January 12 2018
21% corporate tax rate
20% deduction for qualified business income from pass-throughs
Carried interest holding period requirement
Interest expense and NOL limitations
Full expensing for capital expenditures
Repeal of partnership technical termination rule
Expanded inclusion of foreign earnings and participation exemption
Sale of foreign partner's interest as ECI
The 2017 tax reform act, entitled "An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018" (the Act), is now law, leaving private equity and M&A professionals to digest these significant changes and reconcile the new provisions with how they do business. The following is a summary of important features of the Act that will affect private equity and M&A transactions going forward.
Effective for taxable years beginning after December 31, 2017, the Act provides for a permanent reduction of the corporate tax rate from a top graduated rate of 35 percent to a flat rate of 21 percent, as well as a repeal of the corporate alternative minimum tax (AMT).
Aside from the general benefit to corporations from reduced taxes on earnings and gains, the Act diminishes the impact of double taxation on such earnings and gains to shareholders. Specifically, the combined 21 percent corporate rate and 23.8 percent dividend rate should result in an effective combined tax rate of 39.8 percent on dividends paid to individuals, compared to the top federal income tax rate on ordinary income of individuals of 37 percent plus the 3.8 percent Medicare or Net Investment Income tax, if applicable, which itself was reduced from 39.6 percent plus the 3.8 percent Medicare or Net Investment Income tax, if applicable.
This change should reduce the tax impact of asset purchases from C corporations, particularly in instances where other attributes are available to offset gain from such transactions. Moreover, we may see an increased efficiency in the use of C corporations to act as holding companies, particularly in businesses that cannot take full advantage of the 20 percent deduction for qualified business income (QBI) from pass-through businesses, discussed below. A company currently structured as a pass-through LLC may consider "checking the box" to be treated as a C corporation for 2018 and beyond. An analysis of an LLC conversion to C corporation should also take into account state income taxes, including their deductibility by C corporations but not individuals, the extent to which the LLC will reinvest after-tax earnings rather than distribute them to the owners, and the fact that reinvested LLC earnings build up the outside tax basis in the LLC interest.
Additionally, certain "qualified small businesses" structured as C corporations should be even more attractive with the reduced 21 percent rate, given that the reduction of taxable gain from the sale of qualified small business stock remains available and was untouched by the Act.
Lastly, the elimination of the corporate AMT was widely regarded as necessary to avoid a bevy of issues that would have emerged given the reduction of the tax rate to 21 percent. Without the corporate AMT, corporations may be able to reduce effective tax rates below 21 percent with various deductions, the benefit of which would otherwise have been reduced or eliminated if the corporate AMT applied.
The Act allows individuals to deduct 20 percent of qualified business income (QBI) from a partnership, S corporation or sole proprietorship, as well as 20 percent of the total qualified REIT dividends and qualified publicly traded partnership income. QBI is generally taxable income (i.e., the net amount of items of income, gain, deduction and loss) with respect to a trade or business within the United States or Puerto Rico, and excludes passive investment income such as capital gains, dividends and interest income (unless the interest is received in connection with a lending business).
QBI is intended to capture business earnings from capital investment and therefore does not include any amount paid by an S corporation that is treated as reasonable compensation or any guaranteed payments (or other amounts) paid by a partnership to a partner in exchange for services. The contention between the IRS and taxpayers over determination of reasonable compensation of S corporation employee/shareholders and characterization of partnership profits earned by service partners is expected to increase under the Act.
The 20 percent deduction generally results in a net rate on QBI of 29.6 percent plus the 3.8 percent Medicare tax, if applicable. Notably, this effective rate is still lower than the effective 39.8 percent rate applicable to taxable income received as dividends from a C corporation, because there is no additional taxation beyond the 29.6 percent on distributions of QBI from pass-throughs.
The QBI deduction is subject to several limitations and phase outs, and the benefit of the deduction is limited for income from a "specified service trade or business," which includes (but is not limited to) the performance of services in the fields of health, law, financial services, any business principally relying on the reputation or skill of one or more of its employees or owners, and investing and investment management services.
No deduction is generally allowed with respect to the income of a specified service trade or business, unless an individual's taxable income is below an applicable threshold amount, in which case a deduction with respect to such income may be allowed. The specified service trade or business exclusion phases in for a taxpayer with taxable income in excess of the applicable threshold amount, currently $315,000 plus $100,000 for joint filers, and $157,500 plus $50,000 for other taxpayers.
The QBI deduction is applied to partnerships and S corporations at the partner or shareholder level and is effective for taxable years beginning after December 31, 2017, and before January 1, 2026.
The Act extends the holding period to three years with respect to certain long-term capital gain recognized by service providers to investment funds from carried interests, referred to in the Act as "applicable partnership interests." An applicable partnership interest is any interest in a partnership that, directly or indirectly, is transferred to (or is held by) an individual in connection with the performance of substantial services in any "applicable trade or business."
