The House tax bill contains several provisions that could significantly affect private equity sponsors, investors and portfolio companies. Below we have highlighted a number of these proposals, including discussions of:
- Carried Interest
- Changes in Rates
- 25% Rate on Certain Pass-Through Income
- State and Local Income Taxes
- Interest Deductibility
- Deferred Compensation
- Compensatory Stock Options Issued by Certain Closely Held Corporations
- International Tax Changes
- State Pension Plans
- Changes to Self-Employment Tax
Carried Interest. The House bill generally would limit the favorable taxation of carried interest to investments that have a holding period of more than three years, and treat carried interest attributable to gains on investments held for three years or less as short-term capital gain (taxed at the rates applicable to ordinary income). Qualified dividend income allocated in respect of carried interest would remain eligible for long-term capital gains rates without regard to the three-year holding period. Unlike some prior proposals on carried interest, the provision would not subject the amounts treated as short-term capital gain to self-employment tax. However, such gain would remain subject to the 3.8% Medicare tax on net investment income.
Changes in Rates. The House bill would reduce the corporate tax rate from 35% to 20% but would retain 39.6% as the highest individual income tax rate. The 39.6% rate does not include Medicare tax and employment-related taxes imposed on or with respect to individuals. Long-term capital gains rates would remain capped at 20%.
25% Rate on Certain Pass-Through Income. The House bill would provide for a reduced tax rate of tax on business income derived by individuals through sole proprietorships, partnerships and other pass-through entities. A special 25% maximum tax rate would apply to “business income” derived by individuals, subject to “guard rails” intended to prevent the conversion of wages and other personal services income into business income. Business income excludes certain categories of passive investment income, such as dividends, interest and gain.
Individual investors (limited partners and, potentially, individual members of the sponsor general partner) in private equity funds that hold investments in portfolio companies that are organized as pass-through entities (so-called “operating partnerships”) would generally be eligible for the 25% rate with respect to the business income derived from such investments (including in respect of carried interest). Private equity firm owners who are, or have been, engaged in the business of the management company would generally not be eligible for the special 25% rate on income received from the management company. However, it is not clear how the rules would apply in the case of management company income if the private equity firm sponsors funds that employ differing investment strategies and an individual does not do work for one or more of the strategies. You can read more about the special pass-through rate here.
State and Local Income Taxes. Under the House bill, the deduction for state and local income taxes would be repealed in the case of individual taxpayers. Chairman Brady recently clarified that the provision would also apply to deny deductions for state and local income taxes imposed on an individual’s share of the income received from an operating partnership or management company.
Interest Deductibility. The House bill includes two provisions that would significantly limit deductibility of interest. Neither provision grandfathers existing debt.
The first provision would generally limit the deduction for “business interest” to 30% of the taxpayer’s “adjusted taxable income” (ATI) for the taxable year. ATI would be defined to mean taxable income but computed without regard to (i) any deduction for depreciation, amortization or depletion, (ii) any NOL, (iii) any non-business items, and (iv) any business interest income or business interest expense. The 30% limitation would be increased by any business interest income earned by the taxpayer. Any interest that is not deductible under the provision could be carried forward for five years. Following a change of control, unused interest expense carryforwards would be subject to limitation under Section 382 (which limits the use of NOLs and similar tax assets upon a change of control). Under a specific exception, the 30% cap would not apply to business interest attributable to a real estate business.
The 30% cap on the deduction for interest would have a significant impact on the amount of tax payable by some portfolio companies and may cause private equity sponsors to search for alternative financing arrangements that do not involve the payment of “interest.”
Special rules are provided for partnerships. First, in the case of business interest incurred by a partnership, the 30% limitation is determined at the partnership level based on the ATI of the partnership. Second, in applying the 30% limitation to business interest incurred at the partner level, the partner’s ATI is generally determined without regard to business-related items allocated to the partner by a partnership. Third, if the amount of business interest expense of a partnership is below the 30% cap, the cap on business interest deducible by the partners is increased by this excess amount.
It is not entirely clear how the provision would apply to debt of a “blocker corporation” the sole asset of which is an interest in an operating partnership. Typically, during the life of such an investment, the blocker corporation would have no income other than income from the operating partnership. As a result, if the blocker’s share of the operating partnership’s income is disregarded in determining the blocker’s ATI, then the blocker’s ATI would generally be zero each year. Thus, assuming that the interest on blocker debt is treated as business interest under these rules (a point that is not clear) and that the business interest at the operating partnership level equals or exceeds the cap (as determined at the partnership level), the blocker would not receive a current tax benefit for any interest paid or incurred on the blocker debt. However, the deduction for that interest would be carried forward up to five years and could potentially be used by a future buyer of the blocker (depending on how the statute is interpreted) to offset gain upon a sale of the blocker’s interest in the operating partnership.
The provision would generally not apply to debt borrowed at the fund level since the interest on such debt would generally be considered investment interest rather than business interest.
The second limitation applies to U.S. corporations that are members of an “international financial reporting group,” generally defined as any group of entities that includes at least one foreign corporation engaged in a U.S. trade or business or at least one domestic corporation and one foreign corporation, prepares consolidated financial statements and reports annual gross receipts in excess of $100 million. The provision would limit the corporation’s deduction for net interest expense (i.e., the excess of its interest expense over its interest income) to 110% of the same percentage of its net interest expense as its percentage share of the group’s book net interest expense, determined on the basis of the respective amounts of EBITDA generated by the group members. You can read more about these proposals here and here.
