It proved to be a busy 2018 as private equity started trying to understand the myriad changes of the new US tax law. President Trump signed into law at the end of 2017 the Tax Cuts and Jobs Act, which unleashed reforms ranging from the reduction in the top corporate tax rate to raising the length of ownership of an investment to qualify for long-term capital gains tax.
Indeed, the start of the year gave way to interpreting the impact of the tax law, and there’s still much guidance needed from the tax authorities.
Lower tax rates
The reduced corporate tax rate in the US was much trumpeted by Wall Street, with enthusiasm spilling over onto private equity. Ares Management took the plunge to convert to a C-corporation from partnership, to take advantage of the reduced corporate rate — to 21 percent from 35 percent. That move was followed by KKR, though KKR said its reason was to broaden ownership of its stock.
Other firms stood on the sidelines, waiting to see how Ares and KKR’s stock fared, and wisely so. The luster from making the move proved fleeting. Shares of Ares and KKR popped in the weeks following the move, only to move back to levels prior to the switch.
In hindsight, firms that weren’t swayed by the allure of lower corporate tax rates were proven correct in avoiding the rush to switch. Apollo Global Management remained unconvinced of the C-corp conversion, but it hasn’t discounted the idea.
“If we think we can create value… for our shareholders, we’re going to do it. That’s really as much as I can say at this point,” Apollo co-founder Josh Harris said in late October.
Aside from the C-corp switch, CFOs were seeking advice on other aspects of tax reform. The holding period for carried interest was increased to three years from one, but there wasn’t much of a pushback from firms, which tend to hold their investments for long timeframes. Still, firms continue to wait for guidance from the Internal Revenue Service for clarification on certain measures, such as tax breaks for qualified business income.
While Congress failed to take a stance on closing the loophole on the capital gains tax, states such as California introduced legislation calling for a 17 percent tax on capital gains, which combined with the federal rate would bring the total tax rate on par with the highest personal income tax rate, at 37 percent. California has shown itself to take the initiative in matters relating to private equity, and that has put the industry on their toes.
Elsewhere in the world, Sweden went ahead and raised the tax on carried interest, ending a decade-long legal battle that pitted a number of big Nordic private equity firms against the country’s tax authority. Time will tell whether Swedish firms will move out of the country and seek domiciling in tax-friendly jurisdictions.
Speaking of jurisdictions, funds that were based in the UK found themselves having to comply with the Alternative Investment Fund Managers Directive if they wanted to continue doing business in the EU. Luxembourg and Ireland were seen as popular destinations to domicile. Luxembourg had the support business in place for any firm to set up jurisdiction within its borders. Need a fund administrator? Got those. Looking for a favorable regulatory environment? It’s there, too.
Other jurisdictions have been nipping at the heels of investors as the UK prepares to secede from the EU in March 2019. Ireland touts its fast approval timeframe – 24 hours. Jersey has its status as a national private placement regime, which allows firms to skirt the passporting regime.
Some CFOs felt that regulation was becoming more strict in Europe than in the US, where regulators were looking to ease back on private equity. Regulation in Europe was on investors’ minds from the start of the year, as the EU’s data privacy law, known as General Data Protection Regulation, went into effect in May. Firms had to comply with protecting the data of their clients and their employees, lest they risk being penalized by regulators. Rather than wait for the US government to implement a similar law across the nation, California took the initiative to pass its own data privacy law which is set to go into effect in 2020.
Just as California was taking bold steps through its legislation, the Securities and Exchange Commission looked to be clawing back certain aspects of the Volcker Rule under the Dodd-Frank Reform and Consumer Protection Act. Specifically, the agency was open to the possibility of eliminating restrictions that prohibit banks from investing in private equity funds.
At the same time, staff reductions at the SEC continued, putting into question the effectiveness of overseeing private equity as it wished it could. Better oversight could have helped prevent the collapse of The Abraaj Group. As a result, some CFOs say they are getting pushback from investors, which are starting to asking for more detailed information from general partners on how their money is being managed. To boost transparency, the Institutional Limited Partners Association launched a template on portfolio company metrics to enable GPs to provide more consistent and comparable information to LPs regarding portfolio company development. That’s been part of ILPA’s push on transparency from GPs, even going so far as sending a letter to the SEC to consider changes during the agency’s rulemaking decision process, including requiring GPs to disclose their fees and expenses to LPs. A move for a singular federal rule on fees and expenses disclosure, though, could fend off the potential of every state following California’s lead in seeking such disclosure and creating complexity in separate filings.
There are certainly bound to be more regulatory issues facing firms in 2019, and firms’ compliance teams will be busy – from working out the impact of doing business in Europe post-Brexit to figuring out how to deal with California’s data privacy law.