There are two recent tax developments we are following which may have a significant effect on the private equity space. First, in October 2016, the Treasury finalized regulations directed at curbing inversion transactions and other tax practices that shifted profits away from the United States or reduced a corporation’s taxable income, including regulations under Section 385 of the Internal Revenue Code (the “385 Regulations”). In addition, last year, House Republicans published a policy paper outlining their tax reform proposals (the “House Blueprint”).
(I) The 385 Regulations. The 385 Regulations recharacterize certain debt issued by a U.S. corporation after April 4, 2016 (“Covered Debt”)1 as equity, and may impact the extent to which a private equity fund can debt finance investments in its portfolio companies or may impact the use of “levered blockers” in their investment structures. Although we would expect private equity funds in most cases to be able to continue to use “levered blockers” to hold assets that generate effectively connected income, there may be some circumstances where the use of levered blockers may be more difficult or not feasible.
Portfolio companies can incur third-party debt without running afoul of the 385 Regulations. Under these rules, a mezzanine fund would likely be treated as a third-party lender to a portfolio company in which it only holds a minority equity stake, and it is likely that such mezzanine loans would likely not be treated as Covered Debt.
Finally, because of the complexity of the 385 Regulations, private equity funds and managers should consult their tax advisors when contemplating leveraged investment structures or debt investments into portfolio companies.
(II) The House Blueprint. Though it is still early in the lawmaking process, tax reform is at forefront of the policy agenda in Washington. We have reviewed the House Blueprint in its current form, and while there is no certainty that any of its proposals will pass, the following are our observations of how it may impact the private equity space:
* Carried Interest. While the House Blueprint does not discuss the tax treatment of carried interest, because it has been criticized by both political parties, we expect that any comprehensive tax reform may address carried interest, possibly treating it as ordinary income to a fund’s general partner (or the interest holders of an entity that is the general partner). Given the foregoing, as well as the talk of lowering individual income tax rates (see below), it is possible that the manner in which private equity managers are compensated in the future could change dramatically.
* Reduced Corporate and Individual Tax Rates. The House Blueprint lays out a plan for reducing corporate and individual tax rates and proposes to tax individuals on their capital gains, dividends and interest at an effective tax rate that is 50% of the ordinary tax rate (by allowing a deduction for 50% of such income).
* Taxing Imports, Exempting Exports. With the proposed introduction of a destination-based cash-flow tax (“DBCFT”), the House Blueprint intends to encourage exports by reducing a corporation’s income by the value of goods, services or intangibles exported. This may also allow for simpler rules, including possible modifications to the PFIC and CFC regimes, pertaining to U.S. ownership of foreign corporations. It is unclear how outbound investments would be treated under a new tax code, but simplifying the PFIC and CFC rules would benefit onshore private equity funds by simplifying the taxation of outbound investments.
* Interest Deductibility. It is unclear what the future deductibility of interest expense may be, as the House Blueprint states that the Ways and Means Committee will develop interest expense rules for financial services companies, “such as banks, insurance, and leasing.” It is also unclear as to whether investment funds will even be included in this category. However, the House Blueprint provides, as a general rule, that “job creators” will be allowed to deduct interest expense to the extent of interest income, and carry forward any amounts of net interest expense indefinitely. To the extent that private equity funds are included in this proposal, it may encourage greater use of debt financing and significantly alter how future deals are consummated.
If you have any questions concerning the foregoing, please contact one of the attorneys listed below, or any other attorney in the Firm’s Private Equity Practice.
1 Covered Debt generally is any debt instrument issued after April 4, 2016 by a member of a corporation’s “expanded affiliated group” to another member of the expanded affiliated group. Covered Debt in excess of $50 million is subject to the recharacterization rule.