December 22, 2017
US tax reform enacted — Key provisions for private equity and alternative asset management industry
On December 22, 2017, the President signed into law the "Tax Cuts and Jobs Act" (H.R. 1, the Act) following passage in the House and Senate earlier in the week. This Alert highlights the key aspects of the Act with a focus on the provisions that could impact the private equity (PE) and alternative asset management industry. The Alert summarizes the issues affecting funds, transactions, portfolio companies, and fund principals/investment professionals.
The House and Senate conferees for H.R 1 were able to reconcile the earlier House and Senate bills and reach agreement on the legislative language in the Act less than a month after the House of Representatives passed its version of the Tax Cuts and Jobs Act on November 16 (the House Bill), and less than two weeks after the Senate passed its tax reform bill on December 2 (the Senate Bill). A Joint Explanatory Statement of the Conference Committee was issued along with the Conference Agreement. For a detailed discussion of the House and Senate Bill provisions relevant for the PE and alternative asset management industry, see Tax Alerts 2017-1891 and 2017-1945, respectively.
For a general discussion of the provisions included in the Act, see Tax Alert 2017-2130.
The Act largely adheres to the framework of the Senate Bill, but also reflects significant compromises between the House and the Senate. With respect to business taxes, the Act generally adopts the Senate approach to pass-through, corporate and individual income taxation, with the following rates:
— 20% deduction for qualified pass-through business income
The Act also limits the deduction for business net interest expense by amending Section 163(j). The revised limitation is on net interest expense that exceeds 30% of adjusted taxable income (ATI). For the first four years, ATI is computed without regard to depreciation, amortization or depletion. Beginning in 2022, ATI is decreased by those items, which could further limit interest deductibility. In addition, unlike the House and the Senate Bills, the Act drops the additional interest expense limitation that would have been imposed through a worldwide debt cap under what would have been Section 163(n).
1. Investment income
The Act retains preferential tax rates for investment income. Net long-term capital gains and qualified dividend income continue to be taxed at current rates (i.e., a top rate of 20%) and continue to be subject to the 3.8% net investment income tax.
2. Pass-through income: special 20% deduction
The Act largely adopts the Senate approach but provides individual owners — as well as trusts and estates — with a 20% (rather than 23%) deduction on domestic qualified pass-through income. A special rule allows the deduction for otherwise ineligible service-related pass-through income for taxpayers with taxable income below certain thresholds. In addition, the deduction generally is restricted to the greater of 50% of W-2 wages paid, or the sum of 25% of wages paid plus a capital allowance, with relief from wage restriction for individuals with taxable income below certain thresholds. The income threshold is $315,000 for joint filers. The Act maintains carve-outs for investment income.
Under the Act, a "specified service trade or business" means any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business whose principal asset is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.
The pass-through provisions under the Act 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 20% deduction.
— Hedge funds and other alternative funds. It is possible that limited types of non-investment income earned by a trader fund could be net business income potentially eligible to be taxed as QBI. However, in addition to the "specified service business" limitations, the Act adopts the Senate's 50% W-2 wage limitation (with a new alternative limit based on 25% of wages paid plus a capital allowance), which should begin to phase in for an individual with taxable income of over $315,000 (for joint filers).
— Tiered fund structures. Although the Act does not include any specific tiering rules or guidance on how unblocked income flows up through a fund structure, regulatory authority is provided to address the application of the pass-through rules in the case of tiered entities. Subject to any implementing guidance, presumably qualifying income generally should retain its character:
1. GP entities. It seems that income of a partnership allocated to a GP entity should retain its underlying character that flows up from a fund.
— Management companies. The Act closely tracks the Senate Bill. Management activities may be a "specified service business," and "the trade or business of performing services as an employee" is not a "qualified trade or business." A specified service business is defined broadly (e.g., to include "consulting," "financial services," and a business whose principal asset is the reputation or skill of one or more of its employees or owners, etc.). If a management company is considered an ineligible services business, the 20% deduction is phased out for high-income taxpayers.
