Fund VP holds a carried interest in a fund that was received in connection with the performance of services in 2013. In 2018, Fund VP’s net long-term capital gain allocated from the fund attributable to such interest is $20 million. However, only $15 million of that amount is attributable to underlying investments of the fund that have been held in excess of three years. Under this new rule, Fund VP will recognize $15 million of long-term capital gain in 2018, and $5 million of short-term capital gain, which will be taxed at the applicable ordinary income tax rate.
Funds should pay particular attention to the manner in which add-on investments are made by their portfolio companies to ensure, to the extent possible, that they do not lose the benefit of a historic holding period with respect to such investments. Certain add-on investments may result in a bifurcated (or new) holding period that would implicate the application of this rule.
Profits interests issued by an LLC or other partnership entity to an employee of a corporate subsidiary or another entity that is conducting a trade or business (that is not an applicable trade or business), and which provides services only to that other entity, are excluded from this holding period requirement. So, we would expect that most profits interests issued to executives of portfolio companies should be exempt from this change, even if they are held in an LLC owner on top of a corporation.
The fact that an individual may have included an amount in income upon acquisition of an applicable partnership interest, or that an individual may have made a Code Section 83(b) election with respect to an applicable partnership interest, does not change the three-year holding period requirement for long-term capital gain treatment with respect to the applicable partnership interest.
An applicable partnership interest does not include an interest in a partnership directly or indirectly held by a corporation. Therefore, interests in joint ventures between two corporations should generally remain exempt from this holding period requirement, and, subject to further guidance, it appears that interests held by S Corporations should remain exempt as well.
The holding period requirement should not apply to capital interests in any fund to the extent such interest only provides a return commensurate with other capital contributed (as of the time the partnership interest was received). While this exception exempts basic capital interests, it should mean that certain “catch-up” type interests or profits interests embedded in a capital interest will be subject to the holding period requirement.
Interest Expense and NOL Limitations
Under the Act, the net interest deduction is limited to 30 percent of adjusted taxable income, which will generally mean earnings before interest, taxes, depreciation and amortization (EBITDA) for the next four years (2018–2021), and earnings before interest and taxes (EBIT) thereafter (2022 and beyond). This limitation applies to newly issued loans as well as those originated before 2018. The limitations apply to both corporations and partnerships, but businesses with average annual gross receipts of $15 million or less should generally be exempt from the limitation.
Disallowed interest expense can be carried forward indefinitely, but as adjusted taxable income declines, so does the ability to deduct interest. Funds should pay particular attention to the application of these rules to their portfolio companies in cash flow modeling for leveraged companies.
Additionally, the Act limits the deduction for a net operating loss (NOL) to 80 percent of taxable income, determined without regard to the NOL deduction itself. The Act also repeals the carry back of any NOL.
For example, if in 2018 a corporation has a $900,000 NOL, without any other NOL carryovers, and the corporation has taxable income of $1 million in 2019, the corporation’s 2019 NOL deduction is limited to 80 percent of such income, or $800,000. The remaining $100,000 of NOL cannot be deducted in 2019, but can be carried forward indefinitely. The NOL cannot be carried back.
This change will affect negotiations regarding the payment of additional purchase price for tax benefits attributable to transaction deductions that give rise to an NOL in the taxable year of the closing of a transaction. The lack of the ability to carry back any such NOL will eliminate sellers’ ability to obtain the benefit of refunds of pre-closing taxes paid and will instead require sellers to seek the benefit of NOL carryforwards realized by the buyer in post-closing periods, which will be subject to this new 80 percent limitation, as well as the Code Section 382 limitations, which remain intact.
Full Expensing for Capital Expenditures
The Act extends the bonus depreciation rules to allow taxpayers to deduct 100 percent of the cost of most tangible property (other than buildings and some building improvements) and most computer software in the year placed in service, to the extent such property is acquired and placed in service after September 27, 2017 (with no written binding contract for acquisition in effect on September 27, 2017). Such property eligible for bonus depreciation can be new or used as long as it is “new” to the taxpayer. This 100 percent depreciation deduction is decreased to 80 percent for most property placed in service in calendar year 2023, 60 percent in 2024, 40 percent in 2025, 20 percent in 2026, and 0 percent in 2027 and afterward.
The impact of these rules on asset deals will be felt both by buyers, with respect to increased deductions, and by sellers, with respect to increased depreciation recapture recognized on the sale depending on the purchase price allocation for a particular asset subject to these new rules.
