US tax reform for financial services Alternative funds could see significant changes under tax reform proposals
Contents Alternative Investment Industry Introduction 3 Border adjustments 4 Interest deductibility 4 Individual rates 4 Carried interest 5 Taxation of pass-through entities 5 Taxation of financial products 5 Mandatory tax on unrepatriated income 6 Self-employment taxes 6 Conclusion 6 Potential tax implications for the alternative fund industry 2
Introduction Republican control of both the White House and Congress in 2017 could translate into traction on the party s tax reform proposals, which seem a top priority for both. The House Republican Blueprint for Tax Reform (the Blueprint) and the White House tax reform principles will likely be the foundation for potential tax reform. The White House unveiled its tax reform principles, which have very little detail hewing closely to the tax plan put out during the campaign. In addition, provisions from other proposals, most notably former House Ways and Means Chairman Camp s comprehensive 2014 tax reform plan, will likely play a role in reform discussions. Several of the proposed tax reform provisions could have significant implications for the wealth and asset management sector. And, apart from broader tax reform, a repeal and replace of the Affordable Care Act, including the most recently revised version, will include a full repeal of all associated taxes, including the Net Investment Income Tax (NIIT). This brochure highlights eight potential tax reform provisions alternative asset managers and investors should keep a close eye on, along with their potential implications to the industry. US tax reform for financial services 3
Border adjustments A substantial element of the Blueprint s tax reform plan would be to switch the United States to a destination-based tax system, under which cash flow from exports would be excluded from taxable income, and cash flow used to purchase imports would be included in taxable income regardless of the place of production. This type of tax is commonly known as a border adjustment tax (BAT). Such a fundamental change to the way taxation applies would not affect all industries equally, but industries with significant imports such as many retailers, refiners and automakers could expect to see some of the biggest tax increases. In addition, even within industries, some firms would be affected more than others, depending on their relative reliance on imports. Economists have long held, however, that border adjustments would have little longterm effect on the balance of trade because of offsetting changes in real price levels occurring primarily through changes in exchange rates. Most economists suggest that once international price levels fully adjust, businesses real after-tax incomes would generally be unaffected by border adjustments. The White House principles do not address BAT and the President has spoken out against having a BAT tax. However, many supporters of BAT feel it s a necessity for keeping tax reform and general tax cuts revenue-neutral. In the President s tax plan, the Administration calls for a territorial system of taxing foreign earnings, which is a shift from the worldwide system he was focused on during the campaign. Alternative funds: Under the current language in the Blueprint, as limited as it may be, the US hedge and private equity fund industry would be viewed as an exporter of services. Receiving a significant portion of its income from offshore buyers could create a tax-favorable result for alternative asset managers. This assumes BAT would apply in its most basic form and that no exceptions or carve-outs would apply to the industry. Fund managers located outside of the US having US investors may be subject to the BAT on any revenues generated by those US taxpayers. Interest deductibility The Blueprint proposes to eliminate most deductions, including the deduction for net interest expense. Specifically, under the Blueprint, taxpayers could deduct interest expense against interest income, and any net interest expense could be carried forward indefinitely as a deduction against net interest income in future years, but net interest expense could not be taken as a current deduction. The Blueprint notes that the House Ways and Means Committee is working on special rules on interest expense for certain financial services companies. It remains to be seen what those special rules might look like. Nonetheless, the loss of interest deductibility would mean the loss of a significant tax benefit for many taxpayers. Alternative funds: Hedge funds and private equity funds utilizing significant leverage in their strategy could be most impacted by such a provision. It s possible that there would be a shift in the use of derivatives in trading an otherwise leveraged portfolio if such provisions are passed. Individual rates The Blueprint would reduce the top individual income tax rate from 39.6% to 33% and collapse the current seven individual income tax brackets into three: 12%, 25% and 33%, to be indexed for inflation going forward. It would also repeal the individual alternative minimum tax (AMT), the NIIT (as part of the planned repeal and replacement of the Affordable Care Act), estate tax and the generation-skipping transfer (GST) tax. The Blueprint would allow taxpayers to deduct 50% of the tax on capital gains, dividends and interest. The provisions could cause a significant shift in the taxation of the alternative asset management industry eliminating most of the existing tax benefits and tax planning opportunities that currently exist. The current standard deduction, additional standard deduction, personal exemption, personal exemptions for children and dependents, and child tax credit would be consolidated into two benefits: a larger standard deduction and an enhanced child and dependent tax credit. The only itemized deductions retained under the Blueprint would be for mortgage interest and charitable contributions. The current tax incentives for retirement savings would be retained, as would the Earned Income Tax Credit. The President s tax plan also addresses lower individual tax brackets but the highest rate would be 35%, another shift from his campaign proposals, which were more aligned with the blueprint rates. There is no detail on what the income thresholds would be for each of these rates. The plan also Potential tax implications for the alternative fund industry 4
