CFOs continued to digest the full implications of the Tax Cuts and Jobs Act of late 2017, which turned out to be far less negative for their tax affairs than they had feared.
“It was really a gift to the industry,” one tax lawyer who didn’t want to be named tells pfm. “It could have been a lot worse.”
During the presidential campaign, Donald Trump complained about the gap between the 20 percent tax paid by managers on carried interest and the top income tax rate at the time of 39 percent.
The act extended from one to three years the requirement for carried interest to be held within a fund before it could be treated as a capital gain, incurring a lower rate of tax. Any gain held for less than three years is taxed at the new ordinary income tax rate of 37 percent. However, advisors felt that CFOs could easily live with this. “The average holding period is probably four to six years,” Edward Daley, partner at Deloitte Tax LLP, tells pfm. “Thus, changing to a greater than three-year holding period for long-term capital gains on carry might not seem so bad.”
Moreover, experts noted that this negative, but far from disastrous, news was counterbalanced by other good news on tax.
Owners of sole proprietorships, trusts, S-corporations and partnerships, including management at private equity firms and real estate investment trusts, can write off 20 percent of their qualified business income against tax. However, eagerly awaited guidance from the Internal Revenue Service, published in August, said the deduction would only be available to eligible taxpayers whose 2018 taxable incomes fell below $315,000 for joint returns and $157,500 for other taxpayers.
Experts also highlighted another part of the act, designed to spur economic growth in poor communities, that allows corporations and partnerships to designate themselves as Qualified Opportunity Funds investing in Qualified Opportunity zones. The funds have to invest 90 percent of their capital in stock, partnership interests or business properties in the zones. A taxpayer who has a capital gain that’s been realized can invest that gain in such funds, without it being taxed. There is also tapered tax relief on appreciation on the invested gain. Ultimately, if they hold the fund for 10 years, all appreciation on the invested gain is excluded from tax.
During the year, a number of states responded to what they regarded as the underwhelming nature of the president’s tax crackdown on fund managers by putting forward their own proposals. By the middle of the year at least 10 states and territories were considering or had introduced plans to top up the 20 percent federal capital gains rate with their own local tax.
Some, such as California and New York, proposed a 17 percent rate that would bring the total rate, including both federal and local levies, to the current top federal income tax rate of 37 percent. Others put forward a surcharge that would bring the combined tax rate higher than this. However, states faced an obstacle to implementing these proposals: a fear by each state that in enacting first it could see an exodus of funds and tax revenue. The carried interest tax proposal from New York Governor Andrew Cuomo is conditional on Connecticut, New Jersey, Massachusetts and Pennsylvania enacting the same shift.
New York-based Blackstone gave fuel to these fears by announcing in a May regulatory filing that the national and local carry tax changes “may adversely affect our ability to recruit, retain and motivate our current and future professionals.”
Europe, for its part, saw a small number of national initiatives and rulings that worsened the tax situation for funds.
In June, the Swedish Supreme Administrative Court passed its final judgement in a decade-long legal battle that had pitted a number of big Nordic private equity firms, including EQT and Nordic Capital, against the country’s tax authority.
The court ruled in favor of the Swedish Tax Agency by determining that a significant portion of carried interest paid to general partners should be taxed as income, not capital. In response, a number of Sweden-based funds said they were exploring leaving the country.
Further south, a double tax treaty between France and Luxembourg signed in March will, when it comes into effect in 2019, make it more difficult for Luxembourg funds with agents in France to avoid being taxed there.
The treaty stems from the OECD’s base erosion and profit-shifting initiative, which aims to stop funds and other entities from taking advantage of low-tax jurisdictions if they don’t have “substance” in those countries. n