Tax Reform’s Impact on Investment Funds
Jan. 18, 2018
On Dec. 22, 2017, President Donald Trump signed into law the most sweeping tax policy changes since the 1986 Tax Reform Act. While the bill primarily addresses the reduction of corporate and individual taxes, a number of provisions will affect the broader investment fund community. Following are the most noteworthy of the provisions that will have an impact on fund taxation.
Carried Interest Taxation
Historically, fund managers have enjoyed pass-through treatment on the character of income from a fund. That is, if the fund generated long-term capital gains (for instance, from the sale of portfolio securities held more than one year), the manager would enjoy capital gain treatment with respect to its carried interest in the fund. If the fund generated ordinary income or short-term capital gains, the manager would pay tax at a higher rate for its carried interest. Under the new law, when a fund holds an investment for less than three years, the manager generally will pay at ordinary income tax rates even if the asset meets the one-year long-term holding period. Due to the nature of hedge fund managers’ respective investment strategies, this provision likely will have a greater affect on them than it will on most private equity and venture capital fund managers.
Pass-Through Entity Deduction
The new law introduces a limited 20 percent deduction on certain qualified income from a fund. The requirements imposed by the deduction (found in the new Section 199A) are extensive and generally unavailable in most fund settings. However, for individual investors in a fund that holds certain pass-through investments (such as portfolio companies generating qualifying business income within a partnership or limited liability company), the new deduction effectively could lower the tax rate on fund income to a maximum 29.6 percent. Note, though, that the pass-through entity deduction is not available to reduce the 3.8 percent net investment income tax.
Interest Expense Deduction Limitation
Beginning with the 2018 tax year, the deductibility of business interest is limited to the sum of business interest income and 30 percent of a taxpayer’s adjusted taxable income (effectively earnings before interest, taxes, depreciation, and amortization (EBITDA) through 2021 and earnings before interest and taxes (EBIT) thereafter). Often, when a fund complex employs so-called blocker entities within its structure, it uses the blockers to reduce any resulting U.S. tax leakage. This new limitation could reduce the utility of using such blockers (although other provisions found in the new law might enhance the use of blockers). This provision also will affect the investments of a private equity or venture capital fund to the extent a portfolio company itself is leveraged.
Treatment of Non-U.S. Partners Upon Sale of Interest in U.S. Fund
The new law resolves a longtime debate by codifying the IRS’ position that the sale of an interest in a partnership engaged in a U.S. trade or business effectively generates connected income for a non-U.S. holder of such interest. Accordingly, a foreign investor in a U.S. fund potentially will face new withholding obligations upon a sale of its interest in the fund. The withholding obligation initially is imposed on the transferee of an interest, but that burden shifts to the fund as it makes distributions to a foreign investor if the initial withholding is not made.
Reduction of Corporate Tax Rate, Limitations on Use of NOLs, and Immediate Expensing of Capital Expenditures
The top corporate tax rate now stands at 21 percent (down from 35 percent). For capital expenditures made after Sept. 27, 2017, taxpayers now generally are permitted to immediately expense the expenditure. However, net operating losses (NOLs) no longer may be carried back. In fact, using NOLs generated in 2018 or later years generally is limited to 80 percent of taxable income. NOLs generated in 2017 and earlier years, however, still can offset 100 percent of taxable income. The reduced tax rates will be welcome news for an investment fund with corporate portfolio investments, as will a portfolio investment’s ability to expense immediately amounts spent in a capital-intensive enterprise. However, the reduced rates might affect the valuation of a portfolio company’s tax attributes going forward and should be considered in portfolio transaction planning. Similarly, the limitation on NOLs might have an effect on the tax drag on C corporations, including blockers.
Overall, the new tax law presents welcome opportunities for investment funds. With appropriate planning, the additional burdens presented by the new law should be manageable.