Private Investment Funds and Tax Reform

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A Private Investment Funds and Tax Reform Carried Interest, QBI and Interest Deductions, Sale of Partnership Interests, Computation of UBTI, and More WEDNESDAY, OCTOBER 3, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Brian D. Huber, Senior Counsel, Proskauer Rose, Boston Jeremy Naylor, Partner, Proskauer Rose, New York The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 1. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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5 Private Investment Funds and Tax Reform Brian Huber Jeremy Naylor

6 Agenda 1. New Rates 2. The Suspension of Certain Itemized Deductions 3. Taxation of Carried Interest 4. ECI from the Disposition of Certain Partnership Interests 5. UBTI Loss Limitations 6. Limitations on Business Interest Deductions 7. 20% Deduction of Partnership Qualified Business Income 8. Certain International Provisions Applicable to Investment Funds 9. Other Noteworthy Provisions 10. Takeaway Considerations for Investment Fund Professionals 6

7 Sections 1(j) and 11(b)*: New Rates Old Law Individuals: graduated rates with maximum rate of 39.6% Corporations: graduated rates with maximum rate of 35% New Law Individuals: revised schedule of graduated rates, with maximum rate of 37% Corporations: single rate of 21% The revised individual rates are temporary (tax years beginning after 12/31/17 and before 1/1/26) The revised corporate rate is permanent *Section references are to the Internal Revenue Code of 1986, as amended 7

8 Sections 63(c)(7), 67(g) and 164(b)(6): Suspension of Certain Itemized Deductions Old law - Individuals itemize certain deductions, such as state and local income tax and investment expense - Itemized deductions are subject to limitations and phase-outs, and are not deductible for AMT purposes New law - State and local taxes are deductible up to $10,000 - Standard deduction increased from $12,000 to $24,000 - Most other itemized deductions (e.g., management fees) are no longer allowable - Applicable to tax years beginning after 12/31/17 and before 1/1/26 8

9 Section 1061: Taxation of Carried Interest New Law: Imposes a 3 year holding period requirement, rather than a 1 year holding period requirement, for long-term capital gain in respect of an applicable partnership interest - Test looks to the holding period of the asset giving rise to the gain, not to the holding period of the applicable partnership interest. - Also applies to gain on sale of applicable partnership interests held for three years or less Does not apply to: - Dividends - An interest in a partnership directly or indirectly held by a corporation - Notice : regulations will provide that corporation does not include an S corporation - Any capital interest in the partnership which provides the taxpayer with a right to share in partnership capital commensurate with (i) the amount of capital contributed (determined at the time of receipt of such partnership interest) or (ii) the value of such interest subject to tax under Section 83 upon the receipt or vesting of such interest. 9

10 Section 1061: Taxation of Carried Interest Applicable partnership interest: Any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any related person, in any applicable trade or business. Related person: A person is related to the taxpayer if the person is a member of the taxpayer s family within the meaning of Section 318(a)(1) [in general, spouse, children, grandchildren and parents] or the person performed services within the current year or the preceding three calendar years in any applicable trade or business in which or for which the taxpayer performed a service. 10

11 Section 1061: Taxation of Carried Interest Applicable trade or business: any activity conducted on a regular, continuous, and substantial basis which, regardless of whether the activity is conducted in one or more entities, consists, in whole or in part, of (A) raising and returning capital and (B) either (i) investing in (or disposing of) specified assets (or identifying specified assets for such investing or disposition) or (ii) developing specified assets. Specified assets: securities (as defined in Section 475(c)(2) without regard to the last sentence thereof), commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to extent of the partnership s proportionate interest in any of the foregoing. - Securities: (i) stock of a corporation, (ii) partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust, (iii) note, bond, debenture or other evidence of indebtedness and (iv) certain other interests (including derivative interests) in, or hedges with respect to, a security. 11

