All change

Debevoise & Plimpton’s Matthew Saronson and Cécile Beurrier examine the House Republicans’ ‘A Better Way’ blueprint and Donald Trump’s campaign tax reform plan for clues on likely changes

With Donald Trump entering the White House in January 2017 and a Republican majority in both houses of Congress, significant tax reform is now widely expected in the United States. Tax legislation could come early in the new administration with Steven Mnuchin, Trump’s pick as Treasury Secretary, saying recently that tax reform would be the first priority.

The starting point for any tax reform discussions is anticipated to be the ‘A Better Way’ blueprint released by House Republicans in June. Trump also released a high-level tax reform plan during the campaign and there are many shared priorities between his plan and the blueprint, as well as some discrepancies, notably on the treatment of carried interest and offshore investments. Some of the proposals in the blueprint and the tax plan involve a radical overhaul of the US tax system and would change many fundamental and long-standing US tax principles governing private equity funds and their investments, such as permitting all business investments to be expensed and limiting interest deductions to businesses. Undoubtedly, it is too early to tell which proposals will be part of any final legislation – after all, the devil is in the detail – but the Blueprint and the tax plan provide clues for the possible changes to the US tax system that would be relevant to private equity funds.


Lowering of tax rates. A central component of the blueprint and the tax plan is a significant reduction in the overall US federal income tax rates. For individuals, the top tax rate on ordinary income would go down from 39.6 percent to 33 percent. Simultaneously, the income tax base would be broadened as some existing deductions and credits would be curtailed, thereby offsetting some of the benefits of the reduction in rates.

Passive income would also benefit from a rate reduction under the blueprint (but not under the tax plan) as the top individual rate on capital gains and dividends would be lowered from 20 percent to 16.5 percent. In a departure from long-standing US tax rules that will be of particular interest for mezzanine funds, interest would also benefit from the 16.5 percent rate and would no longer be taxed at the ordinary income rate.

Consistent with the Republican programme, both the blueprint and the tax plan propose to repeal the 3.8 percent ‘Medicare’ tax on passive income that was introduced in 2013 as part of the healthcare reform in the United States (the Affordable Care Act would also be repealed). The estate tax would be eliminated.

Tax treatment of carried interest. Although the blueprint is silent on carried interest, during his campaign Trump announced his intention to tax carry earned by private equity fund managers as ordinary income and this proposal has been included in his tax plan. Under current rules, carried interest attributable to capital gains is generally taxed as capital gains, so that much of the income is taxed at a maximum rate of 20 percent instead of 39.6 percent. Under the tax plan proposal, however, carried interest would be taxed at 33 percent and would not enjoy the reduced rate of 16.5 percent.

After the recent introduction of the ‘income-based carried interest rule’ in the UK earlier this year that subjects carried interest arising in respect of assets held for less than 40 months to UK tax at a top rate of 47 percent rather than 28 percent, private equity fund managers will no doubt follow any development in this area with interest.


Lowering of tax rates. For US portfolio companies that are corporations, the US federal income tax rate would also be cut significantly from 35 percent to 20 percent under the blueprint, and to 15% under the tax plan. By comparison, the UK has announced its commitment to lowering the corporation tax rate to 17 percent by 2020.

Full deduction for capital investments and limited interest deduction. In addition to the rate reduction, two key proposals could significantly impact taxes paid by US portfolio companies: the first narrowing and the second broadening their income base.
First, US businesses would be allowed to fully expense the cost of investments in tangible and intangible assets, other than land, in the year of acquisition, instead of having to spread this deduction over time by way of depreciation. This upfront deduction would benefit many industries. Second, under the blueprint, interest paid by non-financial businesses would not be deductible, except against interest income (under the tax plan, US businesses would have the option to expense the cost of capital investments upfront, in which case the trade-off would be the non-deductibility of interest).? This new limitation on the deductibility of interest could affect most private equity fund structures, in particular US leveraged buyouts where interest on acquisition financing is used to offset operating income of the target.

Offshore investments. For private equity funds with US businesses operating offshore, the blueprint, and the tax plan to a lesser extent, would fundamentally change the US tax landscape. Initially, existing untaxed earnings held offshore would be deemed repatriated and subject to an immediate and one-time tax at a rate of 8.75 percent for cash earnings and 3.50 percent for other earnings (a single 10 percent rate would apply under the tax plan). Prospectively, the blueprint contemplates that the United States would move from a ‘worldwide’ system of taxation, where a US corporation pays US tax on both its US and non-US income and avoids double tax on its non-US income through foreign tax credits, to a ‘territorial’ system, where the same US corporation would pay US tax on its US income only. Although the territorial system is more commonly used in the G7 and OECD countries, the blueprint is thin on details for transitioning from one system to the other.

Certainly, as far as the US tax landscape is concerned, 2017 promises to be full of surprises.

Matthew Saronson is a partner and Cécile Beurrier an international counsel at Debevoise & Plimpton.