The US treads new ground on tax reform

While the Trump administration has its sights set on tax reform, proposed tariffs – potentially harmful to US-based portfolio companies – could sink plans to get it done by August. The controversial border-adjustment tax would levy around 20 percent on the cost of imports into the US, and while it has the backing of House Republicans, a number of GOP lawmakers have come out against the plan.

In his first speech to a joint session of Congress on 28 February, President Donald Trump said his economic team is working on “historic tax reform”, though he didn't directly weigh in on the proposed border tax which would affect private equity portfolio companies that rely on imported goods and services. And while a preliminary House Blueprint has been put forward, as of press time neither the president nor his team had offered clarity on any proposed changes to carried interest taxation, interest deductibility rules or income tax.

“The tax environment is shrouded in uncertainty. Firms should maintain flexibility in their affairs so when the mist clears, and the contours of the law come into focus, they can respond accordingly,” Matthew Saronson, tax partner at Debe-voise & Plimpton, tells PEI.

BORDER TAX
The border adjustment tax is widely considered the most controversial section of tax reform. This will hit US-based private equity portfolio companies that rely on imported goods or services to do business. Supporters, including House Republicans, argue it would end an advantage for foreign-made products over American-made goods, while opponents say it would lead to higher prices for consumers.

“This marks a shift to a territorial system. US manufacturers selling in the US, using goods or services domestically sourced will not pay the import tax, but if they are importing parts from outside the US, they will be subject to import tax on those parts,” Saronson says. “Any US company relying on foreign imports will be impacted, but it’s a potential windfall for those manufacturing in the US, not relying on imports. On its face, it pitches US businesses against other US businesses.”

Trump’s level of support for the proposal is unclear. In his February 28 speech to Congress, the president pointed to an “export tax inequity” between the US and other countries. He said he was asking for a change in the way US imports are taxed, saying that other countries “make us pay very high tariffs and taxes” while the United States charges “nothing or almost nothing” on imports.

But following the speech, new US commerce secretary Wilbur Ross said this was not an endorsement of the proposal.

“What he addressed was the issue that needs to be solved, which is [that] there's inequitable treatment of the US. Other countries have a value-added tax which they rebate on exports,” Ross said.

INTEREST DEDUCTIBILITY
A proposed change to interest deductibility rules would force companies to include the interest they pay on loans in their taxable income. This would pitch financial services firms, which have been promised relief from the proposal, against private equity firms, which rely on leverage and wouldn’t get special treatment.

In its annual report, Blackstone said a change to the rule could force it to adjust its funds’ investment strategies and potentially lower returns for investors, adding it could also hit profitability of portfolio companies; under current tax law, of course, private funds can deduct interest expense off its taxable income, making leverage on which many firms rely more attractive

“[Changing the rule] has the potential to remove perhaps the most significant tax benefit of debt financing,” Saronson says.

This plan is likely to get support from House Republicans, who are supportive of the tax treatment of debt and equity being equal – companies can’t currently deduct dividend payments.

An associated plan, which would allow companies to deduct the cost of capital expenses immediately instead of spreading them out over several years, would also impact private fund managers.

“Essentially it’s a timing change that will impact cashflow, as currently these costs are expensed over the useful life of the asset,” Saronson says.

CARRIED INTEREST
During his campaign, Trump announced his intention to tax carry earned by private equity fund managers as ordinary income, and this proposal has been included in his tax plan. Under current rules, carried interest attributable to capital gains is generally taxed as capital gains, so that much of the income is taxed at a maximum rate of 20 percent instead of 39.6 percent. Under the tax plan proposal, however, carried interest would be taxed at 33 percent and would not enjoy the reduced rate of 16.5 percent.

“There’s mention in the Trump tax plan of changes to taxing carried interest from ‘speculative investment partnerships’ because they’re not investments that create jobs. But the House Blueprint is silent on changes to carried interest tax,” Saronson says.

As seems to be the case with proposed changes put forward in most policy areas, private fund managers will have to play the long game in waiting to see how potential changes to tax laws materialise. This, Saronson says, makes it imperative that private fund managers take a flexible approach to managing their tax affairs.

“Even when a decision is made, it’s not inconceivable that the goal posts will change. We only have to look at the UK which changed its direction on the taxation of PE professionals a number of times in a single tax year,” he says. “Much of US tax law has been in place since 1986. The changes that are proposed are fundamental and unprecedented.”

INDIVIDUAL JEOPARDY
It’s not just stateside that tax issues are impacting US private fund managers; those living in the UK have been dealt two blows over the past two tax years. 

Rules restricting the situations in which carried interest can be taxed as capital gains were introduced in April 2016 – in some circumstances it’s now taxed as income. Carried interest was also exempt from a reduction in capital gains tax, so in the instances carry is taxed as capital gains, the applicable tax remains at the top rate of 28 percent. 

The rules also over-ride the remittance basis for non-UK domiciled individuals which may previously not have needed to pay UK tax if the carry returns comprised only foreign income and gains. This is because it treats the carry payment as a UK capital gain, but allows a remittance-basis non-dom to treat a portion of each carry payment as foreign capital gain, to the extent they have performed services for the fund outside of the UK. 

US non-doms will again be hit at the start of the 2017-18 tax year following a revision to the non-dom rule, effective 6 April. The US is the only developed country in the world that taxes its citizens on worldwide income and gains, no matter where they reside. Under the new UK rules, they will now also face taxation on the same income in the UK. 

“Previously, many US PE professionals based in the UK were not subject to UK tax on their worldwide income, so the interaction of the two tax regimes was much less relevant,” Saronson says. “The changes in the UK to the non-dom rules and the sourcing of carried interest and other fund-related returns result in a huge change for US citizens residing in the UK.”