November 16, 2017 Senate Finance Committee Chairman's Mark of the "Tax Cuts and Jobs Act": Key provisions for private equity and alternative asset management industry On November 9, major tax reform proposals were released in both houses of Congress. First, the House Ways and Means Committee approved a revised version of the "Tax Cuts and Jobs Act" (the House Bill), which includes certain amendments made since its original release on November 2. In addition, late on November 9, Senate Finance Committee Chairman Orrin Hatch (R-UT) released his Chairman's Mark of the "Tax Cuts and Jobs Act" (the Senate Explanation, and together with the House Bill, the Proposals). The Senate Explanation adheres to the same basic tax overhaul framework as the House Bill, but includes significant differences in the design of provisions and their effective dates. Concerning business taxes, the Senate Explanation varies from the House Bill on pass-through taxation and interest deductibility. Chairman Hatch's plan would provide a general 17.4% deduction for pass-through income, with a more limited deduction for taxpayers with income related to services. Deductibility of net interest expense would, like the House Bill, be subject to a 30% limitation, but at a different measure of adjusted taxable income that excludes depreciation and raises significantly more revenue than the House approach. There is also a worldwide interest limitation for domestic corporations that could have broader applicability. Below we have highlighted the key aspects of the Senate Explanation, including significant divergences from the House Bill, with a focus on the provisions that could impact the private equity (PE) and alternative asset management industry. We have summarized the issues impacting funds, transactions, portfolio companies, and fund principals/investment professionals. We will continue to monitor the further deliberations of the Proposals in Congress, as well as the responses of state and local jurisdictions, including whether they will conform to some or all of any enacted federal income tax law changes. Fund-level issues 1. Investment income Similar to the House Bill, the Senate Explanation would continue to tax net long-term capital gains and qualified dividend income at current rates (i.e., top rate of 20%) and would continue to subject them to the 3.8% net investment income tax. 2. Pass-through income: special 17.4% deduction Unlike the House Bill's special rate of 25% for certain qualified business income (QBI) of a pass-through, the Senate Explanation would provide individual owners with a 17.4% deduction on certain pass-through income. For a taxpayer who has QBI from a partnership or S corporation, the amount of the deduction would be limited to 50% of the Form W-2 wages of the taxpayer that are properly allocable to QBI. Special limitations would apply to "specified service businesses" based on the income of their owners. A "specified service trade or business" appears to include the same activities described in the House Bill, including carve-outs for financial services, brokerage services, and any business whose principal asset is the reputation or skill of one or more of its employees or owners. Investing, trading, or dealing in securities and commodities, however, was not specifically identified as a specified service activity. We will continue to monitor the legislative language and related guidance addressing potential industry carve-outs. The Senate pass-through provisions could apply as follows: — Private equity funds. Investment income from a PE fund that is treated as an investor, which is not engaged in a trade or business, generally should not be eligible for the 17.4% deduction. — Hedge funds and other alternative funds. While both the House Bill and the Senate Explanation carve out investment income, it is possible that limited types of income earned by a trader fund could be net business income potentially eligible to be taxed as QBI. Each proposal, however, has additional limitations on the ability to claim the special pass-through rate. The Senate Explanation provides that the 17.4% deduction would be available only in the hands of an individual with W-2 wages that are properly allocable to QBI. In such a situation, we would need to determine whether the activities of a trader fund are considered a "specified service business." Also, we would need consider the proper allocation of fund-level expenses. — Tiered fund structures. Neither the House Bill nor the Senate Explanation includes any specific tiering rules or guidance on how unblocked income flows up through a fund structure, but presumably qualifying income should retain its character. i. GP entities. Income of a partnership allocated to a GP entity should retain its underlying character that flows up from a fund. ii. Fund of funds. Depending on the character of income allocated from underlying portfolio funds, upper-tier fund of funds should have consistent treatment. iii. Pass-through portfolio companies. Like the House