November 9, 2017 House tax reform bill would significantly affect private equity and alternative asset management industry The House tax reform bill, the Tax Cuts and Jobs Act (the House Bill), released on November 2, 2017, by House Ways and Means Committee Chairman Kevin Brady (R-TX), contains a number of provisions that would impact the private equity (PE) and alternative asset management industry. This Alert summarizes the key provisions of the House Bill that could impact PE and alternative investment funds and their portfolio companies. For a general discussion of the House Bill, see Tax Alert 2017-1831. A "mark-up" of the House Bill commenced on November 6. This Alert includes a discussion of the changes set forth in Chairman Kevin Brady's (R-TX) Amendment to the Chairman's Mark of the "Tax Cuts and Jobs Act," which was adopted on November 6. The Senate Finance Committee also is expected to release its own tax reform bill after the Ways and Means Committee completes its work. The two bills will need to pass in their respective houses and be reconciled before they reach the President's desk. This Alert addresses the House Bill provisions that would affect fund, transaction, portfolio company and fund principal issues. The House Bill provisions remain subject to the issuance of further guidance and deliberations in Congress. In addition, we will need to monitor the responses of state and local jurisdictions, including whether they will conform to the federal income tax law changes, if enacted. I. Fund level issues Passthrough provisions The House Bill would add a new maximum income tax rate of 25% for individuals on certain net income from passthrough entities, which include partnerships and S corporations. The proposal generally would provide a 25% tax rate for an individual who has passthrough taxable income otherwise subject to a rate higher than 25%. The 25% tax rate would apply to qualified business income (QBI), after the exclusion of net capital gain. QBI generally is 100% of "net business income" derived from a "passive business activity" and 30% of any "net business income" derived from an "active business activity." Identifying business activities and determining income or loss. In the case of a passthrough, QBI is determined by first identifying each particular business activity of the passthrough. The House Bill would define a "business activity" as any activity (within the meaning of Section 469) that involves the conduct of a trade or business. After each business activity of a passthrough is identified, an individual owner's income, gain, deduction and loss from the activity are netted, taking into account only items includible or allowable in determining taxable income. The House Bill would exclude certain items from being allocated to the business activity, including: capital gains and losses, dividends and dividend equivalents, interest income unless properly allocable to a trade or business, certain foreign currency and commodity hedging gains and losses, annuities not connected with the trade or business, as well as any deduction or loss on these items, which is of particular importance to many alternative asset managers. Specified service activities. Subject to an exception for capital-intensive activities, active business income from "specified service activities" is generally ineligible for the QBI rate. Activities treated as specified service activities are determined by cross-reference to Section 1202(e)(3)(A), and include law, accounting, consulting, financial services, brokerage services or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. In addition, the House Bill also would treat investing, trading or dealing in securities, partnership interests or commodities as a specified service activity. Determining the capital percentage. Although 100% of net business income derived from a passive business activity would generally be eligible for the new 25% rate, because only a portion of the net business income from an active business activity would be eligible for the new lower rate, a capital percentage would need to be determined for each active business activity. For the specified service activities already described, the capital percentage is zero unless an individual partner can establish an "applicable percentage" (further discussed later) that is at least 10%. In effect, active QBI attributable to a specified service activity can be eligible for the 25% rate only if the individual can establish an applicable percentage of at least 10% for such activity. For all business activities other than those involving specified service activities, the capital percentage is 30% unless an individual taxpayer elects to use the applicable percentage. Implications for alternative asset management A case-by-case analysis will be necessary to determine whether, and the extent to which, an individual's income from an alternative asset management fund, a general partner (GP) or management company entity, or a flow-through portfolio company would be eligible for the new 25% tax rate on QBI: — Private equity funds: In general, many PE funds are treated as investors not engaged in an active trade or business. There is no