— Master limited partnerships (MLPs). The Act allows a 20% deduction for certain income allocated to an individual partner of a publicly traded partnership (PTP) that is taxable as a partnership because it qualifies for the passive income exception of Section 7704(c). This should primarily benefit MLP/PTPs in the energy space, rather than PE/asset management PTPs, based on nature of the income they earn.
3. State and local tax (SALT) deduction for pass-throughs
Unlike individuals, under the Act, pass-through entities retain the ability to deduct entity-level state and local taxes.
4. Carried interest
The Act adopts the same three-year minimum asset holding period for service providers to qualify for long-term capital gain treatment. No further changes were made to expand this provision, e.g., to cover other types of income or gain.
5. Self-employment tax for limited partners
The Act maintains the status quo for investment professionals who are limited partners in a state law limited partnership who claim an exemption from self-employment tax.
6. Sales of partnership interests by foreign partners
The Act adopts the Senate approach and codifies Revenue Ruling 91-32, effectively reversing the Grecian Magnesite decision (see Tax Alert 2017-1156). Gain or loss on the disposition of a partnership by a foreign partner is treated as effectively connected income (ECI) and subject to taxation in the US if the gain or loss from the sale of the underlying assets held by the partnership is treated as ECI. In addition, a withholding tax obligation is imposed on the purchaser/transferee 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 provision has potential implications for pass-through investments at the portfolio-company, fund and limited-partner level (including for fund of fund investors) and for certain management company sale transactions. The proposal applies to sales or exchanges occurring on or after November 27, 2017. Taxpayers considering filing refund claims for open tax years before 2017 should consider this legislative provision, as well as the IRS's recent choice to appeal the Grecian Magnesite decision.
7. Partnership terminations
Under Section 708(b)(1)(B) of current law, a sale or exchange of 50% or more of interests in partnership capital and profits within 12 months causes a "technical termination" of the partnership. The Act repeals Section 708(b)(1)(B) for partnership tax years beginning after December 31, 2017.
8. Tax-exempt investors
The Act adopts the Senate approach to impose a new 1.4% excise tax on the net investment income of private colleges and universities with aggregate assets (other than those used directly in carrying out the institution's educational purpose) of at least $500,000 per full-time student.
It also adopts the Senate's approach to require a tax-exempt investor to calculate separately the net unrelated taxable income of each trade or business, beginning in 2018.
The Act includes no provision that would subject super tax-exempt investors (including state and local entities and pension plans) to unrelated business income tax.
9. Computing basis in securities
The Senate Bill would have required the cost and holding period of any specified security disposed of on or after January 1, 2018, to be determined on a first-in first-out (FIFO) basis. Following extensive lobbying and negotiations during the reconciliation process, this provision was not included in the Act.
10. Private activity bonds
The Act does not adopt the provision in the House Bill to repeal the exclusion from gross income for interest on qualified private activity bonds.
11. Recognition of income
The Senate Bill included a book/tax conformity rule, which was narrowed through amendments, that addressed satisfaction of the "all events test" in certain circumstances. As adopted, the rule generally requires a taxpayer to recognize income at the earlier of when recognized for tax purposes under Section 451 or when taken into account on an applicable financial statement (effectively requiring tax recognition at the earlier of earned, due, received or recognized for financial statement purposes). The provision directs taxpayers to follow the income recognition rules under Section 451 before applying the rules under part of V of Subchapter P, which includes the original issue discount (OID) rules. In its final form, the provision appears less likely to potentially require the acceleration of fee and incentive payments, but questions remain as to how the new provision will impact funds that hold market discount and other debt securities.
12. Other tax issues, including real estate
The Act makes no changes to the tax treatment of MLPs or PTPs, except as previously described in relation to the pass-through deduction.
The Act makes no changes to FIRPTA. However, it adopts the Senate Bill provision under which a real property trade or business can elect out of the interest expense deduction limitation (discussed later) and use the alternative depreciation system to depreciate real estate.