12 Section 1061: Taxation of Carried Interest Not all funds are equally impacted - Hedge: unaffected where typical hold period is 1 year or less - Venture: early stage investments generally have longer hold periods, but followon investments may be an issue - Buyout: potential issue for dividend recaps (distributions in excess E+P and basis) and shorter term holds - Growth equity: likely will be an issue Planning alternatives - Forego gain allocations with later true up - Structure acquisition for holding period tacking - Distributions in kind - Dividend income 12

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14 Section 864(c)(8): ECI from the Disposition of Certain Partnership Interests Section 864(c)(8): Rev Rul Codified - All or a portion of gain or loss on the sale or exchange or other disposition of an interest in a partnership engaged in a trade or business within the US is treated as a ECI - Amount of gain or loss treated as ECI is based on hypothetical liquidation of partnership s assets (through all lower-tier partnerships, including ECIgenerating flow-through operating companies) as of the date of disposition 14

15 Section 1446(f): New ECI Withholding Rules Section 1446(f): Withholding obligations on disposition of a partnership interest if gain would be treated as ECI - Buyer required to withhold 10% of the amount realized on the disposition - Partnership required to withhold amount that Buyer fails to withhold, plus interest, from distributions that otherwise would be made to Buyer - Exception: Seller furnishes affidavit of non-foreign status - Process to apply for reduced withholding based on actual taxable ECI gain may be implemented by regulations (similar to FIRPTA) Notice suspends 1446(f) for publicly traded partnerships Notice provides withholding exemptions for buyers who obtain a permitted certification (see next slide) in connection with transfers of interests in privately held partnerships. Also provides guidance in determining amount realized. 15

16 Section 1446(f): New ECI Withholding Rules IRS Notice (cont.) permitted certificates: - Seller certification: no realized gain - Seller certification: de minimis historical ECI - < 25% of Seller s distributive share of partnership income for the preceding year and two prior years was ECI - Seller must have received K-1s and Forms 8805 to substantiate - Timing issues what if < 3 years of K-1 history; transfers before due date for K-1s may require additional year of reporting - Partnership certification: de minimis ECI - < 25% of gain would be ECI under 864(c)(8) upon a hypothetical sale of the partnership s assets - Will managers of funds agree to provide certification? 16

17 Section 1446(f): New ECI Withholding Rules IRS Notice (cont.) - Partnership secondary withholding suspended (for now) - Further guidance to come - 25% threshold may be reduced - Non-recognition transactions Additional open questions: Interaction with other withholding obligations (e.g., non-us partnership-seller s withholding obligations)? - Can equivalent reports be used to substantiate lack of historic ECI (e.g., where K-1s were not required to be provided)? 17

18 Section 512(a)(6): UBTI Loss Limitations New Law - UBTI losses from one trade or business cannot be used to offset gains from another unrelated trade or business. - Special transition rule permits carryforward of net operating losses arising in a taxable year beginning before January 1, IRS Notice Tax-exempt orgs can treat unrelated businesses held through multiple partnerships as a single trade or business - Qualifying partnership interests - 2% capital and profits threshold - 20% capital threshold where tax-exempt lacks control or influence - What does control or influence mean? 18

19 Section 512(a)(6): UBTI Loss Limitations IRS Notice (continued) - Transition rule: Existing partnership interests carved out of above rule (those acquired prior to August 21, 2018) - May treat that interest as single trade or business - Unclear whether multiple existing partnership interests may be combined - Determining an unrelated trade or business - NAICS codes Additional Questions to Consider - Will Tax-exempt investors limit percentage invested in Funds to comply with ? - Possible K-1 implications? - Fund structural considerations? 19

20 Section 163(j): Limitations on Business Interest Deductions New Law: Deductions for a taxable year for business interest generally limited to 30% of adjusted taxable income of the taxpayer for such taxable year. - Disallowed interest is generally treated as a carryforward to the next taxable year - No limitation on ability to offset business interest income, and limitation does not apply to investment interest Exception: Limitation is not applicable to: - a taxpayer that meets the gross receipts test of Section 448(c) for a taxable year (i.e., average annual gross receipts of such taxpayer for the 3-taxable-year period ending with the taxable year which precedes such taxable year does not exceed $25 million), or - Certain real estate companies that make an election. Adjusted taxable income: similar to EBITDA until 1/1/22, and thereafter similar to EBIT, but Code provides for such other adjustments as determined by the Secretary. Special rules apply to Partnerships 20