An applicable trade or business is any activity conducted on a regular, continuous and substantial basis that, regardless of whether the activity is conducted in one or more entities, consists (in whole or part) of raising or returning capital, and either investing in (or disposing of) specified investment assets (or identifying specified investment assets for such investing or disposition) or developing specified investment assets. This definition should capture virtually all investment funds. Therefore, the typical carried interest issued to such funds' principals will be subject to this new requirement for any dispositions in 2018 and beyond, regardless of whether the carried interest was issued on or prior to December 31, 2017.
The holding period requirement is generally expected to work in the following manner:
Fund VP holds a carried interest in a fund that was received in connection with the performance of services in 2013. In 2018, Fund VP's net long-term capital gain allocated from the fund attributable to such interest is $20 million. However, only $15 million of that amount is attributable to underlying investments of the fund that have been held in excess of three years. Under this new rule, Fund VP will recognize $15 million of long-term capital gain in 2018, and $5 million of short-term capital gain, which will be taxed at the applicable ordinary income tax rate.
Funds should pay particular attention to the manner in which add-on investments are made by their portfolio companies to ensure, to the extent possible, that they do not lose the benefit of a historic holding period with respect to such investments. Certain add-on investments may result in a bifurcated (or new) holding period that would implicate the application of this rule.
Profits interests issued by an LLC or other partnership entity to an employee of a corporate subsidiary or another entity that is conducting a trade or business (that is not an applicable trade or business), and which provides services only to that other entity, are excluded from this holding period requirement. So, we would expect that most profits interests issued to executives of portfolio companies should be exempt from this change, even if they are held in an LLC owner on top of a corporation.
The fact that an individual may have included an amount in income upon acquisition of an applicable partnership interest, or that an individual may have made a Code Section 83(b) election with respect to an applicable partnership interest, does not change the three-year holding period requirement for long-term capital gain treatment with respect to the applicable partnership interest.
An applicable partnership interest does not include an interest in a partnership directly or indirectly held by a corporation. Therefore, interests in joint ventures between two corporations should generally remain exempt from this holding period requirement, and, subject to further guidance, it appears that interests held by S Corporations should remain exempt as well.
The holding period requirement should not apply to capital interests in any fund to the extent such interest only provides a return commensurate with other capital contributed (as of the time the partnership interest was received). While this exception exempts basic capital interests, it should mean that certain "catch-up" type interests or profits interests embedded in a capital interest will be subject to the holding period requirement.
Under the Act, the net interest deduction is limited to 30 percent of adjusted taxable income, which will generally mean earnings before interest, taxes, depreciation and amortization (EBITDA) for the next four years (2018–2021), and earnings before interest and taxes (EBIT) thereafter (2022 and beyond). This limitation applies to newly issued loans as well as those originated before 2018. The limitations apply to both corporations and partnerships, but businesses with average annual gross receipts of $15 million or less should generally be exempt from the limitation.
Disallowed interest expense can be carried forward indefinitely, but as adjusted taxable income declines, so does the ability to deduct interest. Funds should pay particular attention to the application of these rules to their portfolio companies in cash flow modeling for leveraged companies.
Additionally, the Act limits the deduction for a net operating loss (NOL) to 80 percent of taxable income, determined without regard to the NOL deduction itself. The Act also repeals the carry back of any NOL.
For example, if in 2018 a corporation has a $900,000 NOL, without any other NOL carryovers, and the corporation has taxable income of $1 million in 2019, the corporation's 2019 NOL deduction is limited to 80 percent of such income, or $800,000. The remaining $100,000 of NOL cannot be deducted in 2019, but can be carried forward indefinitely. The NOL cannot be carried back.
This change will affect negotiations regarding the payment of additional purchase price for tax benefits attributable to transaction deductions that give rise to an NOL in the taxable year of the closing of a transaction. The lack of the ability to carry back any such NOL will eliminate sellers' ability to obtain the benefit of refunds of pre-closing taxes paid and will instead require sellers to seek the benefit of NOL carryforwards realized by the buyer in post-closing periods, which will be subject to this new 80 percent limitation, as well as the Code Section 382 limitations, which remain intact.
The Act extends the bonus depreciation rules to allow taxpayers to deduct 100 percent of the cost of most tangible property (other than buildings and some building improvements) and most computer software in the year placed in service, to the extent such property is acquired and placed in service after September 27, 2017 (with no written binding contract for acquisition in effect on September 27, 2017). Such property eligible for bonus depreciation can be new or used as long as it is "new" to the taxpayer. This 100 percent depreciation deduction is decreased to 80 percent for most property placed in service in calendar year 2023, 60 percent in 2024, 40 percent in 2025, 20 percent in 2026, and 0 percent in 2027 and afterward.
The impact of these rules on asset deals will be felt both by buyers, with respect to increased deductions, and by sellers, with respect to increased depreciation recapture recognized on the sale depending on the purchase price allocation for a particular asset subject to these new rules.