indication that investment income from a PE fund that is not engaged in a trade or business would be considered business income potentially eligible for the preferential QBI rate. — Other alternative funds: Hedge funds and other alternative funds that actively trade securities are deemed to be engaged in a trade or business. It will need to be determined whether some, or all, of the types of income earned by a trader fund is net business income potentially eligible to be taxed as QBI. Further, it will need to be determined whether the activities of a trader fund are considered a specified service activity. In addition, assuming net business income derived from a trader fund is eligible to be taxed as QBI, the proper allocation of fund-level expenses against income will need to be examined. — General partner (GP) entities: Although the House Bill does not include tiering rules, income of a partnership allocated to a GP entity structured as a passthrough could retain its underlying character as business income potentially eligible for the 25% rate. — Management companies: Management companies may generate active business income from a "specified service activity," generally ineligible for the 25% rate on QBI. However, we will need to monitor how the legislation defines "financial services," which could impact eligibility for the 25% preferential rate. In addition, certain management companies might make capital investments that would permit its owners to establish a capital percentage of 10% or more. — Operating passthrough portfolio companies: In general, it is expected that income from a flow-through portfolio operating company would be eligible for the 25% preferential QBI rate. It is unclear whether active trade or business income that flows unblocked through tiered partnerships would retain its eligibility for the preferential rate. There is no guidance as to how a 30% (or greater) "capital percentage" is to be determined in the case of tiered partnerships. Other partnership tax changes Repeal of partnership technical terminations. Under current law, a sale or exchange of 50% or more of interests in partnership capital and profits within a 12-month period causes a "technical termination" of the partnership. The House Bill would repeal Section 708(b)(1)(B) for partnership tax years beginning after December 31, 2017. Repeal of exclusion from self-employment tax for limited partners. Section 1402(a), which defines "net earnings from self-employment," is modified to conform to the new passthrough rate regime and the determination of QBI. Sections 1402(a)(1) and (13) would be repealed such that individuals would have net earnings from self-employment as a result of rental income and any partner would have net earnings from self-employment regardless of the individual's status as a limited partner. This provision could affect management company structures and the taxation of fund principals. In particular, the net earnings of investment professionals who are partners in a management company structured as a state law limited partnership could become subject to self-employment tax, regardless of the individual's status as a limited partner. Amended and expanded Section 163(j). For partnerships, the computation of the new limitation on the deduction for business net interest expense (described below) is made at the partnership level. Where the interest limitation also applies to a partner, the partner's interest limitation is increased by the partner's share of any "excess amount" of the partnership. Investment income The tax rates for long-term capital gains and qualified dividend income would remain at 15% for married couples making over $77,200, and 20% for married couples making over $479,000 (indexed for inflation). Investment income would be excluded from the determination of a business owner's "capital percentage," discussed above. Carried interest Under an amendment to the House Bill adopted on November 6, capital gains allocated in accordance with carried interests held in connection with the performance of services would be eligible for long-term capital gain treatment (i.e., 20% tax rate) only if the underlying capital asset (e.g., stock, debt security, investment real estate, partnership interest, etc.) is held for at least three years. If the three-year holding period is not satisfied, any allocated gain would be treated as short-term capital gain, taxable at a partner's marginal income tax rate (e.g., as high as 39.6% federal). The amendment would not otherwise change the nature or character of the income. This carried interest provision would not differentiate between types of alternative asset management funds or investment strategies, per se. However, the holding period of many private equity, venture capital and real estate investments may exceed three years. It bears watching whether changing the taxation of carried interest is also included as a revenue raiser in the Senate bill. Taxation of financial products The House Bill does not discuss any changes to the taxation of derivatives or financial products. Tax-exempt investors As amended on November 6, the House Bill would impose a new 1.4% excise tax on the net investment