calls for a repeal of all deductions for individuals (aside from the mortgage interest and charitable deductions), and eliminates AMT and the estate tax. Alternative funds: Although individual tax rates are seemingly reduced, potential limitations on itemized deductions, including the elimination of state and local tax deductions, could cause an overall tax rate increase for high net worth individuals. The definition of investment income subject to the 50% deduction under the Blueprint seems to include all dividend income (not just qualified dividend income) and interest income, which is not currently taxed at beneficial reduced rates (i.e., 23.8%). Depending on fund strategy and income composition, as well as other potential tax reform provisions (i.e., taxation of pass-through entities, carried interest, ACA repeal and replace), the overall effective tax rate for a successful alternative fund manager could increase from their current rates. Carried interest In tax plans released during the campaign, President Donald J. Trump stated his intention to eliminate the preferential tax treatment of carried interest. The new White House tax plan is silent on carried interest, as is the House Republican Blueprint. Nevertheless, the topic continues to be relevant, as closing the loophole has become a political talking point that has garnered bipartisan support through similar proposals in the past. Carried interest reform could provide revenue to partially offset the cost of lower corporate tax rates. Changing the tax treatment of carried interest has been proposed several times in recent years by members of both parties, including the former Chairman of the House Ways and Means Committee, Representative Dave Camp (R-MI); President Barack Obama, who included it in his annual budget; and most recently Senator Tammy Baldwin (D-WI), who reintroduced the Carried Interest Fairness Act. Chairman Camp s comprehensive 2014 tax reform plan contained a carried interest provision and could serve as the starting point for any new carried interest legislation. Alternative funds: The common theme among the various proposed reforms is that carried interest would be taxed as ordinary income, resulting in less favorable tax treatment for fund managers. The Camp proposal, however, does allow for some long-term capital gain treatment to the extent income does exceed what is called a recharacterization account balance. Otherwise, all of the income earned by a fund manager would be subject to ordinary income tax treatment. The Camp proposal, unlike the Obama proposal, would not tax enterprise value. Taxation of pass-through entities The Blueprint included a proposal to tax the business income of pass-through entities, such as partnerships and S corporations, at 25%. The tax would be imposed at the partner level and not on the entity itself. This would make the top tax rate for partnership income (25%) lower than the currently applicable top individual rate (39.6%), as well as the top applicable individual rate proposed in the Blueprint (33%) or the President s tax plan (35%). The White House plan envisions taxing businesses organized as partnerships at a 15% rate. Alternative funds: It s unclear what constitutes business income, and whether income earned from the trade or business of trading might fall under the business income definition, or if it would just be income earned from the management company. Depending on the final application, hedge funds and private equity funds may find restructuring beneficial in certain cases. Without further clarification, under these changes, alternative fund managers who run highly profitable businesses could potentially be taxed at a lower rate (15%-25%) than their highly compensated employees (33%-35%). Interestingly, this provision could make carried interest legislation a moot point. Taxation of financial products The Blueprint and White House tax plan do not discuss any changes to the taxation of financial products. However, Senator Ron Wyden (D-OR) reintroduced the Modernization of Derivatives Tax Act (released originally in May 2016, and reintroduced in May 2017), which has similar provisions to Senator Carl Levin s (D-MI) bill, Cut Unjustified Tax Loopholes Act, introduced in 2013, and Chairman Camp s Tax Reform Act of 2014. The bills similarly include provisions intended to end offshore tax abuses, in addition to sections dealing with stock options, derivatives and carried interest. With respect to derivatives, the bill would move many derivatives, including options to a mark-tomarket regime, and end the more favorable blended tax rate that applies to certain derivatives. The blended tax rate allows a portion of the gains on such derivatives to be treated as long-term gain, even if held only briefly, thereby decreasing the overall applicable tax rate. Alternative funds: For mark-to-market funds with little to no futures trading, these provisions may not mean much. However, funds with no mark-to-market election in place, and those trading in regulated futures contracts, could be significantly impacted by these provisions. The taxation of nearly all of the financial assets in a trading portfolio would effectively be taxed as ordinary income. The provisions could cause a significant shift in the taxation of the alternative fund industry and cause many funds to reconsider their fee structure and/or elect into a mark-to-market regime eliminating most of the existing tax benefits and tax planning opportunities that currently exist. US tax reform for financial services 5