Bill, operating pass-through income should be eligible for QBI. If eligible for QBI at the operating partnership level, it is unclear how such income would flow through one or more pass-throughs, but presumably the income should retain its eligibility as it tiers up through a fund structure. — Management companies. Management activities may be a "specified service business." We will need to monitor how the Senate legislation defines this term, which is currently defined broadly (e.g., to exclude "consulting," "financial services" and a business whose principal asset is the reputation or skill of one or more of its employees or owners, etc.), meaning management companies could be carved out as ineligible services businesses. Unlike the House Bill, it does not seem that individual owners of a management company could, by virtue of capital investments in airplanes, information technology, etc., be able to establish eligibility for the 17.4% deduction. 3. Carried interest Unlike the House Bill, which would introduce a three-year minimum asset holding period for service providers to qualify for long-term capital gain treatment, the Senate Explanation does not include a carried interest provision. It is widely expected, however, that carried interest will be addressed during the Senate mark-up process. We will continue to monitor the legislative negotiations, and whether final legislation adopts the three-year holding period used in the House Bill or makes any other fundamental changes to the tax character of carried interest. It remains to be seen whether the potential inclusion of, or change to, the tax treatment of carried interest is more of a revenue raiser or a political issue. 4. Self-employment tax for limited partners Under both the House Bill (as amended) and the Senate Explanation, the net earnings of investment professionals who are limited partners in a management company structured as a state law limited partnership could continue to be exempt from self-employment tax, under the plain language of the existing statute (i.e., Section 1402(a)(13)). We will monitor the potential inclusion of this provision in the legislation and related impact on management company structures and fund principals. 5. Sales of partnership interests by foreign partners The Senate Explanation indicates that it would codify Revenue Ruling 91-32, which would effectively reverse the Grecian Magnesite decision (see Tax Alert 2017-1156). Gain on disposition of a partnership by a foreign partner would be treated as effectively connected income and subject to taxation in the US. In addition, the Senate Explanation would impose a withholding tax obligation on the purchaser of a partnership interest unless the transferor certifies it is not a foreign person (similar to the operation of the Foreign Investment in Real Property Act of 1980 (FIRPTA) rules applicable to sales of US real estate by foreign owners). This proposal would have potential implications for flow-through investments at the portfolio company, fund and limited partner (LP) level (including for fund of fund investors) and for certain management company sale transactions. The proposal would apply prospectively to transfers occurring after 2017. In addition, given the present uncertainty surrounding these issues, it bears watching whether this proposal has any impact on the IRS's decision to appeal or acquiesce to the Grecian Magnesite decision, or on the ability for taxpayers to obtain refund claims for open tax years before 2017. 6. Partnership terminations The Senate Explanation does not address the partnership technical termination rule (i.e., for the sale or exchange of 50% or more of the interests in a partnership within a 12-month period), which the House Bill would repeal beginning in 2018. 7. Tax-exempt investors The House Bill would subject super tax-exempt investors (including state and local entities and pension plans) to unrelated business income tax. In addition, both Proposals would impose a new 1.4% excise tax on the net investment income of certain private colleges and universities. We will continue to monitor the deliberations around legislative provisions that would affect tax-exempt investors. 8. Financial products The Senate Explanation would require the cost of any specified security disposed of on or after January 1, 2018, to be determined on a first-in first-out (FIFO) basis, except when an average cost basis method is otherwise permitted under Treasury regulations (e.g., as for the stock of a regulated investment company). 9. Recognition of income A provision in the Senate Explanation would revise the rules associated with income recognition, requiring a taxpayer to recognize income no later than the tax year in which such income is taken into account as income on an applicable financial statement. We will need to monitor whether this provision survives, and if so, whether there is any impact on certain fee and incentive allocation arrangements. 