Finding ways to work with US tax reform

A new framework for US tax reform has replaced plans from President Trump and House Republicans. We look at the implications for PE funds

On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act (TCJA). The TCJA will have far-ranging and complex effects on private equity (PE) funds, their investors and portfolio companies. Below we summarise Citco’s insights in six main areas.

Deduction of interest expense 

Under the TCJA, both corporate and pass-through entities will have net business interest expense limitation of 30% of the business’s “adjusted taxable income”, which will include an add-back of depreciation and amortization for the next four years only, resulting in a harsher limitation thereafter. 

Reducing this deduction will decrease PE funds’ returns, as much current tax planning is designed around leverage. Additionally, the value of portfolio companies would be expected to drop because potential buyers would expect to pay less for them. There is no rule for grandfathering existing debt but unused deductions can be carried forward indefinitely. 

Lower tax rates

The TCJA retains the current structure of seven individual tax brackets, but reduces the top rate to 37%, while retaining alternative minimum tax (AMT), which was anticipated to be repealed. However, both exemption amounts and phase-out amounts for AMT purposes have been increased. With the increased exemption, new limitations on state and local income tax deduction, and the repeal of miscellaneous itemised deductions, fewer taxpayers will be impacted by the AMT. Business taxes at the entity level that are reflected in a funds’ partners’ distributive share of income will continue to reduce such partners distributive share. 

The corporate income tax rate has been reduced to 21%. This will reduce incentives for companies to shift profits overseas and also reduce portfolio companies’ tax expenses and the value of the deferred tax assets and liabilities. In some cases, the change in the value of the deferred assets may impact debt covenants. 

Carried interest

The TCJA characterises certain gains with respect to “applicable partnership interest” from long-term to short-term to the extent the gains relate to property held for less than three years. The “applicable partnership interest” is defined to include the general partners of PE and other investment partnerships. However, given that most PE funds hold investments for longer than three years, their general partners would not be affected by this provision. Nonetheless, allocations from funds with shorter holding periods would be impacted and those cases need to be monitored. 

Tax on partnerships’ business income 

The TCJA introduces a 20% deduction for qualified business income from pass-through entities. Qualified income does not include investment type income or “specified service trade or business”, which is defined to include investing and investment management, trading and dealing in securities or partnership interests. Therefore, much of the income of a typical PE fund would not be qualified business income and not eligible for the deduction. 

International provisions

The TCJA will exempt all dividends from foreign subsidiaries. Additionally, repatriation tax on accumulated earnings and profits is introduced, with 15.5% rates on accumulated foreign earnings held in cash and 8% for all other earnings. This tax can be paid in installments spread over eight years. As a result, portfolio companies may need to reassess their cash flow modelling. 

Capital expense 

Under the new rules, taxpayers are permitted to fully expense the cost of new depreciable property, which provides a significant benefit for portfolio companies with high capital expenditures. Depending on the facts, this may partially offset limitations on interest deductibility.

Preparing a strategy

Although the tax reform is comprehensive, the themes above should enable private equity managers to think strategically about some issues to address. There may be significant opportunities to re-structure transactions to maximise the potential benefits and minimise the potential drawbacks of the new rules.

22nd February 2018

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Julia Kogan

Julia Kogan

Executive Vice President – Private Equity Tax, Fund Services

T+1 201 793 5527
Ejukogan@citco.com