US tax: The obstacles ahead

Part 1:

Show me the substance!

The US government has codified its doctrine of 'economic substance', a symbolic move that seems to leave private equity in the clear, but maybe not indefinitely. 

It may not have been fodder for gossip in most office settings, but the codification of what’s known as the “economic substance doctrine” in March 2010 was something to talk about across US law firms’ tax practices. Codification did little in terms of clarifying what tax strategies might create blips on the taxman’s radar, but what it did do was conglomerate decades-worth of case rulings into a tidier package. It also strengthened the test tax planners needed to meet if called to demonstrate a transaction was done for more than just tax savings. The tax practitioner community immediately began wondering if the law was a precursor to a more aggressive IRS, though the tax authority stressed it was business as usual.

Two years out and there’s reason to believe the claim, but there’s still reason for scepticism. President Obama certainly made tax reform (and more emphatically tax evasion) a central component of his successful 2008 bid for the White House, and voters will have a chance to grade his ability to keep campaign promises at the ballot box come this November. Indeed, Obama’s latest budget proposal is a bold reminder the President is hardly one of the industry’s greatest tax allies.

Assuming an election cycle and indebted state coffers results in a tax authority with more bite, are there any popular private equity tax planning strategies that could come in the crosshairs? The answer, perhaps surprisingly, is not so much, according to several US tax lawyers with a private equity bent.

“Private equity firms take considerable care in their tax planning and are generally risk-averse in their strategies,” says David Schnabel, a tax partner at law firm Debevoise & Plimpton, who explains private equity firm’s conservative approach in structuring transactions leaves a strong trail of evidence demonstrating substance. 

Steve Bortnick, a tax partner at Pepper Hamilton, agrees but qualifies his answer by saying some in the market are questioning the use of “blocker corporations”. The appeal of blocker corporations is discussed in detail in the following section, but the crux of the matter is that their use has been left untouched at the moment based largely on precedent. Bortnick explains the IRS has ruled in the past that blocker corporations satisfy the substance test, but if the tax authority were to review the structure with a fresh pair of eyes today, it’s no guarantee they would continue being rubberstamped. 

Some in Congress are certainly questioning their veracity with a greater pitch. A “sham” is how Senator Carl Levin, a vocal critic of perceived tax abuses, described the use of blockers to IRS Commissioner Doug Shulman at a Senate hearing earlier this year on mutual funds. “Thankfully, in response, the Commissioner indicated he felt that there were better ways to deal with Levin’s concerns, and was very reluctant to apply the economic substance doctrine to attack blocker entities,” says Bortnick. 

But if the Commissioner’s view were to change, it wouldn’t be unprecedented: “GPs and practitioners got a real surprise when the IRS mentioned that a common planning tool used when acquiring S corporations [small businesses that are taxed more like partnerships than corporations] may fail the economic substance test,” says Bortnick. 

In other words, the IRS is not afraid to bare its teeth, leaving perhaps some scope of uncertainty for GPs’ tax planning strategies. 

Part 2:

The Obama factor 

In what could be political posturing by the US president, the White House’s 2013 budget takes direct aim at tax-deductible interest payments but considers leaving a tax hike on stake sales off the table

There are four major takeaways particularly important to private fund managers in President Obama’s 2013 fiscal year budget.

One is letting the Bush tax cuts expire, which is sure to eat into fund managers’ take home pay (see boxout). But at this stage the proposal is just that, and many sources said the chance for any major tax legislation becoming law before the November elections is low – but not impossible. A battle over raising the debt ceiling is expected to reignite sometime this year as federal borrowing begins to bump up against its new $16.4 trillion limit. And some commentators say it is possible a Republican-controlled house might compromise on their puritan-like objection to tax cuts if it means spending cuts elsewhere in the budget. 

Speaking of tax hikes, another important takeaway is something Obama has made a regular feature of in his budget proposals: the tax treatment of carried interest. Carry is taxed under a 15 percent capital gains rate, but Democrats, led by the Obama administration, say it should be treated as ordinary income, subject to a top income tax rate of 35 percent. Republicans have been able to thus far block the switch-up, but market rumours are forming that this year Democrats may have accumulated enough political sway (read Romney) to finally gain an edge on this never ending legislative battle. If so, the White House estimates some $13 billion in tax revenue over a ten year period, a figure ratcheted down from earlier budget estimates. 

Barack Obama

The third takeaway is the President’s pitch to lower the deductibility of interest payments on corporate debt, the lifeblood of most private equity firms. The proposal was short on specifics, but a reform of any calibre would likely have a widespread effect given the importance of leverage in the industry’s development. On the plus side, the President attempted to sweeten the deal by reducing the corporate tax rate from 35 percent to 28 percent, though it’s unlikely for many firms that a lower corporate tax rate would offset the pain resulting from a weakened debt tax shield. That, alongside Obama’s recent effort to increases taxes on divided income, could also make dividend recapitalisation strategies less attractive – but until specifics are unveiled, sources say it’s hard to pin down to what extent. 