21 Section 163(j): Limitations on Business Interest Deductions Questions to Consider - Impact on Funds implications for leveraged blockers generally? Credit fund strategy? - Impact on capital structure? Credit provider Borrower Credit provider Borrower Preferred Equity? Interest deductions by borrower subject to limitation Business assets Interest paid out in the form of equity in a pass through entity 21

22 Section 199A: 20% Deduction of Partnership Qualified Business Income New Law: Non-corporate taxpayers eligible to deduct a portion of qualified business income Qualified business income: generally, items included in determining ECI, other than capital gain or loss, dividend income, interest income that is not allocable to a trade or business. Deduction limited to the lesser of: - (1) the combined qualified business income of the taxpayer, or - (2) 20% of the taxpayer s income for the taxable year in excess of net capital gains for the taxable year. Note: Sunsets after December 31,

23 Section 199A: 20% Deduction of Partnership Qualified Business Income Combined qualified business income: - for each qualified trade or business: the lesser of (A) 20% of the taxpayer s qualified business income with respect to the qualified trade or business or (B) the greater of (i) 50% of W-2 wages or (B) the sum of (i) 25% of W-2 wages and (ii) 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property (generally depreciable tangible trade or business property), plus 20% of qualified REIT dividends and qualified publicly traded partnership income. - Proposed Regs provide that certain related businesses may be aggregated for purposes of 199A deductions Qualified trade or business: Any trade or business other than a specified service trade or business (see next slide) or the trade or business of performing services as an employee. Certain relaxed rules for taxpayers with income below certain levels. 23

24 Section 199A: 20% Deduction of Partnership Qualified Business Income Specified service trade or business: Any trade or business which involves the performance of services - in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, - or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees, or - that consist of investing and investment management, trading or dealing in securities, partnership interests or commodities. - Proposed Regs provide that reputation or skill prong be narrowly construed (e.g., income from endorsements or licensing of one s likeness) Key Takeaway for Private Investment Funds: deduction generally does not apply to investment income or management fees. 24

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26 Certain International Provisions Applicable to Investment Funds Sections 951(b) and 958(b): Expansion of CFC Rules Section 951A: Global Intangible Low-Taxed Income (GILTI) Section 250: Deductions for GILTI and Foreign Deductible Intangible Income (FDII) Section 267A: Disallowance of deduction for certain related party payments pursuant to hybrid transactions or by, or to, a hybrid entity 26

27 Sections 951(b) and 958(b): Expansion of CFC Rules United States Shareholder: - Old law: Any US person that owns at least 10% of voting power of a non-us corporation - New law: Any US person that owns at least 10% of voting power or value of a non-us corporation Attribution: - Old law: No downward attribution from a non-us person to a US person - New law: Stock owned by a non-us person can be attributed to a US person 30-day rule eliminated 27

28 Sections 951(b) and 958(b): Expansion of CFC Rules Attribution Example Non-US LPs No US Owners Non-US GP US LP Attribute to US Corporation all of the stock in Non- US Corporation owned by Non-US Fund: - Non-US Corporation is a CFC Non-US Fund - US LP of Non-US Fund subject to tax as a United States Shareholder as long as it indirectly owns 10%+ of the vote or value of Non-US corp. - Attribute to US Corporation all of the stock in Non-US Corporation owned by Non-US Corporation US Corporation KEY TAKEAWAY: REVIEW STRUCTURES TO IDENTIFY CFC UNITED STATES SHAREHOLDER STATUS 28

