Chris Hayes, Director of Industry Affairs at Institutional Limited Partners Association, co-authored this alert.
The week of December 11, 2017, brought two shots of holiday cheer: Congress decided not to subject public retirement plans to unrelated business income tax (“UBIT”) from their commingled fund investments, and the IRS proposed regulations benefitting public retirement plans in the event of a fund audit.
Strong Advocacy by Public Pension Leaders & Their Advocates in Washington = No UBIT
We reported in November that the tax reform bill introduced by the House Ways and Means Committee on November 2 would have subjected public pension plans to UBIT on their commingled fund investments starting in 2018, without any transition relief for plans that had entered into commingled funds or made other investments before 2018. Although the House passed that provision intact on November 16 as a result of the $1.1 billion in revenue it was projected to bring in, the version of the bill introduced by the Senate Finance Committee on November 14 and passed by the Senate on December 2 did not contain the UBIT provision. The final bill, as agreed between House and Senate conferees and released on December 15, follows the Senate version, as a result of a significant “full court press” advocacy effort by US public pensions and their advocates in Washington. On December 19, the final bill passed the House of Representatives and advanced to the Senate. Final passage into law is expected during the week of December 19, 2017.
Public retirement plans (and most other organizations for that matter), have their own defenders in Washington, ensuring that these plans and their beneficiaries have a constant voice in proposed legislation and regulation. There are five primary groups representing the public retirement plan community in Washington: the National Conference of Public Employee Retirement Systems (NCPERS) representing the systems, National Association of State Retirement Administrators (NASRA) representing Executive Directors of the systems, the National Council on Teacher Retirement (NCTR) representing teacher systems, the Council of Institutional Investors (CII) focused on corporate governance, and the Institutional Limited Partners Association (ILPA) representing limited partners in private equity. The first three primarily are focused on retaining state control of public retirement plans, while the latter two are focused on improving the playing field for the public plans as investors – thereby protecting returns for beneficiaries.
Beginning this spring, all five of these groups began coordinating through a newly formed Pension Investment Council (PIC), to share information and work together on common issues. Tax reform, and the UBIT provision provided the first test of that cooperation, resulting in a victory of public retirement systems and their beneficiaries. Beginning in early November, the PIC started to organize and conduct outreach – the strength of public retirement systems comes from their grassroots connections and role as a trustee to beneficiaries, rather than campaign contributions. All five trade groups and others began by sending letters highlighting the immense impact these changes would have on returns, primarily from alternative investments like private equity. ILPA played an important role, given its focus on alternative investments, which were the pension investments most impacted by the new tax.
The groups mobilized their members, and tapped their investment partners, which helped gain access to the Republican leadership in the House and Senate. Leading the charge were the leaders of certain influential public plans, including those with constituent connections to Speaker Paul Ryan (R-WI) and Finance Committee Chairman Orrin Hatch (R-UT). This culminated in a series of in-person meetings with House and Senate leadership and these members, as well as a variety of other trade associations including the Fraternal Order of Police and the National Association of State Treasurers at the end of November. Ultimately, last week we learned that despite a final attempt to include the UBIT provision as a revenue raiser in the legislation by the House Ways and Means staff, the Speaker’s staff determined that it should not be included in the final conference bill.
Does this mean that public retirement plans can breathe easy? Not necessarily. Our last e-alert noted that the UBIT exemption for public retirement plans is a justified position that public retirement plans have taken with the IRS’ and Congress acquiescence but not official sanction, and that this most recent tax legislation was not the first time that Congress proposed to eliminate this exemption. Tax proposals like this have a nasty habit of coming back even after they appear to have died one or more deaths. This provision had previously appeared in a proposal in 2014 from former House Ways and Means Chairman Dave Camp (R-MI). Public retirement plans should remember that the law can always change as they structure their other investments, and in their commingled funds pay attention to the future availability of “blockers” – i.e., intermediate holding entities that shield tax-exempt investors from UBIT -- should the UBIT threat ever come back.
But Funds Can Push It
The benefit to public retirement plans from the IRS proposed audit regulations is more esoteric, but there nonetheless.
Up to now public retirement plans didn’t really care if their commingled funds got audited because through the end of this year those audits were governed by the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). Under TEFRA those persons that were partners in the year being audited are responsible for paying back taxes (and any penalties and interest) based on amended K-1 Schedules distributed by the partnership reflecting the audit results. An IRS audit of a commingled fund after 2017, however, will be governed by the Bipartisan Budget Act of 2015 (the “BBA”) under which the partnership pays the back taxes, penalties, and interest (an “imputed underpayment”) unless the partnership duly elects (a “push-out” election) to distribute amended K-1 Schedules to those persons that were partners in the year being audited, in which case those persons are responsible for paying the audit amounts (in a manner similar to TEFRA).
Public retirement plan investors always prefer a push-out election (especially now that their UBIT exemption has stayed safe) because if their fund makes an imputed underpayment then there is no guarantee that the fund will try to or can recover those amounts from the persons to whom those amounts are attributable – i.e., taxable investors in the year under audit. The problem is that the IRS may well audit, not the commingled fund itself, but another partnership or LLC in which that fund invests. If the lower-tier entity is audited and makes a push-out election, can the upper-tier fund similarly elect to push out that liability to its own investors? The BBA was not clear and the first round of IRS proposed regulations from this summer punted this issue. Last week, however, the IRS issued a second round of proposed regulations that allow the upper-tier entity to make such a push-out election. These regulations do not ensure that a commingled fund can make a push-out election as a practical matter – the lower-tier entity must itself make such an election, and the commingled fund does not usually control that decision – but the proposed regulations certainly are a step in the right direction.
Fund managers tend not to like push-out elections -- they are expensive and difficult to administer, and generally expose the partners to higher interest and tax rates than would have otherwise been the case had the fund made an imputed underpayment -- and resist committing to them in fund documents or side letters. Up to now they had added justification because the BBA was unclear as to whether a commingled fund could push out a lower-tier entity’s adverse audit results. With the newest IRS proposed regulations that excuse is gone, and public retirement plans can and should be bolder in scrutinizing fund documents and asking in side letters that fund management make a push-out election whenever available.