The new tax law introduced as the Tax Cuts and Jobs Act (TCJA) includes considerable changes to the Internal Revenue Code that will impact the private equity and venture capital industries. The majority of the changes are effective Jan. 1, 2018, but some of the changes will have an impact on 2017 taxes as well. Private equity and venture capital firms should understand how the changes will impact their business, including the impact to their funds, investors, underlying investments, current and future tax structuring, as well as their management company. Firms should develop a course of action to address the changes imposed by the TCJA that will affect areas such as effective tax rates, preferred operating and acquisition structures, and the potential need for additional K-1 disclosure.
The following provisions of the TCJA are the most relevant to private equity and venture capital companies:
- Section 965 transition tax,
- 100 percent dividends-received deduction,
- Stock attribution rules,
- Carried interests,
- Limitations on interest expense deductions,
- IRC Section 199A – Deduction for qualified business income of pass-through entities,
- Bonus depreciation,
- Reduction in tax rates for corporate and individual taxpayers, and
- Sourcing the gain from the sale of a partnership interest.
Section 965 Transition Tax
TCJA implements a transition tax in an effort to move the U.S. to a territorial-like tax regime. Section 965 imposes a one-time tax on a 10 percent or greater U.S. shareholder’s share of most post-1986 accumulated and previously untaxed foreign earnings and profits (E&P) of a specified foreign corporation, regardless of whether such profits are actually repatriated. A specified foreign corporation is defined as a controlled foreign corporation (CFC), or another foreign corporation having a U.S. corporate shareholder with at least 10 percent ownership. The mechanism for imposing this transition tax is an additional Subpart F inclusion on the U.S. shareholder’s tax return for the last taxable year that begins before Jan. 1, 2018. For a calendar-year taxpayer, this will affect the 2017 U.S. federal tax return filing.
Deemed repatriated earnings held in cash and cash equivalents will be taxed at 15.5 percent and remaining earnings held in illiquid assets will be taxed at 8 percent for any shareholder that is a U.S. corporation. For individual shareholders, deemed repatriated earnings held in cash and cash equivalents will be taxed at 17.5 percent, and the remaining earnings will be taxed at 9.05 percent (a partial foreign tax credit is allowed in proportion to the taxable amount of the repatriated earnings for 10 percent U.S. corporate shareholders). U.S. shareholders may elect to pay this one-time tax in installments over a period of eight years: 8 percent of the liability in each of the first five years, 15 percent in the sixth year, 20 percent in the seventh year, and 25 percent in the eighth year. A special provision for S corporations defers the tax until the S corporation sells substantially all of its assets, ceases to conduct business, changes its tax status, or the electing shareholder transfers its stock.
This provision could potentially affect portfolio companies and certain fund structures that directly or indirectly hold investments in foreign subsidiaries. The transition tax will impact immediate and future cash flows and thus influence the valuation of investment portfolios.
Private equity and venture capital funds will face challenges in determining which of their foreign investments are considered specified foreign corporations under the TCJA whose E&P will be subject to deemed repatriation under Section 965. Funds will need to understand the indirect ownership of their investments in foreign corporations by U.S. corporate investors within its ownership structure on a look-through basis. In circumstances where a U.S. corporate partner is deemed to hold a 10 percent or more interest, directly or indirectly, in a foreign corporation, the foreign corporation may be considered a specified foreign corporation. A fund may determine that its constructive ownership would not deem the foreign corporation to be a specified corporation. However, in this circumstance, the fund will need to confirm that the foreign corporation is not considered a specified foreign corporation due to an unrelated, third-party U.S. corporate owner owning 10 percent or more of the foreign corporation.
For example, consider a situation where a U.S. fund with a 30 percent U.S. corporate partner owns a 40 percent interest in a foreign corporation. The U.S. corporate partner in the fund is deemed to own 12 percent of the foreign corporation and thus would cause the foreign corporation to be a specified foreign corporation under Section 965. This would require the U.S. fund to have to include additional Subpart F income to the extent of its share of the foreign corporation’s post-1986 undistributed E&P. Another example illustrates how the definitional rules of Section 965 pose a potential trap. Suppose the U.S. fund owns 40 percent of the shares in a foreign corporation, but none of the U.S. funds’ partners constructively own 10 percent or more of the foreign corporation. However, assume that another, unrelated U.S. corporation directly owns 10 percent of the foreign corporation. This could cause the foreign corporation to be a specified foreign corporation with respect to the U.S. fund, and the U.S. fund would have to include in Subpart F its share of the foreign corporation’s post-1986 undistributed E&P.
Funds with specified foreign corporations will then face the challenge of obtaining all of the necessary information from these entities in order to be able to calculate the amount of their Section 965 inclusion.
