Impact of US tax reform on PE funds and portfolio companies

June 2018  |  FEATURE  |  PRIVATE EQUITY

Financier Worldwide Magazine

June 2018 Issue

Signed into law in December 2017, the Tax Cuts and Jobs Act (TCJA) is the most significant overhaul of US tax policy since 1986. The new law will impact individual taxpayers in all income tax brackets, all businesses and virtually every sector of the economy, including private equity (PE) firms and their portfolio companies.

Notably, the Act is not yet in its final form. There may be a technical corrections bill in 2018 and the Joint Committee on Taxation will also issue some corrections and modifications later this year. There will also be pressure on both the Treasury Department and the Internal Revenue Service to issue guidance on the new rules given their reach and complexity.

Since most of the provisions became effective on 1 January 2018, it is crucial that PE executives and limited partners (LPs) understand those – that may affect PE funds as well as any future technical corrections made by Congress – and their portfolio companies.

Notable aspects of the reform include the large cut in the corporate tax rate from 35 percent to 21 percent, significantly lower than the highest federal income tax rate applicable to individuals, which is now 37 percent, plus a potential 3.8 percent Medicare surtax, and the shift from an international tax system where tax on overseas profits is deferred until the profits are repatriated, to a modified territorial system in which overseas profits are not subject to US federal income tax when repatriated. The corporate alternative minimum tax has also been repealed. The changes to the corporate tax rate and the alternative minimum tax are effective for a corporation’s first taxable year beginning after 31 December 2017.

The Act also contains a new deduction which will effectively lower the tax rate for owners of certain businesses that operate in pass-through form, such as LLCs treated as partnerships for tax purposes. Furthermore, the Act contains tax breaks including the ability to deduct up to 100 percent of capital expenditures made to acquire tangible, depreciable property in the year of the expenditure.

Government plans relating to unrelated business income tax (UBIT) were also laid out in the Act. Though the House version of the bill included a provision subjecting entities such as governmental pension plans to tax on UBIT, as a result of their exemption from tax under Section 115 of the Internal Revenue Code, the Senate bill did not include this provision. “We were gratified to see that a provision in the initial tax bill that would have for the first time applied UBIT to US public pension plans was not included in the final legislation,” says Christopher Hayes, the director of industry affairs at the Institutional Limited Partners Association. “US public pensions, because of their status as state actors that are not taxed by the federal government, are currently not subject to UBIT as other types of tax exempt investors are. However, there were other provisions that were included in the law that are potentially harmful to certain investors. According to Mr Hayes:   “There is a new provision on the netting of UBIT that could have a significant negative impact on tax exempt US investors that are not public pensions, such as endowments and foundations, which prohibits the ability to net loss making unrelated business activities against profit making unrelated business activities. This provision will make it more likely that tax exempt US investors will have to utilise blocker structures to retain their favoured status. Second, there is a new 1.4 percent endowment excise tax on certain large university endowments with smaller student populations. Most endowments will be required to absorb this new cost as a part of doing business, thereby harming their returns, but those closer to the taxation threshold may choose to spend more and invest less.”

Under the new law, a tax-exempt entity must calculate UBIT separately for each unrelated trade or business activity. As a result, a tax-exempt entity cannot offset expenses or losses from one trade or business with income derived from another. This new rule may influence the decision of some tax-exempt investors over whether to invest using ‘blocker’ corporations, which could potentially ease the reporting and remitting of UBIT. “The new provisions capping the deductibility of interest expense may change how blocker structures are financed in the US. Currently, many ‘blocker’ corporations are financed by foreign investors through shareholder loans to the blocker corporation. With the new cap on interest expense, the interest on these loans is no longer fully deductible, so this may render shareholder loans less attractive for financing these entities,” says Mr Hayes.

Due to the controversial nature of the TCJA, it contains a number of provisions designed to appease Senate rules concerning the increase in the budget deficit. As such, it also has some revenue-raising features which will weigh heavily on the PE industry, adversely affecting firms and their ability to participate in leveraged buyouts. Notably, the Act will introduce measures including a three-year holding period to be eligible for long-term capital gains treatment with respect to carried interest, a new limitation on the deductibility of interest, repeal of the ability to carryback net operating losses and a minimum tax on large corporations making deductible payments to affiliates.

Carried interest

The tax treatment of carried interest has been a contentious issue in recent years. Indeed, when campaigning for the presidency, Donald Trump repeatedly decried the carried interest tax break for fund managers, and vowed to repeal it. However a compromise was achieved in the TCJA which limited the favourable capital gains rates to gains on assets held longer than three years, instead of the usual one-year holding period.