This limitation can be expected to alter the financing structure of some portfolio companies with international operations, particularly if the parent portfolio company is organized in the United States.
Deferred Compensation. Initial versions of the House bill would have largely ended the ability to structure compensation in a manner that allows an employee (or other service provider) to defer income beyond when the income vests. However, an amendment to the bill released on November 9th, 2017 eliminated these provisions. The Ways and Means section-by-section summary of the Amendment confirms that under the amendment, the current law tax treatment of nonqualified deferred compensation is preserved.
Stock Options and RSUs Issued by Certain Private Corporations. The House bill contains a provision that would allow employees holding stock options or restricted stock units issued by certain private corporations to defer income resulting from the exercise of the options or settlement of the restricted stock units for 5 years after the date on which the options or restricted stock units vest or, if earlier, the date the stock becomes transferable or publicly traded or the date of certain other events. This special deferral would not be available to an employee who is or was at any time the company’s CEO or CFO (or a related person), or was at any time during the previous 10 years a 1% or greater owner of the corporation or one of the four highest compensated officers of the corporation. The deferral election would be available only to corporations that, pursuant to a written plan, grant stock options or restricted stock units to at least 80% of their US employees in the calendar year in which the relevant options or restricted stock units were granted.
International Tax Changes. The House bill includes several changes in the international area that would have a significant impact on multinational groups that have either a U.S. parent or a U.S. subsidiary. Among these changes include:
- Dividends-received deduction for distributions from foreign subsidiaries. The House bill introduces a modified “territorial” system of tax in which income earned by foreign subsidiaries is not subject to tax when repatriated to the United States. Specifically, the House bill provides for a dividends received deduction for dividends received by a domestic corporation from a 10%-owned foreign corporation. However, U.S. corporations would continue to be subject to U.S. tax on their share of certain income from foreign subsidiaries, including passive (subpart F) income and so-called “foreign high return” income (described below).
- Deemed repatriation. In order to implement the territorial system, the bill provides for a one-time transition tax that would require a U.S. portfolio company with a non-U.S. subsidiary to include in income the non-U.S. subsidiary’s previously untaxed accumulated earnings and profits, or “E&P” (which is like retained earnings, but computed based on U.S. federal income tax principles). In some cases, the amount of previously untaxed accumulated E&P could be significant. The bill specifies a 12% tax rate on cash or cash equivalents and a 5% tax rate on non-cash amounts, and the tax can be paid in equal installments over 8 years. The transition tax would also apply to a “10% U.S. shareholder” of a non-U.S. portfolio company that is treated as a CFC for purposes of this provision. You can read more about this proposal here.
- Tax on so-called “foreign high return” income. The bill would require a U.S. portfolio company with a non-U.S. subsidiary to pay tax on 50% of its so-called “foreign high returns,” generally the excess of the foreign subsidiary’s aggregate net income over a determined return (7% plus the federal short-term rate) on such subsidiaries’ aggregate adjusted bases in depreciable property, adjusted downward for interest expense. In many cases, the foreign high returns will represent substantially all of the non-U.S. subsidiary’s income. Special foreign tax credit rules are provided. The intent of the provision is to subject the foreign subsidiary’s foreign high returns to a minimum 10% tax in the United States. Like the deemed repatriation proposal, the “foreign high return” tax would also apply to a 10% U.S. shareholder of a non-U.S. portfolio company that is treated as a CFC for purposes of this provision. You can read more about this proposal here.
- Section 956 limited to non-corporate shareholders. The House bill would eliminate the application of Section 956 for U.S. corporations. Section 956 is the provision that, in the context of a U.S. borrower with a non-U.S. subsidiary, effectively limits the ability of the non-U.S. subsidiary to provide a guarantee of the U.S. borrower’s debt or to allow for a pledge of more than 65% of the voting stock of the non-U.S. Subsidiary. This change may cause lenders to now seek changes in credit agreements going forward.
- 20% excise tax on payments to non-U.S. affiliates. The bill would impose a 20% excise tax on certain amounts (not including dividends or interest) paid by U.S. corporations to non-U.S. affiliates that are members of the same international financial reporting group unless the non-U.S. affiliate elects to treat the payment as effectively connected income. This excise tax may, in particular, impact planning by non-U.S. parented multinational groups that have U.S. subsidiaries.
State Pension Plans. The House bill proposes to subject all entities exempt from tax under Section 501(a) to the unrelated business income tax (“UBTI”) rules, notwithstanding an entity’s exemption under any other provision of the Code. The Ways and Means section-by-section summary indicates that this “clarification” is meant to bring state and local government-sponsored entities—such as public pension plans—that are exempt under Section 115(l) within the scope of the UBTI rules. This provision may cause some state pension plan investors to seek to restructure their interest in existing portfolio investments in “operating partnerships” or for which there is “acquisition indebtedness” (including fund-level leverage). However, some state pension plans may challenge the constitutionally of any provision that purports to subject them to U.S. tax.
Changes to Self-Employment Tax. Current law provides an exception from self-employment tax for an individual’s share of income received as a limited partner in a partnership. The House bill would repeal this exception, and instead provide that individuals are subject to self-employment tax on their “labor percentage” of trade or business income, including from pass-through entities. The labor percentage would generally be 100% in the case of a management company. You can read more about this change here.