The Act also provides that the nonrecognition of gain in the case of like-kind exchanges is limited to those involving real property. Current law continues to apply for like-kind exchanges if the property disposed of by the taxpayer in the exchange is disposed of on or before December 31, 2017, or the property received by the taxpayer in the exchange is received on or before December 31, 2017.
Transaction and portfolio company issues
For a portfolio company structured as a C corporation, the reduced 21% corporate tax rate beginning in 2018 and tax shield resulting from immediate capital expensing should increase free cash flow. When compared to current law, these proposals generally should mitigate the effects of any potential limitation to interest deductibility and, except in limited circumstances (e.g., in the case of certain cyclical businesses), result in cash tax savings. The interplay of these provisions will be top of mind for deal professionals as they model tax for prospective transactions and potential impact on existing portfolio companies.
Domestic corporate tax
1. Reduction in corporate income tax
The Act calls for a permanent tax rate reduction to 21%, effective January 1, 2018. The special rate for personal service corporations is eliminated.
2. Corporate alternative minimum tax (AMT)
Like the House Bill, the Act repeals the corporate AMT. For a corporation, the Act allows the AMT credit to offset the regular tax liability for any tax year. The AMT credit is refundable for any tax year beginning after 2017 and before 2022 in an amount equal to 50% (100% for tax years beginning in 2021) of the excess of the minimum tax credit for the tax year over the amount of the credit allowable for the year against regular tax liability.
3. Interest deductibility limitation
Regarding the 30% of ATI limitation, the Act adopts a compromise approach between the House and Senate Bills. Beginning in 2018, business net interest deductions are limited to 30% of ATI, which will be a tax EBITDA-based calculation for 2018 through 2021. After 2021, similar to the Senate Bill, an EBIT-based calculation is used to determine ATI. After 2021, when depreciation, amortization and depletion are NOT permitted to be added back in calculating ATI, the interest limit will likely become significantly lower, which could have a negative cash tax impact on leveraged deals.
Under the Act, disallowed amounts may be carried forward indefinitely. An exclusion is provided for taxpayers that meet a $25-million gross receipts test and certain regulated public utilities and electing real property trades or businesses.
4. Immediate capital expensing for qualified property
The Act adopts the Senate Bill's 100% bonus depreciation approach and provides full expensing for qualified property placed in service after September 27, 2017, and before January 1, 2023. The 100% bonus deprecation for qualified property is phased down after 2022 as follows:
— 80% for property placed in service during 2023
The Act follows the House Bill in permitting immediate expensing for both new and used (i.e., first use) qualified property. This is important for asset deals or deemed asset deals in which capital property is acquired from a third party. In addition, it appears that pre-existing depreciable assets would be recovered under their current cost recovery method.
No provision in the Act permits the immediate expensing of amortizable intangible assets, including goodwill and other Section 197 assets.
5. Net operating losses (NOLs)
A corporation's NOL deduction is limited to 80% of taxable income (determined without regard to the NOL deduction) for losses arising in tax years beginning after 2017. NOL carryback provisions is repealed, and an indefinite carryforward is allowed. Among other things, these changes could impact the tax shield of certain PE portfolio company investments.
6. Dividends received deduction (DRD)
The deduction for dividends received from a domestic corporation is lowered to conform the DRD in light of the new 21% corporate tax rate (from 70% to 50%, and from 80% to 65% for 20%-or-greater-owned domestic corporations). The Act does not include a mechanism for so-called corporate integration.
US international tax
The Act largely adheres to the Senate Bill and significantly modifies the current US international tax system, including by: (1) implementing a territorial tax system for business income; (2) imposing a one-time transition tax on accumulated foreign earnings; and (3) introducing new anti-base erosion rules.