Lastly, in what is a spot of good news for GPs in the budget proposal, the president concedes a so-called “enterprise value tax” should be left out of the carry tax debate. Enterprise value relates to the goodwill behind a private equity firm’s identifiable brand – i.e. the value of the partnership above and beyond its physical assets.

In plain terms, past proposals would have seen buyout firm founders paying a partial ordinary income tax rate on the goodwill value of the partnership when selling some or all of their holdings to outside investors, for example through an initial public offering. Unsurprisingly the industry lashed out at the motion, correctly arguing such a tax applies to no other entrepreneur who starts and eventually sells a business. 

The Obama administration signalled its agreement in the proposal, saying it would attempt to work with Congress “to ensure more consistent treatment with the sales of other types of businesses”. A bill floating in Congress to raise taxes on carry, sponsored by Representative Sander Levin, makes a similar concession, which in less blunt language admits that private equity firm founders deserve equal treatment under law. 

In practice, the buyout industry remains sceptical that enterprise value can be effectively separated from the firm’s carry and other assets. Because enterprise value is difficult to pin down, the industry argues, no one is ever really sure which part of a gain on the sale of a ownership interest should be attributable to future carry streams (and thus taxed as ordinary income), and which is part of the firm’s goodwill (to be taxed a capital gain).

“Democrats want everyone to believe this problem is solved in order to get public opinion on their side”, gripes one industry lobbyist who believes Democrats are willing to forgo an enterprise value tax if it means greater support for their goals on carry.    

To be sure, the proposals are in one sense a political messaging piece for the Obama administration and will likely undergo significant change before the budget becomes law. But what the proposals do is carve a line in the sand, and explicitly lay out the President’s agenda on tax. So as the budget goes through the assembly line that is Congress, the private equity industry is starting out with a handicap on tax matters. 

Part 3:

Shoring up tax status

While tax-exempt investors may find it clever to invest through an offshore company, other types of LPs may find themselves in a more favourable tax position by staying rooted onshore.

If you are a private equity investor who enjoys tax-exempt status (which includes pensions and university endowments), a major element of your tax planning strategy is to avoid unrelated business income tax (or UBIT). As its name suggests, UBIT is a way of throwing tax on an organisation that undertakes business activity which is unrelated to its tax-exempt purpose. 

For unclear reasons (admit tax specialists) debt-financed income is interpreted UBIT. Invest through a flow-through partnership performing a leveraged buyout, and it was as if the pension fund itself borrowed the money to acquire the company, thus becoming subject to UBIT. 

A simple yet elegant solution to the problem is to set up a foreign corporation in a low tax offshore financial centre (such as Cayman). The beauty here is to have the offshore company lay claim to any “debt-financed income”, and then churn out IRS-approved dividends for tax-exempt LPs. By doing so, the LPs effectively create a ‘blocker corporation’ between them and the leveraged buyout.

Seems like a nifty trick designed to avoid UBTI tax, but multiple sources agreed there wasn’t much chance the IRS would begin throwing cold water on the strategy as of now. The main reason they cite? It’s always been done that way; it’s standard practice; the IRS sees little need to disrupt an established market practice; and so forth. Fortunately for UBTI-conscious LPs more practical justifications exist, as an appeal to tradition may not exactly be the most comforting rationale for what is undoubtedly a core component of their tax planning strategy.

Perhaps most importantly, investing in an offshore blocker provides the investor greater liquidity. It’s never a frictionless process backing out of a closed-end private equity vehicle. But exiting a holding company is something the LP can exercise at a moment’s whim. On whole, tax authorities may look to this added liquidity as showing ‘substance’ within the offshore corporation. 

In addition, the use of a foreign blocker can reduce LPs’ tax burden at the individual level, says David Miller, a tax partner at Cadwalader, Wickersham & Taft. The tax code, at both the federal and often state level, restricts the ability of high-income investors from claiming fund fees as a deduction, but using a foreign company can often permit the investor to effectively deduct said fees.

A similar tactic can be used by investors if Obama is able to convince Congress to pass a law requiring high income earners to pay at least 30 percent of their income in federal taxes by restricting their ability to claim deductions (known colloquially as the Buffett Rule). Offshore companies on the other hand can claim all the allowable deductions they want. If the law passes, “investing through a foreign corporation is going to be the next big trend for high net worth taxpayers”, predicts Miller. 

But as of now, Debevoise’s David Schnabel sees less potential in offshore blockers for LPs unconcerned with UBTI, noting that often “the downside outweighs the upside” for taxpayers. The chances of being taxed under ordinary income rates can be higher in blockers; there is an incremental 30 percent withholding tax on US sourced dividends; and net losses from the investment in a given tax year can become trapped in the blocker, he explains.

“I don’t think there is going to be any rush of US taxpayers using this as a tax strategy anytime soon,” says Schnabel, briefly pausing for a moment of thought before making his prediction. If it does become the next big trend, it’s easy to assume tax authorities would be looking on from their onshore headquarters with interest.