The law of unintended consequences

The tax reform bill passed at the end of 2017 leaves private fund managers wondering what will befall them, but for now, there are short-term issues to deal with.

The immediate impact of US tax reform is being felt in the payroll departments of private fund managers, where there is uncertainty over how much people should be taxed at the end of the month.

“The Internal Revenue Service hasn’t issued tax tables yet, so there is confusion over how much people should be taxed, and what the exemption numbers are,” Pam Hendrickson, chief operating officer at the Riverside Company, tells pfm.

Under the reform, which is now effective, income tax rates have been revised, with the top individual rate falling 2.6 percentage points to 37 percent. Rates for the other six brackets were reduced too.

Corporate tax rates have also been reduced, with a permanent top rate of 21 percent introduced at the start of this year. Law firm Foley & Lardner rates this measure as positive or neutral for the industry, and may alleviate some of the added expense from the limitation on interest rate deductibility.

“It could also spur portfolio companies to have more capital to enhance operations or expand,” the firm says.

On the other hand, the cut gives strategics more bargaining power in competitive auctions, potentially making them an even fiercer competitor for deals against private equity firms.

Beyond the immediate impact, Riverside is still digesting the reform, which favours private equity by reducing the corporate tax rate and maintaining the capital gains status of carried interest under certain conditions, but reduces firms’ ability to deduct interest payments from their tax bills.

“We are working closely with our accounting firm to find out what we should be asking; there is so much confusion,” Hendrickson says, adding that the revisions to the conditions under which carried interest can be taxed as capital gains have the potential to be particularly complicated.

The classification of carried interest as a capital gain has been a highly political issue, and one of Donald Trump’s election campaign pledges was to tax it at the higher ordinary income rate, rather than the lower capital gains level. The issue appeared to have been kicked into the long grass after the election but re-emerged in a pared-down form in the tax reform framework published in September.

“We would have cut carried interest. We probably tried 25 times,” Gary Cohn, White House chief economic advisor and former Goldman Sachs chief operating officer, said in a January interview with Axios.

He said the proposal hit resistance in “that big white building with the dome at the other end of Pennsylvania Avenue”, adding it was the reality of the political system.

“The reality of this town is that constituency [hedge funds and private equity] has a very large presence in the House and the Senate. They have really strong relationships on both sides of the aisle, and we just didn’t have the support,” he says.

But managers are frustrated by the coverage of this aspect of the reform package.

“Much of the press coverage suggests there was no change to carried interest capital gains. In fact, the hold period to have access to carried interest capital gains triples under the new law,” Hendrickson says.

There should be a reward for long-term investment, Hendrickson adds, suggesting complicated calculations would be needed to establish tax rates when it comes to add-on investments. They would also be dependent on where you are in the investment cycle.

“It’s disturbing that carried interest is easy to rally round as a political issue. Under the law it’s a capital gain, but the reform has changed the conditions,” she says.

Limited interest

The other big area of change for private fund managers is the newly introduced limit to interest deductibility. There will be a four-year transition period to the new rules, during which firms will be able to deduct interest expenses up to 30 percent of EBITDA. After this, the deduction will be reduced to 30 percent of EBIT.

“The Senate Bill defined adjusted taxable income narrowly by not adding back depreciation and amortisation. The Conference Report [which fills in the gaps between the House and Senate version of the reform bill] compromises by adjusting taxable income by depreciation and amortisation for tax years beginning before 2022,” Debevoise tax lawyers say.

This means the amount of deductible interest for taxpayers that own significant depreciable or amortizable property – whether tangible or intangible – may be substantially reduced from 2022.

“It’s good news that there is a four-year transition period,” Hendrickson says. “Most countries that have a restriction on interest expense deduction do so based on EBITDA and the grace period will give us an opportunity to explain why this is a better system.”

The change is a big one for private fund managers and, according to Blackstone chief executive Steve Schwarzman, has the potential to change the private equity business model. The Association for Corporate Growth Private Equity Regulatory Task Force lobbied against the proposals in Washington, arguing that a measure allowing for 100 percent expensing – which would enable firms to deduct the cost of capital expenses immediately instead of spreading them over several years – is not an alternative to interest deductibility.

Elsewhere, at least one US firm recapitalised before the change was confirmed, in the hope that the rules wouldn’t apply to existing debt. Luckily for them, they have been grandfathered.

“There may have been some firms that recapitalised, but really the amount of time to do so was so short. It’s a very difficult decision to make, and we at Riverside have a portfolio of 80 companies – where would you start?” Hendrickson says.

Overall she says it’s too early to tell whether the impact of the reform will be net positive or negative – most likely it will be, in parts, both.