In regard to taxation and private equity funds, 2017 was defined by the Tax Cuts and Jobs Act (the “Act”) which was signed on December 22, 2017. While the Act will impact many types of taxpayers, some of the more significant changes are relevant to private equity funds. Fund managers and investors should consider the potential impact of the Act on the fund structures and underlying investments and determine whether any changes to fund investment strategies are warranted in light of the Act.
Fund and Management Company Issues
- Three-year holding period for long-term capital gains treatment for carried interests: The Act imposes a three-year holding period requirement to treat capital gains derived from carried interests as long-term capital gains (prior to the change, the holding period requirement was one year). The new rules apply to profits interests transferred or held in connection with the performance of substantial services in the trade or business of raising or returning capital and investing in, or disposing of, developing securities, commodities, debt instruments, options, derivatives, real estate held for investment, or any interest in a partnership to the extent of the partnership’s interest in any of the foregoing assets. Thus, the provision is intended to apply to carried interests issued by private equity and other investment funds. The provision is effective for tax years beginning January 1, 2018. The carried interest provision does not grandfather existing profits interests, such that profits interests issued prior to January 1, 2018, will be subject to the new holding period requirement. If the provision applies, the affected capital gain is treated as a short-term capital gain, which is subject to tax at ordinary income rates.
- Miscellaneous itemized deductions eliminated: Under the Act, effective for tax years after December 31, 2017, and before January 1, 2026, miscellaneous itemized deductions, including investment management fees, will no longer be deductible for individuals, trusts, and estates.
- 20 percent pass-through income deduction: Effective for tax years beginning after December 31, 2017, and before January 1, 2026, the Act provides a new deduction for “qualified business income” (QBI) earned by individuals and certain trusts and estates through partnerships, S corporations, and sole proprietorships. Specifically, the Act permits a deduction of up to 20 percent of such income, thereby potentially reducing the top marginal U.S. federal income tax rate for such income from 37 percent to 29.6 percent. These new rules are somewhat complicated, but it should be stressed that QBI specifically excludes income derived from certain service businesses as well as income derived from investment management, trading, or dealing in securities, unless in the case of a specified service business a taxpayer’s taxable income for the taxable year is less than an inflation-adjusted threshold amount (US$315,000 for married filing jointly taxpayers and US$157,500 for single filers, subject to a phase-out for income in excess of the threshold amount of US$100,000 for married filers or US$50,000 for single filers). However, operating income realized through a carried interest may be eligible for the deduction.
- Repatriation of existing offshore earnings: The Act imposes a one-time transition tax on certain foreign earnings through a deemed repatriation of such earnings. Under this provision, any 10 percent U.S. shareholder (by vote) of a foreign corporation as of December 31, 2017, must include in income for taxable year 2017 its proportionate share of the foreign corporation’s undistributed earnings if such foreign corporation is a “controlled foreign corporation”  (CFC) or is a foreign corporation with at least one 10 percent U.S. corporate shareholder. In the case of a corporate shareholder, earnings held by the foreign corporation in cash or cash equivalents are subject to tax at a rate of 15.5 percent, and earnings invested in noncash assets are subject to tax at a rate of 8 percent. In the case of an individual, the rates of tax are approximately 17.5 percent for cash and cash equivalents and 9.05 percent for noncash assets. U.S. shareholders may elect to pay the tax without interest over an eight-year period. The deemed repatriation provision may result in phantom income for U.S. investors in a U.S. fund that held investments in non-U.S. corporations, as it may not be possible for the fund to compel a cash distribution from the foreign corporation to permit the fund to make a cash distribution to pay the tax. Fund managers should review their holdings in foreign corporations to determine whether the deemed repatriation rules will impact a fund’s U.S. investors.
- Limitation on deductibility of state and local taxes: The Act generally limits an individual’s ability to deduct state and local taxes to US$10,000 for income, property, and sales taxes through 2025.
Portfolio Company and Investment-Related Issues
- Lower corporate tax rates: Under the Act, the U.S. federal income tax rate of corporations has changed from a progressive rate schedule with a maximum rate of 35 percent to a flat rate of 21 percent. In addition, the corporate alternative minimum tax has been repealed. In general, these changes are effective for a corporation’s first taxable year beginning after December 31, 2017.
- Limitation on the deductibility of business interest: Under the Act, for tax years beginning after December 31, 2017, the deduction for business interest will be limited to the sum of (1) business interest income for such year; (2) 30 percent of “adjusted taxable income” for such year (which cannot be less than zero); plus (3) floor plan financing interest for such year. “Adjusted taxable income” essentially refers to EBITDA (that is, earnings before interest, taxes, depreciation, and amortization) for taxable years before January 1, 2022, and EBIT (that is, earnings before interest and taxes) for taxable years beginning January 1, 2022. Business interest that is not deductible under these new rules generally may be carried forward indefinitely, except with respect to partnerships, which are subject to certain special rules. The new limitations on interest deductibility do not apply to a taxpayer whose average annual gross receipts for the three-year period ending with the prior tax year do not exceed US$25 million or to an electing real property trade or business (i.e., any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business).
