PRIVATE EQUITY FUND AND PORTFOLIO COMPANIES: THE IMPACT OF TAX REFORM

PRIVATE EQUITY FUND AND PORTFOLIO COMPANIES: THE IMPACT OF TAX REFORM Jan. 23, 2018 Authors Nick Gruidl, Partner Gennaro Musi, Partner Michael Nader, Partner 1

The Tax Cuts and Jobs Act (TCJA) was signed into law on December 22, 2017, and stands to be the most significant overhaul of U.S. tax policy since 1986. With most of the provisions already in effect as of Jan. 1, 2018, it s crucial that private equity fund C-suite executives understand the key provisions that may affect their private equity funds and the portfolio companies in which they are invested. Below we will discuss relevant general provisions of the TCJA that impact the private equity world. As you consider the following, understand that Congress may pass technical corrections. In addition, we can expect significant regulations and explanations from the Department of Treasury and Internal Revenue Service in the near future to address areas of uncertainty. Provisions impacting funds and investors Carried interest: Carried interest remains narrowly altered. The new provisions now require a three-year holding period of underlying property to qualify for long-term capital gain treatment effective for tax years beginning after Dec. 31, 2017. The portion of the carried interest that relates to gain on property held less than three years would now be considered short term capital gain. Additionally, the clock on holding period (for the underlying property) is reset for any transfers of carried interest to related parties. All other income and expense components of carried interest (e.g., qualified dividends, interest, expenses, ordinary income) remain unchanged. RSM insights: General partners of private equity funds will continue to enjoy carried interest tax benefit as under prior law provided the underlying investments and property (which also could include investments in the form of partnership interests) that gave rise to the gain are held for three or more years. Since a long term trading strategy of three years or more is typical in most private equity funds, the new three year holding period test could result in minimal impact to most general partners. It is important to note that there is no grandfathering of existing investments. In essence, a position exited during 2018 that was held less than three years would be subject to the short-term gain conversion. When exiting positions, fund managers should also be cognizant of any splitting of holding periods that would result in a less than three-year holding period. Foreign general partners are also safe from having any such gain treated as effectively connected income (ECI) because the new rules do not recast gains as a fee for services. Additionally, the potential impact on gifts of carried interests should be assessed and kept in mind. Unrelated business taxable income (UBTI): The TCJA prohibits the netting of separate trade or business activities when computing UBTI effective for years beginning after Dec. 31, 2017. RSM insights: Private equity funds that have tax exempt investors (e.g., pensions, charitable organizations) with more than one unrelated trade or business must compute unrelated business taxable income separately with respect to each trade or business. As a result, a deduction from one trade or business for a tax year may not offset income from a different unrelated trade or business for the same tax year. Sale of partnership interests and ECI: The TCJA effectively re-establishes by statute a provision (similar to Rev. Rul. 91-32) that can categorize the gain/loss on sale of a partnership interest as ECI for sales or exchanges of partnership interests on or after Nov. 27, 2017. More specifically, gain or loss realized on the sale or exchange by a foreign person of a partnership interest that is engaged in a U.S. trade or business would be treated as effectively connected income and subject to U.S. tax to the extent allocable to assets of the partnership that produce effectively connected income. Withholding would be required at a rate of 10 percent on the realized gain attributable to the foreign partner. 2