income of certain private colleges and universities with 500 or more students if the fair market value of the institution's assets (other than those assets used directly in carrying out its exempt purpose) is at least $250,000 per student, up from $100,000 in the previous version of the House Bill. In addition, under the House Bill, certain entities that are tax-exempt under Section 501(a), such as state and local entities and pension plans, would be subject to unrelated business income tax on unrelated business taxable income, regardless of whether they are also exempt from tax under another Code Section. These investors might need to reassess the use of blockers. For additional discussion, see Tax Alert 2017-1844. Other tax issues, including real estate The House Bill would not change the provisions of the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) or the US federal income tax treatment of master limited partnerships (MLPs) or publicly trade partnerships (PTPs). The 25% passthrough tax rate would apply to certain dividends from a real estate investment trust (REIT). The House Bill would modify Section 1031 so that deferral of gain for like-kind exchanges would be restricted to real property transfers. See Tax Alert 2017-1843. II. Transaction and portfolio company issues Changes to the corporate tax rate and tax shield resulting from the trade-off of immediate capital expensing versus partially limited interest deductions for businesses will be top of mind for deal professionals as they model tax for prospective transactions and potential impact on existing portfolio companies. In general, the proposed reduction in the corporate tax rate should improve free cash flow and reduce cash tax for PE portfolio companies structured as C corporations, although the proposed changes to the Section 163(j) thin capitalization rules could reduce interest expense in leveraged deals. Corporate tax rate reduction The House Bill would permanently reduce the top corporate federal income tax rate from 35% to 20% for tax years beginning after 2017. Personal service corporations would be subject to a 25% tax rate. The House Bill would repeal the corporate AMT. Taxpayers with AMT credit carryforwards generally would be permitted to claim a refund of 50% of any remaining credits (to the extent the credits exceed regular tax for the year) in the 2019, 2020 and 2021 tax years, and could claim any remaining credits in the 2022 tax year. Modification to net operating loss deduction The House Bill would allow indefinite carry forward of NOLs arising in tax years beginning after December 31, 2017. The House Bill also would repeal all carrybacks for losses generated in tax years beginning after December 31, 2017, which would preclude the ability to obtain tax refunds by amending a corporate tax return. Although the AMT would be eliminated, the House Bill would limit the amount of all NOLs that a taxpayer could use to offset taxable income to 90% of the taxpayer's taxable income (computed without taking into account the NOL deduction) for tax years beginning after December 31, 2017. In addition, the House Bill would permit NOLs arising in tax years beginning after 2017 and carried forward to be increased by an interest factor to preserve the NOL value. Corporate tax credits The credit for certain qualified research and development (R&D) expenses and the low-income housing tax credit (LIHTC) would be retained, but many other business deductions and credits, including the Section 199 domestic production activities deduction and certain energy-related incentives, would be eliminated. Also, no deduction would be permitted for entertainment, amusement or recreation expenses. This would be a significant departure from current law, which allows a 50% deduction for qualified client entertainment and recreation. For additional detail, see Tax Alert 2017-1843. Immediate capital expensing for qualified property The House Bill would allow taxpayers to immediately expense 100% of the cost of qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023 (January 1, 2024, for certain qualified property with a longer production period, as well as certain aircraft). The House Bill also would expand the property eligible for immediate expensing by repealing the requirement that the original use of the property begin with the taxpayer; instead, property would generally be eligible for immediate expensing if it were the taxpayer's first use of that property. Qualified property would not include property used by a regulated public utility company or any property used in a real property trade or business (as defined in Section 469(c)(7)(C)). It appears that qualified depreciable assets placed in service on or before September 27, 2017, would be recovered under their current cost recovery method. The House Bill would allow taxpayers to elect to apply Section 168 of the Code, without regard to the amendments made by the provision (i.e., the current law), to a taxpayer's first tax year ending after September 27, 2017. The immediate capital expensing provisions make no reference to amortizable Section 197 intangibles, i.e., goodwill and certain other intangibles. Accordingly, the