On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act is the most extensive change to the Internal Revenue Code since the Tax Reform Act of 1986 and includes provisions that will significantly impact private investment funds. The following is a brief summary of some of the key provisions of the Tax Act that are relevant to private investment funds.
Although several legislative proposals had been introduced in prior years that would have eliminated any tax benefit to carried interest for fund managers, the Tax Act retains the treatment of carried interest but substitutes a three (rather than a one) year holding period requirement for fund managers to receive long-term capital gain on the sale of capital assets such as stock or partnership interests in portfolio companies. Additionally, the changes apply only to carried interest transferred in connection with the performance of substantial services in an applicable trade or business, which is defined as any activity performed on a substantial, regular and continual basis for raising and returning equity and investing, disposing or developing specified assets (which generally consists of securities, commodities and real estate held for investment or rental). The three-year holding period will be determined based on the holding period of the asset giving rise to the gain and will apply irrespective of whether a Section 83(b) election was made for the carried interest. The three-year holding period will also apply to any sale or disposition of the carried interest itself. The three-year holding period requirement, however, will not impact the favorable long-term capital gain rates applicable to “qualified dividend income” or the gain from the sale of depreciable property and real property used in a trade or business and held for more than one year.
Capital gains not satisfying the three-year holding period requirement will be treated as short-term capital gains, which are taxed at ordinary income rates but can be offset by long-term capital losses.
The three-year holding period requirement does not apply to a capital interest which provides for a right to share in partnership capital commensurate with the total amount of capital contributed or to the value of the carried interest subject to tax under Section 83 upon receipt or vesting of the interest.
This new rule will apply for tax years beginning after December 31, 2017, without any grandfathering of carried interest issued prior to December 31, 2017.
Reduction in corporate tax rates and limitations on NOLs
Under the Tax Act, the corporate tax rate is reduced permanently from 35 percent to 21 percent for tax years beginning after December 31, 2017. This reduction in corporate tax rates may impact the decision by fund managers to structure portfolio companies as corporations rather than pass-through entities, such as LLCs, and will have implications for the use of US “blocker” corporations often established by funds for investment by non-US and US tax-exempt investors.
A corporation’s ability to use net operating losses will be limited to 80 percent of its annual taxable income. The Tax Act disallows the carryback of losses but allows for an indefinite carryforward of losses.
Reduction of tax on income from pass-through entities
Many investments by buyout and venture funds are made in pass-through entities, in particular LLCs that are classified as partnerships for US federal income tax purposes. The Tax Act creates a new deduction for non-corporate taxpayers who have domestic “qualified business income” (“QBI”) from flow through entities (e.g., partnerships, S corporations or sole proprietorships) (a “Flow-Through Deduction”) engaged in qualifying trades or businesses (“QTB”). The Flow-Through Deduction applies to taxable years beginning after December 31, 2017 and before January 1, 2026. The Flow-Through Deduction is generally the lesser of (i) 20 percent of the QBI for the taxable year or (ii) the greater of (a) 50 percent of the W-2 wages with respect to the QTB or (b) 25 percent of the W-2 wages with respect to the QTB plus 2.5 percent of the unadjusted basis of qualified property.
In general, QBI is income from a US trade or business, and also includes certain dividends from REITs and cooperatives and qualified publicly traded partnership income. However, QBI does not include investment income such as capital gain, dividends, investment interest income, and commodity and foreign currency gains, and does not apply to reasonable compensation for services or guaranteed payments paid to a partner for services. Except for persons with income below a threshold, the Flow-Through Deduction also does not apply to taxpayers with pass-through income from specified service businesses including those in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services, or which involve investing, investment management, trading or dealing in securities, partnership interests or commodities.
This provision is very complex and there is uncertainty about the application of particular aspects of the new rule. However, it is expected that the Flow-Through Deduction should benefit US individuals and other non-corporate fund investors receiving allocations of taxable income from fund investments in pass-through entities such as LLCs.
Limit on business interest deductions
The Tax Act limits the deduction for the excess of business interest expenses over business interest income to 30 percent of the taxpayer’s adjusted taxable income, which is defined for years beginning before 2022 as the taxpayer’s taxable income computed without regard to any deduction for depreciation, amortization, or depletion. Beginning January 1, 2022, however, the 30 percent limit will be applied without any adjustment to adjusted taxable income for depreciation, amortization, or depletion. Any disallowed excess interest expense can be carried forward indefinitely. The new interest expense limitation applies to any form of business (e.g., a corporation or LLC), but does not apply to a business if its average annual gross receipts over three years do not exceed US$25 million, and does not apply to electing real estate or farming businesses. The application of the 30 percent limitation is made at the partnership level.
