Observations for European-based investment managers under US tax reform
By Damon Ambrosini, Tax Partner, US Tax and Ted Dougherty, National Managing Tax Partner, Investment Management, Deloitte
Published: 23 April 2018
In a widely reported on process in December of 2017, the Congress of the United States approved and President Donald Trump signed into law what is widely regarded as the largest US tax reform legislation since that brought in by then President Ronald Reagan in 1986. The legislation, officially known as An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018 (the “Act”) contains a number of provisions that fundamentally alter the taxation of individuals and corporations. Further, the Act impacts the taxation of certain economic activity conducted through pass-through entities as well as seeking to impose a transition tax on deferred overseas earnings while implementing a new set of rules related to the taxation of overseas activity commencing on 1 January 2018; the U.S. is in effect moving towards a participation exemption system of corporate taxation. For the purposes of this article, we have focused on the application of rules related to US individuals, US domestic corporations and owners of entities treated as a pass-through (i.e. a partnership) for US tax purposes. Unless otherwise noted, the changes we discuss herein are effective for tax years beginning on or after January 1, 2018.
Taxation of US Domestic Corporations
In one of the more prominent features of the Act, the federal level of tax is reduced from a graduated scale of up to 35 percent to a flat rate tax of 21 percent and fully repeals the corporate alternative minimum tax. Furthermore the Act permits certain tangible property that is depreciated or amortized under current law to be fully expensed in the year placed in service until 2022, providing for a phaseout thereafter. These provisions in particular may make investment into the US marketplace more attractive to European based investment managers seeking to expand their US presence.
For non-US shareholders that have financed an investment in a US domestic corporation with debt, new restrictions are placed on the deductibility of net business interest expense that may require a review of the US domestic corporation’s capital structure. Unlike other provisions in Act, the interest expense restrictions apply to retroactive arrangements rather than solely for arrangements entered into post-enactment. As another example of a prior favourable position being curtailed, the Act reduces the dividends received deduction which applied to applicable corporate shareholders receiving a dividend from certain domestic corporations.
For US domestic corporations maintaining “net operating losses” from prior tax periods, prior to the Act’s passage these were permitted to be carried back two and forward twenty tax periods. On an onward basis, the carryback of net operating losses is eliminated while the carryforward position is expanded indefinitely; however the use of the net operating loss is limited to 80 percent of taxable income in a subsequent tax year computed without regard to the deduction of the net operating loss.
Taxation of Individuals
US individual income taxpayers saw the top graduated rate of 39.6 percent reduced to 37 percent under the Act while the preferential rate of 20 percent remains intact for long term capital gains and qualified dividend income. In an effort to help reduce the complexity of the US individual income tax rules, the standard deduction was nearly doubled thereby limiting the usage of itemized expenses recorded; indeed, most itemized deductions were eliminated entirely by the Act.
In addition to this, additional limitations have been imposed related to the deductibility of state and local income or property taxes as well as the home mortgage interest deduction. With respect to the deduction of state and local taxes, a limitation of up to $10,000 has been imposed as a deduction against income for federal tax purposes for taxes related to (1) state and local property taxes, and (2) state and local income taxes not attributable to a trade or business or an activity associated with the production or collection of income, or sales taxes. Non-business non-US real property taxes are no longer deductible. There is a fair amount of uncertainty as to how some of the provisions limiting the deduction of state and local taxes are to be applied. Mortgage interest is now limited to that generated on home loans of $750,000 or less for new loans entered into, with older loans being grandfathered with a $1 million indebtedness limit. The provision allowing a deduction for interest on a home equity loan was eliminated. Importantly, almost all of the Act’s individual income tax changes expire after 2025.
Taxation of Owners of Pass-through Entities
The Act seeks to provide greater parity between the tax treatment of owners of pass-through entities (such as a partnership) and corporations, but also institutes provisions intended to prevent pass-through owners from recharacterizing wage income as more lightly taxed business income.
Perhaps the most prominent attempt to establish parity relates to the 20 percent deduction of domestic qualified business income earned by a passthrough entity. In particular, an individual, estate or trust taxpayer generally may be able to deduct the sum of:
Twenty percent of the US domestic qualified business income with respect to a qualified trade or business from a partnership, S corporation or sole proprietorship (subject to certain significant limitations based on the passthrough’s employee wages and assets), and
Twenty percent of aggregate qualified real estate investment trust (“REIT”) dividends, qualified cooperative dividends and qualified publicly traded partnership income.
While the rules are more complex than the scope of this writing, it is worth clarifying that qualified business income does not include any amount paid by a partnership to a partner who is acting other than in his or her capacity as a partner for services rendered with respect to the trade or business and does not include any amount that is a guaranteed payment for services actually rendered to or on behalf of a partnership to the extent that the payment is in the nature of remuneration for those services. Furthermore, qualified business income does not include certain investment-related income, gain, deductions or loss. With respect to these new rules, “specified service businesses” are not considered a qualified trade or business. In particular, this means the performance of services that consist of investing and investment management trading or dealing securities, partnership interests or commodities do not generally qualify for the passthrough deduction. However, even owners of passthrough entities that are engaged in specified services businesses such as investment management may realize some small benefit of the deduction based on an exception provided which is based a taxpayer’s adjusted gross income; these thresholds are relatively low compared to earnings in the investment management industry.
As a final thought on the application of the 20 percent deduction of domestic qualified business income, this may suggest that investments into REITs or structuring using REITS may now be more attractive.
The Act repeals the concept of a “technical termination” which occurred for partnerships that, within a 12-month period, had a sale or exchange of 50 percent or more of the total interest in partnership capital and profits. Previously when a technical termination occurred, the business of the partnership continued in the same legal form, but the partnership was treated as newly formed requiring short reporting periods and providing for new elections to be made.
For owners of pass-through entities received in the context of carried interest, a new provision requires a holding period of three years in order to benefit from preferential long-term capital gains rates. This holding period applies both to the assets held within a partnership as well as to the partnership itself.
Finally, the codification of Revenue Ruling 91-32 by the Act provides that gain or loss from the sale or exchange of a partnership interest is effectively connected with a US trade or business to the extent that the transferor would have had effectively connected gain or loss as if the partnership sold all of its assets at fair market value as of the date of the sale or exchange. In addition, the transferee of a partnership interest is required to withhold 10 percent of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that the transferor is not a non-resident alien individual or a foreign corporation. Further guidance on the collection and remittance of the withholding tax is expected imminently despite the law currently being enforced. However a temporary exemption from withholding on distributions to holders of publicly traded partnership units was recently announced.
Conclusion
As discussed at the beginning of this writing, US tax reform has produced an impact for taxpayers of nearly all tax profiles. We have sought to highlight those that may touch upon the European based investment management community; however, the coordination of the new rules necessitates the use of complex modelling due to the challenging interaction of the newly introduced rules.
To contact the authors:
Damon Ambrosini, Partner, Tax Partner, US Tax at Deloitte: [email protected]
Edward Dougherty, National Managing Tax Partner, Investment Management at Deloitte: [email protected]