7. 100% exemption for foreign-source dividends
Like the Senate Bill, the Act provides a 100% exemption for foreign-source dividends received by a US corporation from a 10%-or-greater-owned foreign corporation. The deduction is not available for "hybrid dividends," and a one-year holding period in the stock of the foreign corporation is required. The Act allows an exemption for a US corporation's distributive share of a dividend received by a partnership in which the US corporation is a partner if the dividend would have been eligible for the exemption had the US corporation directly owned stock in the foreign corporation.
8. Deemed repatriation tax
The Act imposes a one-time transition tax on a US shareholder's pro rata share of the undistributed, non-previously taxed post-1986 earnings of a CFC or other "specified foreign corporation," at an effective rate of either 15.5% (to the extent of cash or other liquid assets) or 8% (for illiquid assets) by applying a new participation exemption deduction provided in Section 965(c). A US shareholder can elect to pay the tax over a period of up to eight years, with larger payments due in the last three years.
The Act contains some clarifications for specified foreign corporations held through partnerships. First, the Act explains that, for a foreign corporation that is not a CFC, there must be at least one US shareholder that is a domestic corporation for the foreign corporation to be a specified foreign corporation whose earnings are subject to the transition tax. Second, the Act clarifies that appropriate basis adjustments will be made to increase a partner or S corporation shareholder's outside basis in her partnership or S corporation interest respectively to reflect the full inclusion amount.
9. Worldwide interest limitation
The worldwide interest limitation provision was struck by the Conference Committee, thereby removing a potential impediment to accessing foreign debt financing for certain multinational portfolio companies.
10. Anti-base erosion — intangible assets
The Act follows the Senate Bill and imposes a tax on a US shareholder's aggregate net CFC income that is treated as global intangible low-taxed income (GILTI). GILTI is gross income in excess of extraordinary returns from tangible depreciable assets excluding effectively connected income (ECI), subpart F income, high-taxed income, dividends from related parties, and foreign oil and gas extraction income. The extraordinary return base equals 10% of the CFCs' aggregate adjusted basis in depreciable tangible property. Only 80% of the foreign taxes paid on the income are allowed as a foreign tax credit. All CFCs are aggregated for purposes of the computation. For tax years beginning after December 31, 2017, and before January 1, 2026, the highest effective tax rate on GILTI is 10.5%. For tax years beginning after December 31, 2025, the effective tax rate on GILTI is 13.125%.
The Act maintains the tax incentive in the Senate Bill for US companies to earn intangible income from US intangibles abroad. Income from foreign-derived intangible income (FDII) for tax years beginning after December 31, 2017, and before January 1, 2026, is provided an effective tax rate of 13.125%. For tax years beginning after December 31, 2025, the effective tax rate on FDII is 16.406%. Eligible income does not include, among other items, financial services income under Section 904(d)(2)(D).
11. Base erosion and anti-abuse tax
The Act adopts the Senate Bill's new base erosion anti-abuse tax (BEAT) provision. The BEAT applies to corporations (other than RICs, REITs, or S-corporations) that are subject to US net income tax with average annual gross receipts of at least $500 million and that have made related-party deductible payments totaling 3% (2% for banks and certain security dealers) or more of the corporation's total deductions for the year. A corporation subject to the tax generally determines the amount of tax owed under the provision (if any) by adding back to its adjusted taxable income for the year all deductible payments made to a foreign affiliate (base erosion payments) for the year (the modified taxable income). Base erosion payments do not include cost of goods sold, certain amounts paid with respect to services, and certain qualified derivative payments. The excess of 10% (5% for one tax year for base erosion payments paid or accrued in tax years beginning after December 31, 2017) of the corporation's modified taxable income over its regular tax liability for the year (net of an adjusted amount of tax credits allowed) is the base erosion minimum tax amount that is owed. For tax years beginning after December 31, 2025, the rate increases from 10% to 12.5%.
12. Intangible property
The Senate Bill's proposal to permit a CFC to distribute on a tax-free basis certain eligible intangible property to any corporate US shareholder was not included in the Act.