The 30 percent limitation is expected to impact typical leveraged buyouts and may result in the increased use of preferred equity as a substitute for mezzanine debt in acquisitions, although caution should be exercised to avoid the preferred equity being characterized by the Internal Revenue Service as debt. In addition, this limitation is likely to have implications for leveraged blocker corporations.
Gain on the sale of partnership interests by a foreign person
Under the Tax Act, a non-US person that sells an interest in a partnership (including an LLC that is treated as a partnership for US federal income tax purposes) engaged in a US trade or business will recognize US effectively connected income (“ECI”) to the extent the foreign person would have had ECI had the partnership sold its assets for fair market value. This provision reverses the recent Tax Court decision in Grecian Magnesite Mining v. Commissioner and effectively codifies the IRS’ long standing position in Revenue Ruling 91-32.
In addition, to support the collection of tax from non-US sellers of interests in ECI partnerships, the Tax Act imposes a 10 percent withholding requirement on the amount realized from the disposition of the interest (much like the withholding requirement under FIRPTA in the case of a sale of interest in US real estate). If the transferee fails to withhold, the partnership is required to withhold the amount (plus interest) from distributions to the transferee.
Many funds have established US corporate “blockers” to shield non-US investors from ECI and the resulting US tax filing and payment obligations. Following the Grecian Magnesite decision, there was hope that non-U.S. investors could structure their investments through non-US blockers that would not incur US tax on the disposition of a partnership interest. However, under the Tax Act, non-US investors should continue to consider the use of US blockers. Moreover, the decrease in the corporate tax rate from 35 percent to 21 percent will reduce the tax cost of investing through US blockers.
Separate investment-by-investment computation of UBTI
The Tax Act requires that tax-exempt organizations compute “unrelated business taxable income” (“UBTI”) separately for each unrelated trade or business, which prevents a tax-exempt investor’s expenses or losses from one UBTI activity from offsetting UBTI from another activity, as had been permitted under prior law.
Tax-exempt investors are often provided the opportunity to choose whether to participate in a fund investment that is expected to generate UBTI directly or through a blocker. Because of the elimination of the ability to offset UBTI gains and losses, this change may encourage tax-exempt investors to invest through blocker corporations.
Excise tax on certain private colleges and universities
The Tax Act imposes a 1.4 percent excise tax on the net investment income of private colleges and universities with at least 500 full-time, tuition-paying students and with aggregate assets (other than assets used directly in carrying out the institution’s exempt purpose) of at least US$500,000 per full-time student.
The Tax Act permits the immediate write-off of 100 percent of the cost of property acquired and placed into service after September 27, 2017 through 2022. The available write-off will be reduced by 20 percent per year beginning in 2023 (and for certain property in 2024). This new rule allows write-offs for not only “new” property, but also for “used” property as well. Accordingly, fund managers may be incentivized to make asset acquisitions, including deemed asset acquisitions under Sections 336 and 338(h)(10), in order to reduce the effective tax rate of equipment-intensive businesses.
Controlled foreign corporations
A non-US corporation is a controlled foreign corporation (“CFC”) if “US shareholders” own directly or by attribution, more than 50 percent of the non-US corporation (by vote or value). Section 951(b) defined a US shareholder as a US person who owns, directly or by attribution, 10 percent or more of the total combined voting power of all classes of stock entitled to vote. The Tax Act expands the definition of US shareholder to include US persons who own 10 percent or more of the total value of shares of all classes of stock, voting or non-voting. The Tax Act also provides expanded downward attribution from a non-US person of its stock in a non-US corporation to a related US person for purposes of determining whether the US person is a US shareholder.
These changes are likely to result in more non-US portfolio companies being treated as CFCs, and consequently, US shareholders having greater “phantom income” inclusions and reporting obligations.
The Tax Act also imposes a one-time transition tax, under which US shareholders that own 10 percent or more of the voting stock of certain foreign corporations will generally include in income their pro rata share of the foreign corporation’s post-1986 accumulated earnings and profits that were not previously subject to US tax. The transition tax imposes a 15.5 percent rate applicable to cash and cash equivalents and an 8 percent rate for non-cash assets. A US shareholder may elect to pay the transition tax over eight years without an interest charge. This transition tax could affect US corporate portfolio companies or taxable US investors, depending on the investment structure.
Miscellaneous itemized deductions
Under prior law, individuals, trusts and estates could deduct miscellaneous itemized deductions (e.g., investment management fees) that exceeded 2 percent of the taxpayer’s adjusted gross income. The Tax Act eliminates all miscellaneous itemized deductions beginning after December 31, 2017 and before January 1, 2026.