Managers have previously argued that there is nothing untoward about profits being taxed at the lower capital gains rate, which tops out at around 20 percent. Congress has debated changing the rate for some time, and though the TCJA left the favourable treatment largely intact, the new danger to carried interest tax treatment may come from individual states. Under the TCJA, the rule will change only slightly, as portfolio companies held for less than three years will now be taxed as short-term capital gains, which are taxed at the normal rate.

The three-year holding period, under the TCJA, applies only to a partnership interest transferred or held in connection with the provision of substantial services by the taxpayer or a related person in the trade or business of raising or returning capital and either investing in or divesting certain specific securities, commodities, real estate, cash or cash equivalents, or derivatives, or developing such assets.

The Treasury Department has looked to find a way around this longer holding period by utilising the ‘S corporation’ form of business ownership. In terms of exceptions for corporations, the TCJA is somewhat unclear; however, there is a belief that the exception was designed to benefit only C corporations, not S corporations. In the new ruling, the Treasury advises taxpayers it will soon implement restrictive regulations that will be retroactive to 1 January 2018. “We worked expeditiously to take this first step to clarify that S corporations are subject to the three-year holding period for carried interest,” Treasury Secretary Steven Mnuchin said in a press release. “Treasury and the IRS stand ready to implement the Tax Cuts and Jobs Act as Congress intended and provide the appropriate taxpayer guidance on how the law will be implemented.”

Overall, with regard to carried interest, given the longer term approach of PE, with holdings typically lasting around seven or more years, the industry will probably experience less of an impact than hedge funds, for example. While the PE industry is certainly perturbed by the Act, it is not a disaster. Hugh MacArthur, head of Bain’s global PE practice, for example, believes that the Act will absolutely be positive for the industry. Yet, the Act will be disruptive to usual practice, in terms of carried interest.

Pass-through income

Under the Act, a special 25 percent maximum tax rate will be applied to ‘business income’ derived from individuals, subject to limitations designed to prevent the conversion of wages and other personal services income into business income. ‘Business income’ excludes some categories of passive investment income, including dividends, interest and gain. Individual investors into funds holding investments in portfolio companies that are organised as pass-through entities would probably be eligible for the 25 percent rate. PE firm owners would not be eligible on income received from the management company, the Act states.

For portfolio companies, the introduction of two provisions which will limit deductibility of interest will be important. The first will limit the deduction for ‘business interest’ to 30 percent of the taxpayer’s adjusted taxable income (ATI) for the taxable year. The limitation would be increased by any business interest income earned by the taxpayer. Interest that is not deductible under the provision could be carried forward for five years. However, the 30 percent cap could affect the amount of tax payable by some portfolio companies and could drive some PE sponsors to arrange other types of financing not involving the payment of ‘interest’.

Equally, a limitation applicable to US corporations that are members of ‘international financial reporting groups’ could impact portfolio companies. The provision would likely limit the corporation’s deduction for net interest expense to 110 percent of the US company’s proportionate share of the group’s worldwide earnings before interest, taxation, depreciation and amortisation (EBITDA), according to the group’s financial statements.

Investor impacts

While the TCJA will affect PE funds and their GPs, it will also have consequences for LPs, both in the US and overseas, says Mr Hayes. “There are some significant new impacts for non-US investors looking to invest in the US. First, there is a new provision requiring that sales of a partnership interest to non-US investors be treated as effectively connected income (ECI). We think this could have an impact on the secondaries market for non-US investors in the PE market.

“With regard to other provisions in the Act that may impact investment appetites, there could be an impact on both buyout transactions and debt funds due to the new caps on interest deductibility. While we do not see debt funds becoming less attractive in the current interest rate environment, as a result of the simultaneous lowering of the corporate tax rate, investment appetites for these funds could be harmed if interest rates rise sharply. Similarly, we could see leverage levels in buyout transactions decline, harming the attractiveness of these funds, if interest rates rise, despite the lowering of the corporate tax rate,” adds Mr Hayes.

Time will tell whether the tax reform will be a net benefit to the PE industry, however it is clear that one way or another the sector will certainly feel the impact. The reform will disrupt how potential buyout targets are valued, how quickly PE leaders can reap their rewards, and how some of the leverage will have to be removed from buyouts. These changes, particularly the amendments governing leverage, will hit the larger PE firms which rely on leverage to boost their returns.

However, the significant cut to corporate tax rates will be a boost for funds, potentially leading to improved returns in the future.

© Financier Worldwide

BY

Richard Summerfield