Under pre-Act law, a partnership could be deemed terminated in connection with a sale or exchange of 50 percent or more of the total interests in partnership capital and profits. This technical termination caused the partnership's taxable year to close, potentially resulting in short taxable years. Moreover, following a technical termination, partnership-level elections generally ceased to apply, certain attributes may have been lost, and the partnership's depreciation recovery periods restarted. The Act eliminates the technical termination rule, such that a partnership is terminated only if no part of any business, financial operation or venture of the partnership continues to be carried on by any of its partners in a partnership.
This repeal will cause certain acquisitions of partnership interests to result in "straddle" taxable periods overlapping the closing date for the target, which may introduce added complexity in managing tax liabilities between the buyer and seller for any such period. The change should also avoid the acceleration of deferred revenue in connection with such acquisition transactions, which would have previously been recognized upon a termination. This may result in additional purchase price negotiations regarding the economic treatment of such deferred revenue in partnership transactions.
The Act requires current inclusion by certain US shareholders of a controlled foreign corporation's taxable income exceeding a specified return on the corporation's tangible personal property, and establishes a participation exemption for certain income distributed or deemed distributed by foreign corporations to United States shareholders. The participation exemption is implemented partly through a deduction for certain dividends received from foreign corporations and partly by providing the same deduction in connection with sales of stock of certain foreign corporations that would otherwise be treated as dividend equivalent.
More specifically, under the Act, a domestic corporation is allowed to deduct foreign source dividends received from a specified ten percent owned foreign corporation held for one year or more. In general, a specified ten percent owned foreign corporation is any foreign corporation with respect to which a domestic corporation is a United States shareholder other than a passive foreign investment company. Unlike under pre-Act law, however, the domestic corporation cannot claim a credit or deduction in the United States with respect to any foreign tax paid with respect to such dividend.
In addition, under the Act, a deduction is provided for sales of stock of certain foreign corporations held for one year or more. Under pre-Act law, certain Code provisions recharacterized as dividends certain capital gain from sales of stock of certain foreign corporations. Under the Act, although a US shareholder remains subject to capital gains tax on sales of stock of certain foreign corporations, a US shareholder can now claim a deduction to the extent that the Code recharacterizes such gains as dividends.
The Act expands the categories of undistributed income that are taxed to US shareholders. Undistributed income (referred to as global intangible low-taxed income, or GILTI) is defined to include operating income of foreign subsidiaries in excess of a rate of return on tangible business assets owned by those subsidiaries. US corporations can offset GILTI inclusions with deemed paid foreign tax credits in some instances.
These changes will cause US corporations disposing of foreign assets to be more likely to prefer sales of stock over sales of assets, while US purchasers will continue to prefer to purchase assets. As described above, sales of stock of foreign subsidiaries can in some instances be recharacterized as dividend equivalent transactions for which the US corporation can claim dividends received deduction. On the other hand, if a US corporation's foreign subsidiary sells assets to a purchaser, gain recognized as a result of such sale will typically result in an increase in the amount of income subject to inclusion as GILTI. While a US corporation may have sufficient foreign tax credits or other attributes to offset such an amount, it will likely want to carefully evaluate whether a disposition of stock of the foreign subsidiary would result in less tax.
The Act generally treats individual and pass-through owners of foreign corporations significantly less favorably than C corporation owners. Funds that own portfolio companies in pass-through form accordingly will consider owning their foreign subsidiaries through US C corporations. The Act expands the definition of foreign corporations subject to the rules, so that funds using alternative investment structures through foreign partnerships to avoid controlled foreign corporation status should review those structures.
The Act provides that if a foreign partner owns, directly or indirectly, an interest in a partnership that is engaged in any trade or business in the United States, gain or loss on the sale or exchange of such interest is generally treated as income effectively connected with the conduct of a US trade or business (ECI), and such ECI is taxable to such foreign partner. This provision makes clear that the tax-free treatment in such context, as set forth in the 2017 Grecian Magnesite decision, will not apply to sales, exchanges and dispositions on or after November 27, 2017, and codifies the treatment described in Rev. Rul. 91-32. Any planning that was initiated in order to take advantage of the treatment outlined in Grecian Magnesite to avoid ECI on a disposition of a partnership interest should be reconsidered.
While many tried and true principles of structuring private equity and M&A transactions remain intact, the Act has thrust a new regime upon tax practitioners as well as private equity and M&A professionals, with many new and different provisions to explore. Undoubtedly, the text of the Act will be modified with technical corrections and buttressed by voluminous guidance issued by the US Department of the Treasury and the Internal Revenue Service in the coming months.
For further information on this topic please contact Alejandro Ruiz at McDermott Will & Emery's California office by telephone (+1 650 815 7400) or email (email@example.com). Alternatively, contact Jay M Singer at McDermott Will & Emery's Washington DC office by telephone (+1 202 756 8000) or email (firstname.lastname@example.org). The McDermott Will & Emery website can be accessed at www.mwe.com.
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