100 Percent Dividends Received Deduction for Foreign Source Income
The transition to a territorial-like tax regime means that U.S. corporations will no longer be taxed on certain non-U.S. income, under rules similar to the so-called participation exemption used in a number of foreign countries. More specifically, a U.S. corporation that owns 10 percent or more of a foreign corporation—other than a passive foreign investment company that is not also a controlled foreign corporation—is entitled to a 100 percent deduction for the foreign-source portion of dividends received from such a corporation. Under a similar concept, constructive dividends arising from a U.S. corporation’s sale or exchange of stock in a foreign subsidiary held for more than one year will be treated as a dividend for purposes of this 100 percent dividends-received deduction. Any foreign income taxes attributable to the income that gives rise to the dividend will not be eligible for the foreign tax credit or deduction. All amounts eligible for the 100 percent dividends-received deduction will reduce the U.S. corporation’s basis in its stock of the foreign corporation for purposes of determining any loss on the eventual disposition of such stock. This deduction is only available to C corporations that are not regulated investment companies (RICs) or real estate investment trusts (REITs).
Stock Attribution Rules
TCJA modifies the stock attribution rules for determining controlled foreign corporation status, so that a U.S. taxpayer may now be treated as constructively owning stock held by its foreign shareholders. This change will be effective for the last tax year of foreign corporations beginning before Jan. 1, 2018 and all subsequent years and for the taxable years of U.S. shareholders in which such taxable years of foreign corporations end.
In addition, the TCJA extends the definition of a U.S. shareholder to include a U.S. person who owns 10 percent or more of the total value of shares of all classes of stock of a foreign corporation; the ownership is thus no longer tied solely to voting power. The TCJA also eliminated a requirement that a foreign corporation must be a controlled foreign corporation for an uninterrupted period of 30 days in order for its U.S. shareholders to be subject to Subpart F inclusions.
These changes will require private equity and venture capital funds to review their organizational structures to establish which of their foreign investments meet these new definitions of CFC. This will determine where filing of informational returns is required with respect to certain foreign corporations in the structure. In Notice 2018-13, the IRS indicated that it intends to amend the filing requirements for Form 5471 to exclude certain Category 5 filers from having to file a Form 5471 as a result of the TCJA’s changes to the attribution rules.
Beginning in 2018, TCJA will limit the availability of long-term capital gain treatment attributable to a carried interest. Generally, in order for a taxpayer to receive long-term capital gain treatment related to a gain with respect to a carried interest, the holding period of the property sold must be greater than three years. Firms need to consider the holding period impact of making add-on investments with respect to investments in underlying assets. The holding period of the add-on investment will begin on the date that the additional funding occurs.
This holding period rule does not apply to carried interests (i) held by a corporation or (ii) that provide for a return commensurate with capital contributions made by the interest holder, or with amounts included in the holder’s income as compensation under Section 83. Gains related to carried interests that do not meet the three-year holding requirement will be reported by the taxpayer as short-term capital gain.
The application of the holding period rule is not entirely clear when considering a sale of a partnership carried interest. While it may appear that the holding period rules would apply to the sale of a partnership carried interest, additional interpretive guidance may clarify current uncertainty.
Limitations on Interest Expense Deductions
Beginning in 2018, the TCJA will generally limit the annual deduction of net business interest expense by a taxpayer to its interest income plus 30 percent of the entity’s adjusted taxable income, and any floor plan financing interest (if applicable). The limitation is calculated at the entity level and disallowed business interest deductions are carried forward indefinitely. Adjusted taxable income excludes non-business items and is defined similar to EBITDA for taxable years beginning after Dec. 31, 2017 and before Jan. 1, 2022. For tax years beginning after Dec. 31, 2021 adjusted taxable income is defined similar to EBIT.
A special rule prevents the double-counting of adjusted taxable income across multiple tiers of pass-through entities. Interest expense that is not allowed as a deduction by the partnership is allocated to its partners and can be carried forward by the partners indefinitely. The taxpayer can utilize the interest expense when there is sufficient adjusted taxable income. Disallowed business interest expense reduces each partner’s basis in the partnership, but any amount of unused, disallowed interest expense is recaptured back into basis immediately prior to their disposition of the partnership interest.
The limitation of interest expense deductions will increase the cost of capital, particularly in the private equity sector where a significant amount of debt is often used to acquire a target company. It may also reduce the benefit of using blocker entities to shield foreign and tax-exempt investors from adverse U.S. federal tax consequences that would result from direct investments in such funds. This may cause private equity funds to reconsider how they finance acquisitions to avoid the payment of interest.
TCJA provides several exceptions to the business interest expense limitation. The limitation of business interest expense does not apply to certain small businesses. Generally a small business is an entity whose average annual gross receipts over a three-year period ended with the prior tax year does not exceed $25 million. Additionally, certain other types of entities, such as certain real estate businesses and certain farming businesses may elect out of the interest expense limitation. An entity that elects out of the interest expense limitation would be required to depreciate certain types of property using the alternative depreciation system (ADS).
