled the Senate's version of comprehensive tax reform. Although the Senate Finance Committee did not release draft language of its version of tax reform, it did release a summary of its version. Any or all of these proposals may be substantially modified or eliminated prior to enactment.
Carried interest: The House bill generally would limit the favorable taxation of carried interest to investments that have a holding period of more than three years, and treat carried interest attributable to gains on investments held for three years or less as short-term capital gain (taxed at the ordinary income tax rates).
The original Senate proposal did not provide for any changes to current law regarding the tax treatment of carried interests; however, as a result of a last-minute amendment, the Senate proposal now includes a provision that is similar to the House bill. The Senate proposal, unlike the House bill, also includes a provision intended to treat the sale by a non-US person of an interest in an operating partnership conducting business in the US as effectively connected income subject to US taxation, effectively overturning a recent Tax Court case, Grecian Magnesite.
Changes in rates and net operating losses
The House bill would reduce the corporate tax rate from 35 percent to 20 percent but would retain 39.6 percent as the highest individual income tax rate. Long-term capital gains rates would not be changed and would remain, in general, at 20 percent. The Senate proposal would retain the top corporate tax rate of 20 percent but would defer the effective date until 2019. It would retain the current seven-tax-rate bracket structure, but several of the rates would be lowered and the maximum tax rate would be reduced to 38.5 percent.
The House bill would, in general, allow for net operating losses (NOLs) carryovers to offset 90 percent of a corporation's taxable income and to be carried forward indefinitely (instead of carried forward for 20 years) but would eliminate, in most cases, the carryback of NOLs (instead of two years). This means that, in general, a private equity fund would not be able to monetize bonus payments made upon the disposition of a portfolio company that had been generating taxable income prior to its disposition other than with respect to the taxable year in which the sale occurs. In addition, the House bill proposes increasing an NOL by an interest factor—the short-term applicable federal rate (AFR), currently 1.38 percent, plus four percentage points—to preserve its value. The Senate proposal is generally the same as the House bill except that it does not provide for an increase in the NOL by an interest factor.
Reduced taxation of certain pass-through income
The House bill would provide for a reduced tax rate on business income derived by individuals through sole proprietorships, partnerships and other pass-through entities. A special 25 percent maximum tax rate would apply to “business income” derived by individuals, subject to rules intended to prevent the conversion of wages and other personal services income into business income. Business income excludes certain categories of passive investment income, such as dividends, interest and gains.
Individual investors in private equity funds who hold investments in portfolio companies that are organized as pass-through entities (“operating partnerships”) would generally be eligible for the 25 percent rate with respect to the business income derived from such investments (including in respect of carried interests). Owners of management companies generally would not be eligible for the special 25 percent rate on income received from a management company.
In lieu of a lower tax rate for certain income of pass-through entities included in the House bill, the Senate proposal would permit individuals to deduct 17.4 percent of their domestic qualified business income from a partnership, S corporation or sole proprietorship. The proposal includes limitations and restrictions to limit the deduction so that it does not apply to compensation, guaranteed payments or service providers with incomes in excess of US$150,000.
Under the House bill, the deduction for state and local income taxes would be repealed in the case of individual taxpayers. In a letter to Representative Earl Blumenauer, House Ways and Means Committee Chairman Kevin Brady recently clarified that the provision would also apply to deny deductions for state and local income taxes imposed on an individual’s share of the income received from an operating partnership or management company. Under the Senate proposal, similar to the House bill, an individual would not be entitled to any state and local income tax deduction.
The House bill includes two provisions that would significantly limit deductibility of interest. Existing debt would not be grandfathered.
Limitation on business interest: Under the first provision, every business, regardless of form, would, in general, be limited to deducting “business interest” to 30 percent of the taxpayer’s “adjusted taxable income” (ATI) for the taxable year. The limitation is determined at the filer level (e.g., at the partnership level instead of partner level). ATI would be defined to mean taxable income but computed without regard to:
- Income not properly allocable to a trade or business
- Business interest expense or income
- Deduction for depreciation, amortization or depletion
The 30 percent limitation would be increased by any business interest income earned by the taxpayer. Any interest that is not deductible under the provision could be carried forward for five years. Specific exceptions apply to small businesses (gross receipts of US$25 million or less) and to real estate businesses.
Special rules are provided for partnerships. In applying the 30 percent limitation to business interest incurred at the partner level, the partner’s ATI is generally determined without regard to business-related items allocated to the partner by a partnership, ensuring that net income from a partnership is not double counted at the partner level. Second, if the amount of business interest expense of a partnership is below the 30 percent cap, the cap on business interest deductible by the partners is increased by this excess amount.