RSM insights: This provision overrides the recent court decision in Grecian Magnesite Mining Company vs. Commissioner. Fund managers of private equity fund structures that include investments engaged in a trade or business may want to consider reevaluating fund structures to protect ECI sensitive investors (e.g., increased use of blockers). Nonresident alien (chapter 3) and Foreign Account Tax Compliance Act (FATCA) (chapter 4) withholding: Effective Jan. 1, 2018, W-8 forms provided to U.S. funds must include the investor s foreign tax identifying number (FTIN) or a reasonable explanation of why an FTIN was not provided; otherwise, the investor will be subject to 30 percent withholding. RSM insights: Although not directly related to the provisions under the TJCA, this withholding and reporting regime change is still an area that should be taken under consideration. Funds should modify systems and be prepared to withhold if required and have systems and processes for identifying section 871(m) dividend equivalent payments and for reporting and withholding on such amounts. Controlled foreign corporations (CFC): The TCJA modifies the rules for determining CFC status and expands the definition of a U.S. shareholder under Subpart F. RSM insights: The TCJA changes may affect CFC status and subject U.S. shareholders to the repatriation tax (discussed below) and additional reporting obligations. Additionally, the effective date could cause the repatriation charge to impact a broader range of taxpayers. Business provisions The TCJA significantly changes the way in which businesses and owners are taxed in the United States. As a result, private equity funds may want to reconsider their tax posture on future portfolio companies in terms of pass-through versus corporate structures. Significant drivers in this decision include the make-up of the fund s investor base (e.g., how much are you already blocking) and business characteristics such as location of operations (e.g., domestic versus foreign), and the type of operations (e.g., services versus manufacturing). For example, in analyzing the items below you may come to the conclusion that a corporate portfolio structure may provide significant benefit if your portfolio has significant international operations and you are already blocking a portion of your investment for tax sensitive investors (e.g., foreign and tax-exempt investors). On the other hand, if your investor make-up is primarily domestic, taxable investors and your portfolio is primarily domestic and incurs significant employee and/or capital expenditures, you may find that a pass-through structure makes sense. Provisions impacting portfolio companies Reduction of corporate tax rate to 21 percent: The TCJA reduces the top corporate tax rate from 35 percent to 21 percent for tax years beginning after Dec. 31, 2017. RSM insights: One of the most talked about provisions in corporate tax reform is the rate reduction to 21 percent. The 21 percent rate puts the United States in a much more competitive position globally. As discussed in more detail below, the lower rate came with certain unfavorable changes to interest deductibility and net operating loss (NOL) utilization rules and the one time repatriation tax on offshore earnings. The other significant change to corporate taxation involves the introduction of a territorial tax system where earnings of foreign corporate subsidiaries are generally not taxed at the U.S. corporate level. 3

On the mergers and acquisition (M&A) side, the decrease in corporate rates will have a direct impact on future deal modeling. The decrease in rates lowers the value of tax attributes created or acquired in a deal, but will have a corresponding increase to cash flow due to the lower tax rate. One potential downside could be as more businesses operate in corporate form, the ability to achieve a step-up in basis on an acquisition could become more difficult, as there is still the issue of double taxation in corporations when distributions are paid out of earnings or upon liquidation of the portfolio. That combined rate is now lower, but for investors in high tax states the combined rate of this double taxation could still reach nearly 50 percent. Repeal of corporate alternative minimum tax (AMT): The TCJA repeals the corporate AMT for tax years beginning after Dec. 31, 2017. Corporations that possess AMT credit carry-forwards can claim a refund of 50 percent of the remaining AMT credits (to the extent the credits exceed regular tax for the year) in tax years beginning in 2018, 2019 and 2020. For any remaining AMT credit carry-forwards after 2020, taxpayers can claim a refund for all such credits in the tax year beginning in 2021. RSM insights: Corporations will be able to recover (via refund) over time AMT credit carry overs. Depending on the magnitude of the AMT credits for each corporation, this could be found money that otherwise would have been not immediately eligible to be utilized and in some situations permanently unused. Uncertainty remains as to the application of prior limitations under sections 382 and 383 to the refundable amounts. Foreign derived intangible income (FDII): The TCJA created the FDII deduction as a new deduction eligible to U.S. C corporations that generate revenues through the sale of goods or services to foreign customers for foreign use. Generally sales to a related party who then sells that property to a foreign customer for foreign use are also eligible. The calculation of FDII involves a set of complex calculations to imply a level of income based on the U.S. tangible assets of the corporation and then income in excess of that represents intangible income on which the deduction is based. The deductions could result in an effective 13.25 percent (as opposed to 21 percent) tax rate on FDII. RSM insights: The FDII deduction is eligible only to corporations and as such pass-through portfolios will generally miss out on this deduction. If your portfolio or target is a domestic business that produces or manufactures domestically and generates significant revenues internationally, the FDII could be significant and could tip the scales towards selection of a corporate structure over a pass-through structure. From an M&A perspective, this is another new diligence issue created by the TCJA that should be examined to assess potential exposure (e.g., Has the target claimed too much FDII?) and positive opportunity (e.g., How much FDII is available?). NOL deduction: Under the former law, corporate taxpayers were permitted to carryback an NOL two years and carry forward an NOL 20 years to offset taxable income. Under TCJA, for losses arising after 2017, the NOL deduction is limited to 80 percent of taxable income. Additionally, TCJA repeals the carryback of any and all NOLs that are generated in a tax years ending after 2017 and instead permits all such NOLs to be carried forward indefinitely. Prior NOLs retain their 20-year carry forward and would appear to remain eligible for a 100 percent income offset. All NOLs would remain subject to the rules of section 382 in the event an ownership change would place such a limitation on the NOLs. RSM insights: From an M&A perspective, the elimination of the carryback of NOLs may pose challenges for sellers of portfolio companies seeking to capture the benefit of M&A transaction deductions. Previously where those costs generated an NOL in the pre-acquisition year, the NOL could be carried back with tax refunds paid to the seller. With no carryback potential and an 80 percent income limitation, the value of tax attributes delivered in a transaction may become more contentious, likely requiring a more in depth utilization analysis. Territorial tax system: Under the TCJA, beginning Jan. 1, 2018, U.S. C corporations are entitled to 100 percent dividend received deduction (DRD) on foreign source dividends from specified 10 percent-owned 4