10. Other tax issues, including real estate Like the House Bill, there are no proposed changes in the Senate Explanation to FIRPTA or to the US federal income tax treatment of master limited partnerships or publicly traded partnerships. Transaction and portfolio company issues For a portfolio company structured as a C corporation, the reduced corporate tax rate and tax shield resulting from immediate capital expensing should increase free cash flow. When compared to current law, these Proposals should mitigate the effects of any potential limitation to interest deductibility and result in cash tax savings. The interplay of these issues will be top of mind for deal professionals as they model tax for prospective transactions and potential impact on existing portfolio companies. If a corporation faces a significant interest limitation in 2018, but the lower corporate tax rate is delayed until 2019, this could have a material cash tax impact in the initial transition year. 1. Reduction in corporate income tax Like the House Bill, the Senate Explanation proposes a 20% corporate rate. Unlike the House Bill, the Senate Explanation would delay this rate reduction by one year. The new lower rate would be effective for tax years beginning after December 31, 2018 (i.e., 2019 for calendar-year taxpayers). Unlike the House Bill, the Senate Explanation does not appear to provide a different (higher) tax rate for personal services corporations. 2. Interest limitation Under the Senate Explanation, business net interest deductions would be limited to 30% of "adjusted taxable income" (ATI). Depreciation, amortization and depletion would NOT be added back in calculating ATI, so the limit is likely to be significantly lower than the House Bill, which could have a negative cash tax impact on leveraged deals. Disallowed amounts could be carried forward indefinitely (unlike the House Bill, which has a five-year carryforward). An exception from the limitation would be provided for small businesses that meet a $15 million gross receipts test ($25 million under the House Bill). 3. Immediate capital expensing for qualified property Both Proposals would provide for full expensing for qualified property placed in service after September 27, 2017, and before January 1, 2023. In a potentially meaningful departure from the House Bill, the Senate Explanation does not appear to explicitly permit immediate expensing for "first use" property. This is important for transactions structured as asset deals or deemed asset deals, where capital property is acquired from a third party. Neither proposal would permit immediate expensing of amortizable intangible assets, including goodwill and other Section 197 assets. It appears that pre-existing depreciable assets would be recovered under their current cost recovery method. 4. Net operating losses (NOLs) Under the Senate Explanation, for losses arising in tax years beginning after 2017, the NOL deduction would be limited to 90% of taxable income, and the NOL carryback provisions would be repealed. Among other things, these changes could impact certain PE portfolio company exits. An indefinite carryforward would be allowed, but the Senate Explanation does not address whether NOL carryforwards would increase by an interest factor as proposed in the House Bill. 5. Dividends received deduction (DRD) The deduction for dividends received from a domestic corporation would decrease from 70% to 50% (and from 80% to 65%, for 20%-or-greater-owned domestic corporations). This change is intended to conform the DRD in light of the proposed corporate tax rate reduction to 20%. 6. International tax The Senate Explanation includes major proposals for the international system, including: (1) implementing a territorial tax system; (2) imposing a transition tax on accumulated foreign earnings; and (3) imposing anti-base erosion rules. — 100% exemption for foreign-source dividends. Both Proposals would provide a 100% exemption for foreign-source dividends received by a US corporation from a 10%-or-greater-owned foreign corporation. The Senate Explanation would require a one-year holding period in the stock of the foreign corporation, whereas the House Bill would require only a six-month holding period. — Deemed repatriation tax. The Senate Explanation would change the transition tax to 10% for cash assets and 5% for non-cash assets (the House Bill proposes 14% and 7%), which could impact the potential Subpart F inclusion amounts for US domiciled funds and US multinational portfolio companies. — Worldwide interest limitation. The interest limitations for members of an International Financial Reporting Group under the Senate Explanation would have broad application, as it would apply to 50% or greater affiliates. As drafted, this provision could have a detrimental effect on certain multinational portfolio companies, as well as certain foreign limited partners, especially in highly leveraged investments. — Base erosion minimum tax. The Senate Explanation proposes a new base erosion minimum tax, which would be calculated by reference to all deductible payments made to