It is not expected that this provision would apply to debt borrowed at the fund level since the interest on such debt would generally be considered investment interest rather than business interest.
It is not clear how this provision would apply to the debt of a “blocker corporation,” the sole asset of which is an interest in an operating partnership conducting business within the United States. In such case, which is a typical private equity structure, the blocker corporation would have no income other than income derived from such partnership. Under this provision, the blocker corporation's ATI would be zero because the blocker corporation’s only income (its distributive share of the partnership’s income) would be disregarded in determining the blocker corporation’s ATI. Therefore, although not clear, assuming that the interest with respect to the debt of the blocker corporation is treated as business interest under this provision and that the business interest at the partnership level equals or exceeds the cap (as determined at the partnership level), the blocker corporation would not receive a current tax benefit for any interest paid or incurred on the debt of the blocker corporation.
Under the Senate proposal, for businesses with average annual gross receipts of more than US$15 million, business interest expense would generally be limited to 30 percent of ATI. As described above, the House bill has a similar limitation, although the House provision would not apply to businesses with US$25 million or less in average annual gross receipts. Unlike the House bill, which would allow excess business interest to be carried forward five years, the Senate proposal would allow such interest to be carried forward indefinitely.
Limitation of deduction of interest by US corporations that are members of an international financial reporting group: The second limitation applies to US corporations that are members of an “international financial reporting group,” generally defined as any group of entities that includes at least one non-US corporation engaged in a US trade or business or at least one US corporation and one non-US corporation, prepares consolidated financial statements and earns annual gross receipts in excess of US$100 million. This provision would limit the corporation’s deduction for net interest expense to the extent the US corporation's share of the group's global net interest expense exceeds 110 percent of the US corporation's share of the group's global earnings before interest, taxes, depreciation and amortization. This limitation would apply in addition to the limitation described above.
Taxpayers would be disallowed interest deductions pursuant to whichever provision denies a greater amount of interest deductions. Any disallowed interest deductions would be carried forward for up to five taxable years.
The Senate proposal is similar to the House bill. The proposal addresses base erosion that results from excessive and disproportionate borrowing in the United States by limiting the deductibility of interest paid or accrued by certain US corporations that are members of a "worldwide affiliated group." The proposal would reduce the deduction for interest paid or accrued by a US corporation that is a member of a worldwide affiliated group by the product of the net interest expense of the US corporation multiplied by the "debt-to-equity differential percentage" of the worldwide affiliated group. There does not appear to be a gross receipt exception similar to the House bill.
The initial version of the House bill would have effectively ended the ability to structure compensation in a manner that allows a service provider to defer income beyond when the income vests. However, an amendment to the House bill released on November 9 eliminated these provisions.
The Senate proposal would provide that compensation deferred under a nonqualified deferred compensation plan is includible in the gross income of the service provider when there is no substantial risk of forfeiture of the service provider's rights to compensation. Under this proposal, a condition related to a purpose of the compensation other than the future performance of substantial services (such as a condition based on achieving a specified performance goal) does not create a substantial risk of forfeiture. The Senate proposal effectively reinstates the changes to deferred compensation proposed in the initial House bill.
The House bill (as amended) contains a provision that would allow employees (at their election) holding stock options or restricted stock units (RSUs) issued by certain private corporations to defer income resulting from the exercise of the options or settlement of the RSUs for five years after the date on which the options or RSUs vest or, if earlier, the date when:
- The stock becomes transferable (including to the employer)
- Stock of the issuing corporation becomes publicly traded
- The employee becomes an "excluded employee," or
- The employee revokes the election
This rule would not be available to an employee (i) who was a one-percent or greater owner of the corporation at any time during the 10 preceding calendar years, (ii) who is or was at any time the corporation’s CEO or CFO (including any individual acting in such capacity or a related person), or (iii) who was at any time during the previous 10 taxable years one of the four highest compensated officers of the corporation. The deferral election would be available with respect to corporations that, pursuant to a written plan, grant stock options or RSUs to at least 80 percent of their US employees in the calendar year in which the relevant options or RSUs were granted. Note that the second amendment to the House bill clarifies that Section 83 of the Internal Revenue Code of 1986, as amended ("tax code"), other than this special election pursuant to this provision, does not apply to RSUs.
The Senate proposal does not provide for a similar proposal.
The House bill includes several changes to US international tax rules that would impact multinational groups that have either a US parent or a US subsidiary. Although the Senate proposal is similar in many ways, it would make more extensive changes to the US international tax rules than would the House bill. The Senate proposal borrows more heavily from former Ways and Means Committee Chairman Dave Camp's 2014 tax reform bill.