Repeal of Partnership Technical Termination Rule
Under pre-Act law, a partnership could be deemed terminated in connection with a sale or exchange of 50 percent or more of the total interests in partnership capital and profits. This technical termination caused the partnership’s taxable year to close, potentially resulting in short taxable years. Moreover, following a technical termination, partnership-level elections generally ceased to apply, certain attributes may have been lost, and the partnership’s depreciation recovery periods restarted. The Act eliminates the technical termination rule, such that a partnership is terminated only if no part of any business, financial operation or venture of the partnership continues to be carried on by any of its partners in a partnership.
This repeal will cause certain acquisitions of partnership interests to result in “straddle” taxable periods overlapping the closing date for the target, which may introduce added complexity in managing tax liabilities between the buyer and seller for any such period. The change should also avoid the acceleration of deferred revenue in connection with such acquisition transactions, which would have previously been recognized upon a termination. This may result in additional purchase price negotiations regarding the economic treatment of such deferred revenue in partnership transactions.
Expanded Inclusion of Foreign Earnings and Participation Exemption
The Act requires current inclusion by certain US shareholders of a controlled foreign corporation’s taxable income exceeding a specified return on the corporation’s tangible personal property, and establishes a participation exemption for certain income distributed or deemed distributed by foreign corporations to United States shareholders. The participation exemption is implemented partly through a deduction for certain dividends received from foreign corporations and partly by providing the same deduction in connection with sales of stock of certain foreign corporations that would otherwise be treated as dividend equivalent.
More specifically, under the Act, a domestic corporation is allowed to deduct foreign source dividends received from a specified ten percent owned foreign corporation held for one year or more. In general, a specified ten percent owned foreign corporation is any foreign corporation with respect to which a domestic corporation is a United States shareholder other than a passive foreign investment company. Unlike under pre-Act law, however, the domestic corporation cannot claim a credit or deduction in the United States with respect to any foreign tax paid with respect to such dividend.
In addition, under the Act, a deduction is provided for sales of stock of certain foreign corporations held for one year or more. Under pre-Act law, certain Code provisions recharacterized as dividends certain capital gain from sales of stock of certain foreign corporations. Under the Act, although a US shareholder remains subject to capital gains tax on sales of stock of certain foreign corporations, a US shareholder can now claim a deduction to the extent that the Code recharacterizes such gains as dividends.
The Act expands the categories of undistributed income that are taxed to US shareholders. Undistributed income (referred to as global intangible low-taxed income, or GILTI) is defined to include operating income of foreign subsidiaries in excess of a rate of return on tangible business assets owned by those subsidiaries. US corporations can offset GILTI inclusions with deemed paid foreign tax credits in some instances.
These changes will cause US corporations disposing of foreign assets to be more likely to prefer sales of stock over sales of assets, while US purchasers will continue to prefer to purchase assets. As described above, sales of stock of foreign subsidiaries can in some instances be recharacterized as dividend equivalent transactions for which the US corporation can claim dividends received deduction. On the other hand, if a US corporation’s foreign subsidiary sells assets to a purchaser, gain recognized as a result of such sale will typically result in an increase in the amount of income subject to inclusion as GILTI. While a US corporation may have sufficient foreign tax credits or other attributes to offset such an amount, it will likely want to carefully evaluate whether a disposition of stock of the foreign subsidiary would result in less tax.
The Act generally treats individual and pass-through owners of foreign corporations significantly less favorably than C corporation owners. Funds that own portfolio companies in pass-through form accordingly will consider owning their foreign subsidiaries through US C corporations. The Act expands the definition of foreign corporations subject to the rules, so that funds using alternative investment structures through foreign partnerships to avoid controlled foreign corporation status should review those structures.
Sale of Foreign Partner’s Interest as ECI
The Act provides that if a foreign partner owns, directly or indirectly, an interest in a partnership that is engaged in any trade or business in the United States, gain or loss on the sale or exchange of such interest is generally treated as income effectively connected with the conduct of a US trade or business (ECI), and such ECI is taxable to such foreign partner. This provision makes clear that the tax-free treatment in such context, as set forth in the 2017 Grecian Magnesite decision, will not apply to sales, exchanges and dispositions on or after November 27, 2017, and codifies the treatment described in Rev. Rul. 91-32. Any planning that was initiated in order to take advantage of the treatment outlined in Grecian Magnesite to avoid ECI on a disposition of a partnership interest should be reconsidered.
While many tried and true principles of structuring private equity and M&A transactions remain intact, the Act has thrust a new regime upon tax practitioners as well as private equity and M&A professionals, with many new and different provisions to explore. Undoubtedly, the text of the Act will be modified with technical corrections and buttressed by voluminous guidance issued by the US Department of the Treasury and the Internal Revenue Service in the coming months. We will continue to work through these complex changes to assist in effective decision making in connection with private equity and M&A transactions on the horizon.