As businesses and tax practitioners continue to determine the winners and losers of the December 22, 2017 Tax Cuts and Jobs Act (“TCJA”), it is clear that the substantial impact to private equity funds and their portfolio companies consists of a trade-off between the benefit of reduced corporate and individual rates and increased limitations on a company’s ability to claim various deductions.
While private equity funds should be a net beneficiary of tax reform, careful analysis will be required to determine the specific impact of each of the many provisions affecting the industry and whether a firm’s approach to strategic considerations such as acquisitions and capitalization requires modification.
Some of the notable provisions are the reduction of rates, changes to the treatment of carried interests, limitations on interest expense deductions, full expensing of capital expenditures, repeal of the corporate alternative minimum tax, deduction for pass-through business income, legislative overturn of the Grecian Magnesite Mining decision impacting the sale of partnership interests by a foreign partner and a prohibition on the netting of separate trade or business activities when computing unrelated business taxable income.
Provisions Impacting Funds and Investors
Gains with respect to “applicable partnership interests” will be re-characterized as short-term to the extent that they relate to property that has been held for a period of less than three years.
Due to the longer-term investment strategies common to private equity firms, the fallout from changes to the taxation of carried interest should have minimal impact on most general partners. More likely, general partners will be impacted where partnership assets have split holding periods. Importantly, this rule has immediate effect, such that a disposition in 2018 must meet the 3-year holding period requirement to avoid re-characterization.
Sale of Partnership Interests by a Foreign Partner
In a move that overrules the recent Tax Court decision, Grecian Magnesite Mining Company v. Commissioner, the TCJA provides that gain or loss on the sale or exchange of an interest in a partnership that is engaged in a U.S. trade or business by a foreign person after November 27, 2017 will be treated as effectively connected income (ECI) to the extent allocable to assets that produce effectively connected income.
For additional discussion relating to this provision, please refer to our January 31, 2018 alert, Tax Reform Bill Codifies IRS’s Position Regarding the Sale of a Partnership Interest by a Foreign Partner.
This provision of the TCJA restores the administrative rule relating to the sale of partnership interests by foreign persons set out in Rev. Rul. 92-32. For ECI sensitive investors, the use of blockers should be considered.
Unrelated Business Taxable Income (UBTI)
Tax exempt investors must calculate unrelated business taxable income separately for each trade or business activity for taxable years after December 31, 2017 and will be unable to offset income from different trades or businesses.
The TCJA provides non-corporate owners of pass-through entities with a deduction of up to 20% on qualified business income allocated to them. With respect to each owner, the available deduction with respect to any eligible pass-through business is limited to the greater of (1) 50% of the individual’s share of W-2 wages paid by the business; and (2) 25% of W-2 wages paid by the business plus 2.5% of the unadjusted cost basis of the qualified property of the business.
For additional discussion relating to this provision, please refer to our February 7, 2018 alert, Utilizing the New 20% Pass-Through Deduction.
While there are several notable exclusions to the types of businesses eligible, including service and investment management businesses, income generated by portfolio companies owned in pass-through form should generally be eligible for the deduction. Where applicable, compensation structures should be reviewed to maximize the potential deduction and partnership agreements reviewed for impact on tax distribution provisions.
Excess Business Losses
For taxable years beginning after December 31, 2017 and before January 1, 2016, non-corporate taxpayers will face limitations on the ability to deduct excess business losses; effectively described as aggregate business deductions to the extent they exceed business income plus $250,000 ($500,000 for married taxpayers). Disallowed losses would be carried forward as net operating losses.
Provisions Impacting Portfolio Companies
Corporate Rate Reduction
For taxable years after December 31, 2017, the corporate rate will be a flat 21%, reduced from the previous rate of 35%. Additionally, the Corporate Alternative Minimum Tax was repealed.
The reduced corporate rate should result in the availability of additional capital to portfolio companies; however, the reduction will also limit the benefits of deferred tax assets, as well as tax attributes in an acquisition scenario. The reduction in federal corporate rates may also increase attention on state and local tax planning measures.
Net Operating Losses
Losses that arise in taxable years beginning after December 31, 2017 will no longer be eligible for the 2 year carryback that is available for losses arising in prior years. Additionally, a taxpayer will only be eligible to deduct a net operating loss generated after December 31, 2017 to the extent of 80% of its taxable income. The law generally allows for the indefinite carryforward of such losses. Losses generated in tax years beginning before January 1, 2018 will not be subject to the taxable income limitation and will continue to have a two year carryback and 20 year carryforward period.
Beyond the obvious consequence of not being able to fully utilize NOL carryforwards in a given year, the prohibition on carrybacks may also present an issue for sellers vis-à-vis transaction cost deductions as NOLs arising in connection with a transaction for which a seller is traditionally compensated will not be available.
Limitations on Interest Expense
The deductibility of interest expense incurred in taxable years beginning after December 31, 2017 will be subject to additional limitations, capping the deduction of net interest expense at the sum of interest income plus 30% of adjusted taxable income. For taxable years through 2021, adjusted taxable income references EBITDA and for taxable years after 2021, adjusted taxable income will be measured in reference to EBIT. The interest expense limitation provision does not provide for grandfathering.
The new limitation on interest expense deductions likely represents the largest negative impact for the industry to come out of tax reform. The provision is likely to cause highly leveraged companies to reevaluate their capital structures. The limitation is also significant in that it expands limitations to all debt, rather than focusing on related party debt as under prior law.
Full Expensing of Capital Expenditures
Replacing the current rules relating to bonus depreciation, taxpayers will be able to immediately expense 100% of the cost of qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023. Notably, the definition of qualified property is expanded, making this expensing available for both original and acquired property if it is the taxpayer’s first use.
Immediate expensing of qualified acquired property should provide a boon, particularly for industries with substantial capital expenditures such as manufacturing. The provision is likely to have a positive impact on deals structured to provide a basis step-up for assets.
International Tax Provisions
Perhaps the most dramatic tax reform changes come with respect to international taxation, the entire foundation of which has been transformed. Particularly for outbound private equity investment, there are a number of substantial provisions that will affect portfolio companies and their U.S. shareholders. Among these are a one-time tax on accumulated foreign earnings, a dividends received deduction of 100% on dividends paid by a foreign subsidiary to a U.S. parent, various modifications to the CFC rules and a minimum tax imposed on non-subpart F income (global intangible low-taxed income).
Overall, tax reform looks to be a mostly positive development for the private equity industry, an outcome that would be further bolstered should lobbying efforts to retain EBITDA rather than EBIT as a measurement for adjusted taxable income for purposes of the interest expense limitations come to fruition.
Additionally, the state and local impact of the legislation will bear watching, as the benefit of provisions such as immediate expensing may be subject to decoupling at the state level.
For additional information relating to the tax reform legislation, please refer to our December 22, 2017 alert, Major Tax Overhaul Signed into Law.
Please contact your Mazars USA LLP tax professional for additional information.