US tax reform was expected to have a number of implications for private fund managers. Among the proposals that have emerged since the 2016 presidential campaign were one to tax carried interest as income and not capital gains, another to charge tax on interest paid on loans and a third to introduce a border tax that would impact the profitability of portfolio companies.
Despite being pegged as a priority for the Trump administration, matters such as healthcare reform dominated the agenda in the first half of the year. But at the end of September, officials released an initial tax reform proposal, giving a few clues as to what lies ahead. We have taken a closer look at the measures that will affect private fund managers.
1.Changes to carried interest
Previous proposal: Donald Trump vowed to close the so-called carried interest loophole, by which carry is taxed at the lower capital gains rate rather than at the income tax rate.
Latest position: While the tax reform framework made no mention of carried interest, White House economic advisor Gary Cohn said Trump remains committed to increasing the rate.
Carried interest is likely to be taxed at income tax rates – but only for hedge fund managers, who rarely operate on a carried interest basis because they hold assets for a shorter period of time. Only about a fifth of the tax break’s gains go to hedge funds, according to research from the University of San Diego, compared with about half which go to private equity and venture capital managers.
Industry view: The American Investment Council, which lobbied against the change, said carry is taxed as capital gains because it demands entrepreneurial risk and represents partnership profits that are appropriately taxed on a “pass-through” basis.
“There does seem to be momentum for changing the taxation of carried interest at least for hedge fund managers, but what the scope of the change will be and exactly who it will affect remains unclear,” Matthew Saronson, tax partner at Debevoise and Plimpton, tells pfm.
2. Interest deduction
Previous proposal: House Speaker Paul Ryan called for eliminating interest deductibility – which means businesses would be taxed on the interest paid on loans – saying that it would raise an estimated $1 trillion over 10 years and help pay for rate cuts and other tax measures. But Trump, along with Treasury secretary Steven Mnuchin, spoke out in favor of continuing to allow companies to subtract interest payments from taxable income.
Latest position: Limits on interest deductibility are likely, and while there are no exact figures yet, the change will have huge implications for private fund managers.
Currently, they can deduct interest expenses from taxable income, which makes the leveraged buyout model attractive. In its annual report, Blackstone, the world’s largest private equity firm, said a change to the rule could force it to adjust its funds’ investment strategies and potentially lead to lower returns for investors. It is likely, however, that the rules will be grandfathered so that they won’t apply to existing debt.
Industry view: The potential for grandfathering could encourage firms to act now and recapitalize, but they are advised to be cautious.
“In the case new rules are grandfathered and do not apply to existing debt, businesses could be encouraged to do a recapitalization,” Jeffrey Chazen, tax partner at EisnerAmper, tells pfm. “[But businesses that recapitalized] could be left exposed if the law is not grandfathered and there is not enough cashflow to pay taxes due to the recapitalization and loss of the deduction.”
The AIC said debt is an essential tool used by companies to grow and finance operations, adding that limiting it would “hurt businesses of all sizes in every industry. Costs of new investments would skyrocket.”
3. Border adjustment tax
Previous proposal: In what would have marked a shift to a territorial system – with a huge impact on portfolio companies reliant on imports – US manufacturers selling domestically and using domestically sourced goods or services would not pay tax, but those reliant on imports would be taxed on any parts they import from outside of the country. It was believed it would “pitch US businesses against each other.”
Latest position: The Trump administration dropped its plan to tax imports to the US and exempt exports on concerns it would lead to higher prices for consumers in May, but committed to “discussions about revisions,” adding it was “not dead.”
Industry view: “In a rare glimpse of clarity, it does appear that the administration has come out against the border adjustment tax,” Saronson says. “I think folks in the market have just been sitting tight and waiting for more concrete proposals rather than attempting to divine what the outcome will be.”
4. Corporate tax cuts
Previous proposal: Trump campaigned on cutting the corporate tax rate from 35 percent to 15 percent on the grounds that it would help job creation. The estimated cost – $2 trillion over a decade – was to be paid for by the border adjustment tax and the elimination of interest deduction. By July, however, it became clear that the cut was too big and it was suggested while the rate would still be lowered, it would be by a smaller amount.
Latest position: The framework proposes cutting corporate tax by 15 percentage points to 20 percent, and businesses would be allowed to immediately write off their capital spending for at least five years. Pass-through businesses would have their tax rate capped at 25 percent. However, keeping these rates lower permanently would cut into other popular tax breaks, such as for research and experimentation, suggesting the reduction may be limited to 10 years.
Industry view: A 10-year corporate tax cut would likely increase the number of private equity deals and the price buyers are willing to pay, but eliminating the deduction for interest expenses may reduce appetite for acquisitions.
“Within 10 years of reduced rates, private equity firms could complete about two deal cycles,” lawyers at Miller & Chevalier Chartered say.
The view ahead
While the framework document provides information on tax rates and certain tax references, it leaves most of the details to the congressional tax-writing committees as they craft legislation. The official line is that the full reform will be signed in by the end of the year, but it is widely understood that this is unlikely to happen, as lawmakers still disagree on key elements of the framework.
In the meantime, private fund managers should continue to “wait and see,” as until the full details are released it is difficult to assess the full impact the new tax framework will have on their businesses.
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