- Immediate expensing: The Act provides for an immediate expense deduction (in lieu of capitalization and depreciation) for the cost of “qualified property” placed in service by the taxpayer after September 27, 2017, and before January 1, 2023. For this purpose, qualified property generally is tangible property (including computer hardware) with a recovery period of 20 years or less and certain computer software. After December 31, 2022, these new rules begin to phase-out.
- Net operating loss (NOL) limitations: The NOL deduction now is limited to 80 percent of taxable income, calculated without regard to the NOL deduction. In addition, the two-year carryback of NOLs generally has been repealed, but NOLs now may be carried forward indefinitely. These rules are effective for losses and NOLs arising in taxable years beginning after December 31, 2017.
- Gain on the sale of certain partnership interests by non-U.S. persons: Under the Act (consistent with the IRS’s longstanding position), if a non-U.S. person disposes of an interest in a partnership engaged in a trade or business in the United States through a permanent establishment or fixed place of business, gain or loss on the disposition of such partnership interest is treated as effectively connected income (and thus subject to U.S. income tax) in proportion to the assets held by the partnership and used in the conduct of such U.S. trade or business. The buyer of an interest in a partnership that is engaged in a U.S. trade or business generally is required to withhold 10 percent of the purchase price of such partnership interest unless the seller provides an affidavit certifying its status as a U.S. person (similar to a FIRPTA certificate). If the buyer fails to withhold, then the partnership will be liable for the withholding. This provision applies to sales, exchanges, and dispositions of a partnership interest on or after November 27, 2017, though the withholding requirements apply only to sales, exchanges, and dispositions of a partnership interest after December 31, 2017.
Certain International Provisions
- Impact on the CFC regime: The Act maintained many of the provisions applicable to CFCs and significantly expanded the regime through the addition of a new class of income labeled “Global Intangible Low-Taxed Income” (GILTI). However, the Act made the following noteworthy revisions with regard to the CFC regime: (1) the Act expanded the definition of U.S. shareholder for purposes of the CFC rules to include a U.S. person that owns (directly, indirectly, or through attribution) 10 percent or more of the vote or value of a non-U.S. corporation’s stock (prior to the Act, the test was based solely on vote); (2) the Act modified stock attribution rules for purposes of determining whether a non-U.S. corporation is a CFC such that stock owned by a non-U.S. person may be attributed to a U.S. person; and (3) the Act eliminated the requirement that a non-U.S. corporation must be a CFC for 30 days within a taxable year as a prerequisite to realizing Subpart F income (generally including various types of passive income, including dividends, interest, gains from the sale of stock or securities, gains from certain futures transactions in commodities, and foreign-based company sales and services income).
- Participation exemption: In general, the Act provides a U.S. corporate shareholder of a “specified 10 percent owned foreign corporation” with a 100 percent dividends received deduction for the foreign-source portion of the dividends received from such corporation (with the effect of exempting such dividend from U.S. federal income tax). A one-year holding period generally is required to qualify for the participation exemption. The participation exemption generally does not apply to gains realized on the sale of stock of a non-U.S. corporate subsidiary unless such gains are otherwise treated as a dividend under a separate provision of the Internal Revenue Code.
- GILTI: GILTI is a new type of income that may be taxed to U.S. shareholders of a CFC in a manner similar to the taxation of Subpart F income. GILTI generally includes all net operating income (taking into account allocable interest deductions) of a foreign corporation not otherwise taxed to U.S. shareholders in excess of a 10 percent return on the adjusted cost basis of the tangible assets of the company used in the production of such operating income. Any GILTI realized by a CFC is taxed to the U.S. shareholders of that CFC, whether or not the income is actually distributed to such U.S. shareholders. After accounting for a special deduction on GILTI available for U.S. corporate shareholders (excluding S corporations), the effective U.S. federal income tax rate to U.S. corporate shareholders on GILTI is 10.5 percent for taxable years beginning after December 31, 2017, and before January 1, 2026, and 13.125 percent for taxable years beginning after December 31, 2025. In addition, a U.S. corporate shareholder is eligible for an indirect foreign tax credit of 80 percent of the foreign taxes paid with respect to GILTI. On the other hand, any GILTI of an individual is subject to tax at regular income tax rates (a top rate of 40.8 percent in 2018 under the Act after accounting for the additional 3.8 percent tax that may apply to net investment income). Thus, any U.S. individual shareholder that would have realized (directly or indirectly through a pass-through) “qualified dividend income” (taxed at a maximum U.S. federal income tax rate of 23.8 percent after accounting for the additional 3.8 percent tax that may apply to net investment income) will be significantly worse off under the Act to the extent any CFC with respect to which it is a U.S. shareholder earns GILTI, whereas a U.S. corporate shareholder may fare better than under pre-Act rules since such GILTI will be subject to U.S. federal income tax at a rate substantially less than the previous top U.S. federal income tax rate of 35 percent.
- Foreign-derived intangible income: The Act added the foreign-derived intangible income (FDII) regime, which includes a 13.125 percent tax rate (increased to 16.41 percent in 2026) for a domestic corporation’s FDII. FDII generally is income related to services provided and goods sold by a U.S. corporation to foreign customers. The rules related to FDII apply to taxable years beginning after December 31, 2017.