capitalized costs of Section 197 intangibles should continue to be amortized over 15 years. We will continue to monitor whether the proposed legislation is amended, including to allow expensing of any intangible assets or to include any anti-churning rules. Net interest expense deduction Effective for tax years beginning after December 31, 2017, the House Bill would limit the net interest expense deduction for every business, regardless of form, to 30% of adjusted taxable income. The House Bill would require the interest expense disallowance to be determined at the tax filer level. Adjustable taxable income for purposes of this provision would be a business's taxable income calculated without taking into account business interest expense, business interest income and NOLs, as well as depreciation, amortization and depletion (essentially mimicking the "earnings before interest, taxes, depreciation and amortization" (EBITDA) accounting term). The House Bill would allow businesses to carry forward interest amounts disallowed under the provision to the succeeding five tax years and those interest amounts would be attributable to the business. The House Bill would include special rules to allow a passthrough entity's owners to use the unused interest limitation for the tax year and to ensure that net income from passthrough entities would not be double-counted at the partner level. The House Bill would exempt businesses with average gross receipts of $25 million or less from these rules. The provision also would not apply to certain regulated public utilities and real property trades or businesses; these businesses would be ineligible for full expensing. Additionally, the House Bill would repeal Section 163(j). For discussion of the additional limitation on deductibility of net interest expense in addition to this general limitation, see Tax Alert 2017-1845. International provisions The House Bill proposes sweeping changes that could impact both US domiciled funds and portfolio companies with cross-border operations. Territorial tax system - The House Bill would replace the current United States worldwide tax system with a territorial tax system with a participation exemption regime. Subject to certain requirements, the foreign-source portion of dividends received by a US corporation from a 10% or greater-owned foreign corporation would be exempt from tax. Toll charge on unrepatriated earnings — The House Bill includes a one-time transition tax whereby certain previously untaxed accumulated foreign earnings currently held by foreign corporate subsidiaries of US multinational corporations would be deemed repatriated under a special classification of Subpart F income and subject to tax at lower tax rates (12% for the portion of earnings held in cash and cash equivalents and 5% for illiquid assets). Under the House Bill, for calendar year-end corporations, this one-time Subpart F income pick-up would occur on December 31, 2017 (but measured by the accumulated foreign earnings as of November 2, 2017, or December 31, 2017, whichever amount is greater). Under the provision, the US shareholder could elect to pay the transition tax ratably over eight years or less. A US shareholder's mandatory inclusion would be determined taking into account any post-1986 accumulated deficits of a foreign corporation, thus effectively requiring inclusion of the net positive amount of deferred foreign earnings. Excise tax on certain payments from domestic corporations — As part of a new, sweeping anti-base erosion measure, the House Bill would impose a gross basis excise tax (at the highest tax rate in Section 11, proposed to be 20%) on specified amounts (other than interest) paid by a US corporation to a related foreign corporation, unless the related foreign corporation elects to treat those payments as effectively connected income and thus subject to net US taxation. The excise tax would not be deductible for US federal income tax purposes. This proposal could impact the tax effectiveness of cross-border supply chain structures. Anti-base erosion (outbound, i.e., US parent) — Fifty percent of the "foreign high return amounts" of a CFC would be subject to current US taxation by effectively treating returns that are deemed "high" as Subpart F income. Many of the current Subpart F rules would be retained. Under a new income inclusion rule, a US person that is US shareholder of a CFC would have to include 50% of "foreign high return amounts" as a Subpart F inclusion, subject to a credit for 80% of the taxes paid on that income. The amount deemed a high return would be based on a comparison of the CFC's income to a deemed, net return on its tangible assets. The deemed net return would be the short-term AFR plus 7%, less interest expense associated with the US shareholder's net CFC-tested income. Certain income would be excluded from this test, such as income that qualifies for the active financing exception applicable to banks and certain broker dealers. This proposal will be particularly significant for US taxpayers with considerable offshore intangible property. Worldwide interest limitation. For domestic corporations that are part of a worldwide group, a new worldwide