a foreign affiliate for the year. In general, the minimum tax would apply to US corporations that have average annual gross receipts of at least $500 million and have made related-party deductible payments totaling 4% or more of the corporation's total deductions for the year. — Other anti-base erosion rules. Unlike the House proposal to impose a 20% excise tax on certain deductible foreign payments, the Senate Explanation would create an incentive for US companies to sell goods and provide services abroad, by effectively taxing income from such activities at only a 12.5% rate. At the same time, a tax would be imposed on a US shareholder's aggregate net controlled foreign corporation (CFC) income at a rate that, presumably, would be similar to the rate on the incentives for US companies (i.e., less than or equal to 12.5%). — Intangible property repatriation. Under the Senate Explanation, US companies would generally be allowed to repatriate their intangible property tax-free. There was no such provision in the House Bill. — Controlled foreign corporations.The Senate Explanation's expanded downstream attribution rules and expanded definition of "US shareholder" (with ownership measured by vote OR by value) could result in more CFCs. As a result, in addition to affecting fund reporting, certain portfolio companies could become subject to new anti-base erosion measures, including a minimum tax on low-taxed intangible income and anti-hybrid payment rules. 7. Executive compensation limits (Section 162(m)) The Senate Explanation would expand the $1 million deduction limit that applies to compensation paid to top executives of publicly traded companies. Once an individual is named as a covered employee, the $1 million deduction limitation would apply to compensation (including performance-based compensation) paid to that individual at any point in the future. These changes could impact portfolio company management teams. 8. Business credits Although it is unclear whether the final House legislation will preserve the research tax credit, the Senate Explanation explicitly does so. In addition, unlike the House Bill, the Senate Explanation would not require certain research and experimental costs incurred after 2023 to be capitalized and amortized over five years. The Senate Explanation also defers the repeal of the Section 199 domestic production activities deduction for one year (repealed for tax years after 2018). Further, beginning in 2018, the Senate plan would eliminate a deduction for unused business credits. PE and alternative fund principals and deal professionals Both the House and Senate Proposals could have some adverse effect on PE and alternative asset management principals, as the tax cuts are focused on middle-class tax relief. Both Proposals would almost certainly disproportionally affect individuals living in expensive metropolitan areas, including in the Northeast Corridor, California and Illinois. 1. Individual income tax The Senate Explanation preserves seven tax brackets, with a top rate of 38.5% (for income starting at $1 million for married filing jointly filers) and no "bubble tax" for wealthier individuals. 2. State and local taxes Unlike the House Bill, which would preserve a limited property tax deduction, the Senate Explanation would completely repeal the individual itemized deduction for state and local income, sales and property taxes. The state and local tax deduction is a hot button issue and could be a point of contention between the House and the Senate. It may be an important issue in terms of garnering support in the House, especially for "Blue state" Republicans. We will need to monitor whether some form of this deduction survives. 3. Mortgage interest deduction The Senate Explanation retains the mortgage interest deduction at current levels ($1 million cap) but would repeal the deduction for home equity debt interest. 4. Estate tax Unlike the House Bill, which would eliminate the estate tax, the Senate Explanation merely doubles the estate and gift tax exemption amount, from $5 million to $10 million, indexed for inflation occurring after 2011. 5. Nonqualified deferred compensation The provision eliminating Section 409A was removed from the House Bill in a last-minute amendment. Similar to the House Bill presented on November 2, however, the Senate Explanation would create a new Section 409B that would trigger recognition of tax on certain vesting dates. Potential timeline and path to enactment On November 16, the House passed its version of the "Tax Cuts and Jobs Act" (H.R. 1) by a 227-205 vote. A markup in the Senate Finance Committee of Chairman Orrin Hatch's (R-UT) tax reform bill is continuing and should conclude by the end of the week. (For discussion of the Senate markup, see Tax Alerts 2017-1916 and 2017-1938) A vote on the Senate floor could come in the days after the Thanksgiving recess. The House and Senate would then need to agree on a compromise before final passage. ———————————————
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