29 Section 951A: Global Intangible Low Taxed Income ( GILTI ) New Law: In general, each United States shareholder of a CFC includes as gross income such person s GILTI for such year - Formulaic calculation: generally equal to the excess, if any, of (i) the United States shareholder s pro rata share of CFC income (other than certain amounts, including: ECI, amounts taken into account in determining subpart F income and income that satisfies the high tax exception in 954(b)(4)) less deductions properly allocable to that income over (ii) the United States shareholder s pro rata share of 10% of the average adjusted bases, as of the close of each quarter, in certain tangible assets, less certain interest expense. United States shareholder: Section 951A is only applicable if the person owns (within the meaning of Section 958(a)) stock in such foreign corporation on the last day of the taxable year of the foreign corporation on which such foreign corporation is a CFC. Section 960(d): domestic corporation entitled to a credit for up to 80% of foreign taxes paid. Section 962: election for an individual to be treated as a corporation. Otherwise, role of GILTI tax will be greater 29

30 Section 250: Corporate Deductions for GILTI and Foreign Derived Intangible Income ( FDII ) FDII: Conceptually, income from (i) goods sold to a non-us person for foreign use or (ii) services provided to any person or with respect to any property located outside of the United States. FDII and GILTI Deductions: For any taxable year, a US corporation may deduct an amount equal to the sum of: (i) 37.5% (21.875% after 2025) of its FDII plus (ii) 50% (37.5% after 2025) of its GILTI amount included in income (including corresponding amounts treated as dividends under Section 78) with respect to such taxable year. - Certain limitations apply based on taxable income of the domestic corporation Result: - GILTI taxed at a rate of 10.5% (increasing to % after 2025) - FDII taxed at a rate of % (increasing to % after 2025) 30

31 Section 267A: Related Party payments in Hybrid Transactions/Entities New Law: No deduction allowed for any disqualified related party amount paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity Disqualified related party amount: any interest or royalty paid or accrued to a related party (as defined in Section 954(d)(3)) to the extent that (A) such amount is not included in the income of such related party under the tax law of the country of which such related party is a resident for tax purposes or is subject to tax, or (B) such related party is allowed a deduction with respect to such amount under the tax law of such country. - Note: Such term shall not include any payment to the extent such payment is included in the gross income of a United States shareholder under Section 951(a) Hybrid transaction: any transaction, series of transactions, agreement, or instrument one or more payments with respect to which are treated as interest or royalties for purposes of US tax law and which are not so treated for purposes the tax law of the foreign country of which the recipient of such payment is resident for tax purposes or is subject to tax Hybrid Entity: entity which is either (a) fiscally transparent for US tax purposes but not in the foreign country of which the entity is tax resident or is subject to tax, or (b) fiscally transparent in such foreign country but not for US tax purposes 31

32 Other Noteworthy Provisions Section 461(l): Limitations on NOLs Section 708: repeal of partnership technical termination rule Section 743: expansion of definition of substantial built in loss triggering mandatory basis adjustments Section 59A: Base Erosion Minimum Tax Section 245A: Participation Exemption Section 965: transition tax for CFCs at the end of

33 Takeaway Considerations for Investment Professionals Review partnership agreements Tax distribution rates and implications on permitted distributions (e.g., credit agreements) Ensure transfer provisions adequately address springing ECI withholding obligations Review holding period of investments Consider alternative strategies for exits of investments that do not satisfy 3-year holding period Build in optional carry waiver mechanisms Ownership of partnership with ECI assets Consider holding through a US partnership to avoid withholding issues on exit Consider requesting K-1 even in years when not required 33

34 Takeaway Considerations for Investment Professionals Review investment structures to evaluate: Potential for portfolio interest trap under new CFC rules CFC and United States shareholder status GILTI inclusions Re-evaluate partnership vs corporation status Tax considerations from deduction limitations, especially high state tax jurisdictions Potential benefits to a buyer from a basis step up Potential for gain exclusion under Section 1202 if using a corporation 34

35 Private Investment Funds and Tax Reform Brian Huber Jeremy Naylor