Mandatory tax on unrepatriated income The Blueprint would replace the existing worldwide tax system, which allows US tax on foreign active business income to be deferred until that income is repatriated, with a territorial system allowing a 100% exemption for dividends from foreign subsidiaries. As part of the transition to a territorial system, the Blueprint would impose a mandatory 8.75% tax rate on previously untaxed accumulated foreign earnings held in cash or cash equivalents, and a 3.5% tax rate on all other accumulated earnings. Taxpayers could elect to pay the tax liability in installments over a period of up to eight years. The President s tax plan also includes language on repatriation, but is even less detailed than the Blueprint (e.g., it does not specify a rate for the deemed repatriation tax). Alternative funds: It s unclear whether these provisions would apply to income earned from passive foreign investment companies (PFICs). Offshore feeders of hedge funds and private equity funds are typically PFICs, and oftentimes US taxable investors will invest through the offshore feeder. PFIC income could be taxed under several different regimes, each with different timing and character implications, determined by individual-level tax elections. If the mandatory tax on repatriated income does apply to PFICs, however, this could be beneficial for any taxpayers with significant unrepatriated earnings, if given the ability to recognize the income over an eight-year period, as well as the potentially reduced tax rates, but may be less relevant to those being taxed under the Qualified Electing Fund regime. Self-employment taxes While neither the Blueprint nor the President s tax plan address self-employment taxes, changes to the existing law could be incorporated in some form in tax reform. For instance, under provisions included in Camp s 2014 tax reform plan, partners, LLC members and S corporation shareholders who materially participate in the trade or business of any pass-through entity would be required to effectively treat 70% of their combined compensation and distributive share of the entity s income as net earnings from self-employment, and the remaining 30% as earnings on invested capital not subject to self-employment tax. Alternative funds: The current tax law does not look to material participation as a determining factor in the application of whether income is subject to self-employment tax. Distributive shares of income of a limited partner in a limited partnership are currently exempt from selfemployment tax. Although the IRS has focused on this issue in the past, the statutory rules are explicit. Whether this issue is taken up under a provision of comprehensive tax reform remains to be seen. Conclusion The last time there was a comprehensive overhaul of the US tax system was more than 30 years ago, a process that took several years to complete. The White House and Congress have indicated that tax reform is one of their top legislative priorities. Obstacles to the successful completion of tax reform abound and the timing for when it might be concluded are not clear. The White House is pushing to enact tax reform by year s end, although it is possible that consideration of the measure slips into 2018. Given the substantial uncertainties around the specifics of the Republican tax reform proposals being considered and which ones will ultimately be included in forthcoming legislation, alternative fund managers should monitor legislative and policy developments as they occur and begin to assess the potential effects each of the proposals could have on their structures and transactions. Staying on top of the potential implications and having plans in place when the time comes to restructure and tax plan accordingly should be on the agenda of any asset manager. Potential tax implications for the alternative fund industry 6
Contacts Alternative Investment Industry Joseph Bianco Principal, Financial Services Tax joseph.bianco@ey.com Seda Livian Partner, Financial Services Tax seda.livian@ey.com Gerald Whelan Principal, Financial Services Tax gerald.whelan@ey.com Francis Grab Principal, Washington Council francis.grab@wc.ey.com EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. is a client-serving member firm of Ernst & Young Global Limited operating in the US. EY is a leader in serving the global financial services marketplace Nearly 51,000 EY financial services professionals around the world provide integrated assurance, tax, transaction and advisory services to our asset management, banking, capital markets and insurance clients. In the Americas, EY is the only public accounting organization with a separate business unit dedicated to the financial services marketplace. Created in 2000, the Americas Financial Services Organization today includes more than 11,000 professionals at member firms in over 50 locations throughout the US, the Caribbean and Latin America. EY professionals in our financial services practices worldwide align with key global industry groups, including EY s Global Wealth & Asset Management Center, Global Banking & Capital Markets Center, Global Insurance Center and Global Private Equity Center, which act as hubs for sharing industry-focused knowledge on current and emerging trends and regulations in order to help our clients address key issues. Our practitioners span many disciplines and provide a well-rounded understanding of business issues and challenges, as well as integrated services to ourclients. With a global presence and industry-focused advice, EY s financial services professionals provide high-quality assurance, tax, transaction and advisory services, including operations, process improvement, risk and technology, to financial services companies worldwide. 2017. All Rights Reserved. SCORE No. 03415-171Gbl 1705-2287730 ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com/taxreform