group ratio rule would limit the deduction for net interest expense based on a comparison of domestic EBITDA to worldwide EBITDA. If the 30% EBITDA interest limitation also applies, the one that results in a greater disallowance of interest deductions would take precedence. Insurance exception for PFICs — The PFIC exception for insurance companies under Section 1297(b)(2)(B) would be amended. This would affect certain hedge funds using reinsurance structures. For insurance and reinsurance portfolio companies, the rules in the House Bill are more liberal than earlier proposals. Certain self-created property not treated as a capital asset Section 1221 treats a self-created patent, invention, model or design, or secret formula or process as a capital asset. The House Bill would no longer treat those self-created assets as a capital asset, effective for dispositions occurring after December 31, 2017. As such, gain or loss from the disposition of the property would be ordinary in character. Those items of property also would be excluded from the definition of property used in the trade or business under Section 1231. III. PE and alternative fund principals and deal professionals The House Bill may have some adverse impact on investment management principals, as the tax cuts are focused on middle class tax relief. Individual tax issues Individual income tax rates: The House Bill would compress the current seven brackets to four brackets — 12%, 25%, 35% and 39.6% — with a full repeal of the individual AMT. For married couples, the 35% tax rate would start at $260,000 and the 39.6% tax rate would start at $1 million (for married filing jointly filers). There also would be certain bracket phase-outs for high income individuals that could further increase cash tax, including a so-called "bubble tax" that would increase the tax rate on some individuals making over $1 million to over 39.6%. Further, the House Bill would expand the zero-tax bracket by doubling the standard deduction to $12,000 for individuals and $24,000 for married couples. For additional discussion, see Tax Alert 2017-1840. Deductions: The House Bill might disproportionally impact individuals living in expensive metropolitan areas, including in the Northeast United States, California and Illinois. The House Bill would completely repeal the deduction for state and local income and sales taxes. It would allow a deduction for property taxes, but capped at $10,000. The mortgage interest deduction would be maintained for existing mortgages. But for new home mortgage loans after November 2, 2017, the mortgage interest deduction would be limited to loans of up to $500,000. The itemized deduction for charitable contributions would be retained, with an increased deduction limit for cash contributed to public charities and certain private foundations (limit is increased from 50% to 60% of donor's AGI). Under the House Bill, 401(k) and Individual Retirement Accounts would be retained, and pretax contribution limits to 401(k)s would not be decreased. For additional discussion, see Tax Alert 2017-1840. Estate and gift tax: The House Bill would immediately double the estate tax exemption and completely repeal the estate tax and generation-skipping transfer tax in six years, on January 1, 2024. Also, the House Bill would lower the gift tax rate to a top rate of 35%. For additional discussion, see Tax Alert 2017-1840. Limitations on nonqualified deferred compensation: The House Bill would eliminate Section 409A and add Section 409B. For additional discussion, see Tax Alert 2017-1841. IV. Other issues and next steps Permanent provisions: The House Bill seeks to make certain tax changes permanent, including the 20% tax on corporate earnings. Other incentives, such as capital expensing for business investments, would lapse after five years. In general, the House Bill contains few phase-ins/phase-outs or transition rules, with limited exceptions, such as the transition rule for like-kind exchanges. Revenue neutrality: The Budget blueprint allows for $1.5 trillion in tax cuts over 10 years. To meet this target, certain provisions were changed during negotiations to add revenue, including taxing accumulated foreign earnings held in cash or cash equivalents at a rate of 12%, as well as the sweeping new anti-base erosion measures. Unlike the House, the Senate must adhere to the Byrd rule, which requires that no new title of the legislation can increase the budget deficit after the 10-year budget window. Timeline: The mark-up of the House Bill began on November 6. Ultimately the full House will vote on the House Bill, which could happen the week of November 12. Separately, Senate Finance Committee Chairman Orrin Hatch (R-UT) announced that he plans to release a Senate Republican version of a tax reform bill after the Ways and Means Committee completes its work. The Senate Finance Committee mark-up and Senate floor process could take some time, and ultimately a House and Senate conference committee likely would be necessary to reconcile the House and Senate bills, before President Trump could sign any bill passed by Congress into law. ———————————————
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