foreign corporations (other than a passive foreign investment company (PFIC) that is not also a CFC) whose recipient is a U.S. shareholder with respect to that entity. RSM insights: The implementation of the DRD creates a territorial type tax system and allows a domestic corporate portfolio company to repatriate earnings back to the United States free of tax (after the one time repatriation tax discussed below). In certain situations, it will also allow a U.S. corporate portfolio to sell a foreign subsidiary without incurring U.S. tax. The DRD, which is only available to domestic C corporations, combined with the 21 percent corporate rate is expected to result in significant investment back into the United States and may be a large enough benefit to cause funds to more readily adopt corporate structures for their portfolios. From an M&A perspective, the move to a territorial type system could make deals involving significant foreign operations easier to accomplish as historically a target s foreign structure often would add significant complexity to structuring a deal and that may be lessened due to the DRD. Repatriation tax: The TJCA transitions to a territorial tax system by imposing a one-time mandatory transition tax on foreign earnings that have not already been subject to tax on U.S. persons who own 10 percent or more of specified foreign corporations. Specified foreign corporations includes all CFCs and all foreign corporations (other than PFICs). This repatriation tax will be assessed on the greater of earnings and profits (E&P) as of Nov. 2, 2017, or Dec. 31, 2017, excluding distributions during the taxable year ending (unless the distributions were made to another specified foreign corporation). The tax is imposed at an effective rate of 15.5 percent on E&P in the form of cash or cash-equivalents and 8 percent on all other earnings. An election is available to taxpayers associated with deemed repatriation to pay the tax over an eight year period at the following rates: 8 percent in years 1-5, 15 percent in year 6; 20 percent in year 7; and 25 percent in year 8 (final year). RSM insights: This one time repatriation tax could negatively impact cash flows for private equity funds that hold foreign subsidiaries in their portfolios. This tax is also a very significant new diligence item that must be considered on every transaction involving a foreign corporation as you may inherit any liability from a miscalculated repatriation tax. The calculation of earnings subject to the repatriation tax is complex and opportunities may exist to change accounting methods used to determine earnings so taxpayers should carefully assess their exposures to this item. Global intangible low-taxed income (GILTI): The new GILTI rules require current taxation of significant foreign earnings generated in low tax jurisdictions where the foreign corporation has minimal physical presence in terms of tangible property. However, U.S. corporations receive a corresponding deduction against GILTI resulting in an effective 10.5 percent rate. In addition, taxpayers may claim a credit for 80 percent of the foreign taxes paid on GILTI. While the GILTI rules apply to non-corporate taxpayers, only corporations are allowed the deduction. RSM insights: GILTI operates as a minimum tax on certain earnings of foreign corporate subsidiaries. From an M&A perspective, GILTI is a new and significant diligence item that every deal team should consider when analyzing tax exposure and business operations post transaction. If a portfolio company is likely to have GILTI, then a corporate structure may be beneficial as the corresponding deduction and tax credit utilization provides a benefit as compared to a passthrough entity. Interest expense limitations: The provision of the TCJA that most negatively impacts portfolio companies is the limitation of net business interest expense deductions (i.e. business interest expense netted against business interest income) to 30 percent of a businesses adjusted taxable income (ATI) for tax years beginning after Dec. 31, 2017. The ATI is calculated using tax earnings before interest, taxes, 5