Dividends-received deduction for distributions from non-US subsidiaries: The House bill introduces a modified “territorial” system of tax (in lieu of the current worldwide tax system) in which income earned by non-US subsidiaries is not subject to tax when repatriated to the United States. Specifically, the House bill provides for a participation exemption system whereby a US corporation would receive a dividends received deduction for dividends received by it from a 10 percent–owned non-US corporation. However, US persons would continue to be subject to US tax on their share of certain income from non-US subsidiaries, including passive (subpart F) income (as revised by the House bill) and “foreign high return” income (described below). The Senate proposal is similar to the House bill.
Deemed repatriation: In order to implement the territorial system, the House bill provides for a one-time transition tax that would require US shareholders owning at least 10 percent of a non-US subsidiary that is a "controlled foreign corporation" (CFC) to include in income the non-US subsidiary’s previously untaxed post-1986 accumulated earnings and profits (E&P) even for periods where the US person owned less than 10 percent (including zero percent) of the non-US subsidiary. The House bill specifies a 14 percent tax rate on cash or cash equivalents and a seven percent tax rate on non-cash amounts, and the tax can be paid in equal installments over eight years.
The Senate proposal is similar, except that it provides for a 10 percent rate on cash or cash equivalents and a five percent on illiquid assets and it applies only with respect to previously untaxed post-1986 E&P for the period in which a US person held a 10 percent interest in the non-US subsidiary.
Tax on “foreign high return” income: The House bill would require US shareholders owning at least 10 percent of a CFC to pay tax on 50 percent of its “foreign high returns,” generally the excess of the non-US subsidiary’s aggregate net income over a determined return (seven percent plus the short-term AFR) on such subsidiaries’ aggregate adjusted bases in depreciable property, adjusted downward for interest expense. Special foreign tax credit rules are provided. The intent of the provision is to subject the non-US subsidiary’s foreign high returns to a minimum 10 percent tax in the United States.
The Senate proposal does not have the "foreign high returns" provision in the House bill, but it has a similar provision: the "global intangible low-taxed income" (GILTI), which taxes at a 10 percent tax rate foreign earnings that exceed 10 percent of the aggregate of depreciable property used in a trade or business. Like the House bill, the provision applies to all US shareholders, including individuals. The Senate proposal pairs this provision with new incentives to develop (or bring back) intellectual property and export its usage.
Section 956 limited to non-corporate shareholders: Due to the inclusion in the House bill of the dividend exemption for foreign source dividends from a non-US subsidiary to a US corporation, there would not be a US tax avoided by a US parent corporation reinvesting its non-US earnings into the US. Thus, the House bill would eliminate the application of Section 956 of the tax code (which taxes undistributed non-US earnings that are reinvested, or deemed to be reinvested, in the US). In the context of a US borrower, Section 956 of the tax code effectively limited the ability of the non-US subsidiary to provide a guarantee of the US borrower’s debt or to allow for a pledge of more than 65 percent of the voting stock of the non-US subsidiary. This change may cause lenders to now seek changes in credit agreements going forward.
The Senate proposal includes a similar provision.
20 percent excise tax on payments to non-US affiliates: The House bill would impose a 20 percent excise tax on certain tax deductible amounts (not including dividends or interest) paid by US corporations to non-US affiliates that are members of the same "international financial reporting group" unless the non-US affiliate elects to treat the payment as effectively connected income within the US. The principal purpose of this provision is to prevent non-US-parented multinationals from eroding the US tax base by shifting profits to non-US affiliates.
The Senate proposal does not include this provision. However, it does have a provision intended to reach a similar result: the "base erosion minimum tax." This base erosion minimum tax effectively requires a US corporation that makes deductible payments to a non-US affiliate to pay the higher of (i) a tax equal to 10 percent of its income without any deduction for such otherwise deductible payments to its non-US affiliate ("base erosion payments"), or (ii) its regular corporate tax liability (reduced only by the R&D tax credit). The base erosion minimum tax applies to US corporations that have annual gross receipts equal to at least US$500 million and that have a "base erosion percentage" of four percent or higher for the taxable year (the "base erosion percentage" is the domestic corporation's total base erosion payments divided by its total deductible payments).
State pension plans
The House bill proposes to make clear that all entities exempt from tax under Section 501(a) of the tax code to the unrelated business income tax (UBTI) rules, notwithstanding an entity’s exemption under any other provision of the tax code. This provision is to make clear that state and local government–sponsored entities—such as public pension plans—that are exempt under Section 115(1) of the tax code are subject to the UBTI rules. This provision may cause some state pension plans to seek to restructure their interest in existing portfolio investments in “operating partnerships” or for which there is “acquisition indebtedness.”
The Senate proposal does not appear to have a similar provision.