The Act adopts the House Bill's provision to no longer treat certain self-created assets — including patents, inventions or processes — as a capital asset, effective for dispositions after December 31, 2017. As such, gain or loss from the disposition of the property is ordinary in character. Those items of property also are excluded from the definition of property used in the trade or business under Section 1231.
13. Ownership and attribution rules for CFC status
Like the House and Senate Bills, the Act repeals Section 958(b)(4), effective for the 2017 tax year. In addition, beginning in 2018, the definition of "US shareholder" is extended to US persons that owned 10% or more of the voting power or value of a CFC. These expanded ownership and attribution rules could cause significant changes for many investment structures, particularly when the current-law rules prevent CFC status for foreign subsidiaries owned through foreign vehicles. Managers should consider any potential impact on the one-time transition tax determination, on fund reporting, and whether certain portfolio companies could become subject to anti-deferral or anti-base erosion measures.
Other portfolio company issues
14. Executive compensation limits (Section 162(m))
The Act follows the Senate Bill and expands 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 applies to compensation (including performance-based compensation) paid to that individual at any point in the future. These changes could impact portfolio company management teams.
15. Business credits
The Act preserves the research tax credit without modification. Similar to the House and Senate Bills, it requires the capitalization and five-year amortization of domestic qualified research and experimental (R&E) expenditures (15 years for R&E conducted outside the US), but only for such expenditures incurred in tax years after 2021.
Regarding the Section 199 domestic production activities deduction, the Act follows the House Bill and repeals the Section 199 deduction for tax years beginning after 2017.
The Act retains current law with respect to the Work Opportunity Tax Credit, which expires after 2019. In addition, the Act does not adopt the Senate Bill's changes to the Low-Income Housing Credit. Further, under the Act, the deduction for certain unused business credits is not repealed.
PE and alternative fund principals and deal professionals
The provisions of the Act could have some adverse impact on PE and alternative asset management principals, as the tax cuts are focused on middle-class tax relief. The provisions will almost certainly disproportionally impact individuals living in expensive metropolitan areas, including in the Northeast Corridor, California and Illinois.
1. Individual income tax rates
The Act preserves seven tax brackets, with a top rate of 37% for income starting at $600,000 for joint filers. The new individual tax rate structure sunsets for tax years beginning after December 31, 2025.
Individual AMT. The Act preserves the individual AMT, but temporarily increases both the exemption amount (to $109,400 for joint filers) and the exemption amount phaseout thresholds (to $1 million for joint filers).
2. State and local taxes
The Act provides a state and local tax deduction capped at $10,000, a combined limit for property taxes and state and local income or sales taxes. The Act explicitly prohibits an individual from claiming an itemized deduction in 2017 on a pre-payment of income tax for a future tax year to avoid the new $10,000 limitation.
3. Mortgage interest deduction
The Act splits the difference between the House and the Senate Bills and provides an interest deduction on mortgage debt of up to $750,000 for newly-purchased homes. In addition, the deduction for home equity debt interest is suspended for the 2018 through 2025 tax years. Further, the Act does not modify the current law exclusion of gain on the sale of a principal residence.
4. Medical expense deduction
Under the Act, the itemized deduction for medical expenses is retained and applies to expenses that exceed 7.5% of AGI in 2017 and 2018, and expenses that exceed 10% of AGI thereafter.
5. Affordable Care Act
The Act effectively repeals the "individual mandate" under the Affordable Care Act by reducing to zero the tax that applies to individuals who fail to purchase health insurance, beginning in 2019
6. Estate tax
The Act does not repeal the estate tax. In line with the Senate Bill, the Act doubles the amount of the estate, gift and generation-skipping transfer tax exemption (from $5 million to $10 million per individual) for the 2018 through 2025 tax years. The $10 million amount is indexed for inflation occurring after 2011.
7. Nonqualified deferred compensation
The Act does not change Section 409A, except to exclude the receipt of certain private company qualified stock by an employee as a nonqualified deferred compensation plan for purposes of Section 409A.