depreciation and amortizations (aka EBITDA). For tax years beginning on or after Jan. 1, 2022, depreciation and amortization will not be added back in when calculating ATI, which will result in a lower limitation compared to previous periods. To the extent not utilized the disallowed interest is carried forward like an NOL. The calculation of the interest limitation takes place at the operating company level (corporation or pass-through entity) and there was no provision grandfathering deductibility of existing debt. RSM insights: Analysis for portfolio companies: For portfolios utilizing significant leverage in their portfolios, the TCJA may actually represent a tax hike. Prior to this limitation many leveraged portfolios could generate an NOL in the early years following an acquisition, which meant the tax rate of 35 percent was irrelevant. Now, due to the interest limitation, that same portfolio could incur a tax liability as opposed to an NOL. Similarly for pass-through entities the interest limitation could result in more income passing through to investors. A few important items to note: 1) The limitation applies to net interest expense. The use of intercompany debt to capitalize a worldwide business generally remains a viable option and portfolios that generate significant interest income can net that income against expense. 2) Investment interest expense under section 163(d) is exempt from limitation. 3) If a business entity has $25 million or less in average gross receipts, it is not subject to the 30 percent interest deduction limitation (i.e. small business exception). With respect to the small business exception, related entities are combined in certain situations to test the gross receipts limitation and the application to leveraged blocker corporations remains unclear in some respects. From an M&A perspective, this likely will have a negative impact on cash flow for leveraged deals. As a result, the provision could have a direct impact on how the value and price modeling of deals are calculated. On exit of a C corporation, the previously disallowed interest expense is an attribute of the company similar to an NOL. The transaction may have value to the buyer, although the carryover would be subject to the same section 382 limitations as an NOL in addition to the ATI limitation. An option that funds may want to explore is the replacement of debt with other investment options such as equity, partnership preferred return/guarantee payments and sale leaseback transactions to name a few. Deduction of pass-through business income: The TCJA provides a 20 percent deduction for qualified business income (from a partnership, S corporation or sole proprietorship) which has the net effect of a 29.5 percent rate when combined with a top ordinary income tax rate of 37 percent assuming no other limitations. Qualified business income is generally defined as the net amount of qualified items of income, gain, loss and deduction with respect to any qualified trade or business of the taxpayer. Qualified items generally are those items of income, gain, loss and deduction effectively connected with the conduct of a qualified trade or business in the United States. It is important to note that qualified business income does not include investment-type income (e.g., capital gains, dividends and non-business interest), reasonable compensation and guaranteed payments. RSM insights: The 20 percent deduction is beneficial to pass-through businesses that generate qualified income as it could lower required tax distributions to fund tax payments of the investors. While not bringing pass-through rates down to the 21 percent corporate rate, the deduction is significant and when paired with the other benefits of pass-through structures (e.g., step-up on exit and basis increases to investors) this may be enough to make a pass-through structure preferable in some cases. 6

Full expensing of certain depreciable assets: The TCJA allows for the full (100 percent) expensing of qualified property placed in service on or after Sept. 27, 2017, and before Jan. 1, 2023. The TJCA also expands the definition of qualified property to include acquired used property (e.g., already placed in service). The applicable expense percentage is reduced to 80 percent, 60 percent, 40 percent and 20 percent for qualified property placed in service in calendar years 2023, 2024, 2025 and 2026 respectively. In the case of qualified property acquired before Sept. 28, 2017, but placed in service after Sept. 27, 2017, the applicable expensing percentage (50 percent) under current law would apply. An opt-out election will still be available for taxpayers who do not wish to accelerate depreciation. RSM insights: Portfolio companies that purchase a high volume of capital equipment (e.g., plant and equipment) will experience a huge tax benefit on the accelerated depreciation. States could decouple from the federal provisions which would cause a disparity between federal and state add backs. From an M&A perspective, the issue of purchase price allocation will become more important than ever. Immediate expensing was expanded to previously constructed property, so the acquiring portfolio could have significant write-offs of purchase price in the year of the acquisition. However, full expensing is limited and does not extend to 15-year intangible property and goodwill or to assets such as land or most real estate. This provision increases the benefit of asset transactions over stock transactions, but the lowering of the corporate rate to 21 percent does somewhat offset the benefit of an asset transaction. In conclusion Tax reform is here to stay and its provisions change the landscape of the private equity world going forward. The decrease in corporate rates coupled with new NOL limitations, corporate AMT repeal, and accelerated expenditures (all discussed above) will directly impact how the value and price modeling of deals are calculated. The decrease in rates reduces the value of tax attributes, while the accelerated depreciation/expensing has the opposite effect. Through a global lens, foreign structures will also have to be re-evaluated to take into account the international provisions, which include the introduction of a territorial tax system. When all of the TCJA provisions roll out, we are likely to see the trend of asset based (over stock) deals continue, while the pass-through versus corporate decision is less clear. Regardless of the outcome, deal teams will have many additional tax attribute facets to consider when acquiring or exiting an investment. Of course there will be other non-tax deal considerations (e.g., economic and business), but the tax considerations are here to stay and should not be ignored. 7

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