IRC Section 199A – Deduction for Qualified Business Income of Pass-Through Entities
TCJA adds Section 199A in an effort to better align the effective tax rates for owners and investors of pass-through entities with the newly reduced corporate tax rate. Beginning in 2018, Section 199A provides a 20 percent deduction from a taxpayer’s allocation of qualified business income from an investment in a qualified business. For purposes of Section 199A, qualified business income is generally the net ordinary income earned by a domestic pass-through entity conducting a qualified trade or business. Please note, specified service providers in the fields of health, law, accounting, consulting, financial services, any trade or business where the principal asset of such trade or business is the reputation and skill of one or more employees, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities will not be treated as qualified businesses under Section 199A.
The investment income that most private equity and venture capital funds generate will not meet the definition of qualified business income under Section 199A, and thus the tax savings opportunity provided by Section 199A will not result in a widespread benefit to private equity and venture capital investors. However, there may be some opportunity for benefit under Section 199A for private equity and venture capital investors in tiered structures, where the fund or an alternative investment vehicle has an investment in a lower-tier pass-through entity that generates qualified business income.
For property placed into service after Sept. 27, 2017 and before Jan. 1, 2023, the TCJA increases the bonus depreciation percentage from 50 percent to 100 percent. In addition, the definition of qualified property was expanded to include in-use assets, which would now allow the use of bonus depreciation in asset acquisitions. Taxpayers may elect to claim 50 percent or no bonus depreciation instead of utilizing the 100 percent deduction. In 2023, the 100 percent rate begins to drop by 20 percent per year until it is eliminated in 2027.
Individual and Corporate Tax Rates
Beginning in 2018, a reduction of marginal tax rates will take effect. The highest marginal tax rate will be reduced from 39.6 percent to 37 percent. The tax brackets and corresponding rates will vary based on the taxpayer’s filing status. The reduction of individual tax rates is currently set to expire in 2025.
Please note that the maximum marginal tax rate on long-term capital gains received by individual taxpayers remains at 20 percent. Additionally, the net investment income tax (3.8 percent) remains in place under the TCJA.
The TCJA permanently reduces the top corporate income tax rate from 35 percent to a flat 21 percent. The 21 percent rate is effective Jan. 1, 2018 with non-calendar year corporations subject to a blended rate for the taxable year that includes Jan. 1, 2018. In addition, the TCJA eliminates the corporate alternative minimum tax (AMT).
The TCJA’s lower corporate tax rate will likely reduce the inherent tax inefficiency of using U.S. blocker corporations. Generally, the overall effective tax rate of a U.S. blocker corporation would likely be lower in many cases than under prior law thus reducing some of the negative tax considerations.
Sourcing the Gain from a Sale of a Partnership Interest
Under the TCJA, gain recognized by a non-U.S. investor on the sale of a partnership interest is subject to U.S. tax as “effectively connected income” (ECI). The ECI portion of the gain is determined in proportion to the U.S. trade or business assets held by the partnership. The IRS’s longstanding position was recently called into question when the Tax Court held against the IRS on this issue in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner of Internal Revenue. The tax is effective for sales, exchanges, and dispositions that occur on or after Nov. 27, 2017.
The TCJA also requires a buyer of an interest in a partnership with ECI assets to withhold 10 percent of the seller’s amount realized unless the seller can verify it is a U.S. person. If the buyer does not satisfy this withholding requirement on the purchase, the consequences will be significant. The partnership is then required to withhold from the buyer’s distributions the amount, including interest, that the buyer failed to withhold. This withholding rule is effective for sales, exchanges, and dispositions that occur after Dec. 31, 2017.
Technical Terminations of Partnerships
Effective in 2018, the TCJA permanently repeals the rule related to partnership technical terminations. The repeal of this rule will allow for partnerships to continue through ownership changes without resetting depreciation periods. This change will also remove the requirement for the partnership to establish new elections.
Net Operating Losses and Excess Business Losses
The TCJA will place limitations on the use of net operating losses (NOLs). This may affect the valuation of entities generating NOLs. Historically, a target company’s NOLs may have been considered valuable because NOLs could be carried back two years and carried forward 20 years to offset a business’s corporate alternative minimum tax (AMT). Under the TCJA, the corporate AMT is repealed, and NOLs for individuals and businesses are limited to 80 percent of taxable income for losses arising after Dec. 31, 2017. In addition, the elimination of the carryback provision may be a disadvantage to sellers who are looking to capture the tax benefit of transaction cost deductions which create an NOL in the pre-acquisition year, as they will no longer be able to carry back that NOL to offset income earned in prior taxable years.
Business losses for individuals are limited to $250,000 per year ($500,000 for joint returns) for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026. Disallowed losses are added to the individual’s NOL carryforward. The limitation applies to the aggregate of all personal and pass-through losses generated for the year. As a result, this provision effectively prevents individuals from deducting losses from a management company or pass-through portfolio company in excess of these levels.
For more information on how the new tax law affects you, your business, or a contemplated transaction please contact us.
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