© 2017 The Texas Lawbook.
By Carl Seiler and Michael Cramer of Blue River Partners
Love it or hate it, the President’s current tax proposal could have a substantial impact on the alternative asset industry. In this article, we highlight a number of the President’s proposed reforms (hereafter, the Plan), with the aim of providing a measured analysis of the potential real-world implications for certain taxpayers and, specifically, the alternative asset industry.
Overview of the Proposed Reforms
Lower Individual Income Tax Rates, Elimination of Targeted Tax Breaks and Doubling of the Standard Deduction
With respect to individual taxpayers, the Plan reduces the current number of tax brackets from seven to three and slashes the top tax rate from 39.6 percent to 35 percent. The Plan includes components intended to eliminate targeted tax breaks that mainly benefit the wealthiest taxpayers. It also doubles the standard deduction in an attempt to provide tax relief for lower- and middle-income families, providing a lower level of taxation for those who may not otherwise be able to avail themselves of the numerous tax breaks contained within our current tax code.
Elimination of the Federal Net Investment Income Tax and Federal Estate Tax
The Plan would repeal the net investment income tax included in the Patient Protection and Affordable Care Act (or the “ACA”) as well as the federal Estate Tax. Currently, the net investment income tax imposes a 3.8 percent tax on investment income of certain high earning taxpayers. The Estate Tax imposes a maximum of 40 percent on the transfer of property from a deceased individual’s estate.
Elimination of the Alternative Minimum Tax
The Plan would also repeal the Alternative Minimum Tax, a parallel tax designed to prevent potential tax avoidance by high-earning individuals and entities meeting specific income thresholds.
Reduced “Business” Tax Rate
The Plan calls for a sizable reduction of the corporate tax rate from 35 percent to 15 percent. The intent is to boost global competitiveness among U.S. corporations by moving the rate into closer alignment with those of other developed nations. Additionally, the Plan also calls for the same rate for certain non-corporate businesses, presumably including many pass-through entities currently taxed at the applicable owner’s individual income tax rate.
International Tax Reform and Reduced Repatriation Rate
The Plan proposes a move to a territorial tax system, which would limit taxes paid by domestic companies to income generated in the U.S. It would also allow multinational companies to repatriate profits held overseas at a reduced “one-time” tax rate. The outline provided on April 26th was silent as to the applicable rate with respect to the “one-time” repatriation tax, but 10 percent has been referenced by the administration on prior occasions.
It is also important to note that there were certain frequently discussed reforms noticeably absent from the outline provided by Gary Cohn and Secretary Mnuchin. These include: (1) the potential recharacterization of “carried interest,” or an investment manager’s compensatory share of an investment or an investment account’s net profits from capital gains treatment to ordinary income, (2) immediate expensing of certain assets acquired by manufacturers, and (3) a border-adjustment tax.
Given that these reforms figured prominently in the President’s campaign rhetoric, and that recent public commentary from Administration staff has seemingly reaffirmed the Administration’s continued commitment to various aspects of the Plan—including recharacterization of carried interest—we believe these reforms still warrant inclusion in our summary and analysis as possible, if not probable, reforms to be included within the Plan.
Practical Impacts on Taxpayers
A review of the Plan outlined above immediately draws into focus several potential impacts of particular importance to alternative asset managers and their clients.
High-Net-Worth Individuals (or “HNWI”)
While the individual taxpayer reforms have been publicly promoted as a Plan to provide tax relief for lower and middle-income taxpayers, it is clear that reduced rates coupled with an elimination of the ACA’s net investment tax will benefit many HNWIs currently occupying the top tax bracket.
Additionally, and as referenced above with respect to reduced business tax rates, the Plan calls for a 15 percent tax rate for certain businesses, likely including pass-through entities. Since many individuals operating pass-through entities are HNWIs, this could lead to even greater tax savings.
However, not all proposed reforms will pad the pockets of these tax payers. The Plan also calls for the repeal of state and local tax deductions, so HNWIs living in areas imposing significant state and local taxes, such as cities in New York and California, may in fact experience an increased tax burden.
While there is certainly no guarantee that HNWIs will push any excess funds towards alternative investments, the Plan would result in a greater amount of investable capital in the hands of a key constituency within the typical client base of alternative asset firms.
Corporations and Small Businesses
With respect to businesses, the Plan is aimed at stimulating the economy, and corporations unquestionably stand to gain from the reduced tax rate of 15 percent.
According to S&P Global Market Intelligence, every 1 percent drop in the effective tax rate increases anticipated company earnings in the S&P 500 by $1.34 a share. Assuming that as true, the proposed 20 percent drop in corporate taxes could result in a nearly $27 increase in earnings per share for each S&P 500 corporation.
Adding to this notable earnings hike, corporations with large deferred tax liabilities will almost certainly benefit from the lower rate, ultimately resulting in higher overall valuations. In turn, this will positively impact investors, including those in the alternative asset industry.
However, since many investment funds managed by alternative asset managers are taxed as pass-through entities, such funds will not receive a direct entity-level benefit—with the notable exception of certain funds with significant direct exposure to master limited partnerships, which could see an instantaneous jump in net asset value.
Conversely, corporations with large deferred tax assets—attractive acquisition targets for certain alternative asset firms for that very reason—are likely to see their valuations move in the opposite direction.
Multinational Corporations and Import-Export Businesses
Under the current tax system, businesses are required to pay taxes on corporate profits—even if the profit-generating activity takes place outside of the U.S.—once such profits are domestically remitted. If the President moves forward with the territorial tax system, companies may be subject to little or no tax obligations derived from these overseas profits; thus, multinational corporations with offshore activities should benefit from a U.S. tax perspective.
For instance, Bank of America Merrill Lynch estimated that the elimination of tax on foreign profits, when paired with a lower corporate tax rate of 20 percent, could give S&P 500 companies a 12 percent boost of per-share earnings in 2018 alone. Higher per-share earnings can increase valuations and benefit portfolios managed by hedge funds as well as other alternative asset managers, such as private equity firms with multinational portfolio holdings.
Additionally, as Business Insider notes, any repatriation of overseas funds prompted by the Plan’s one-time tax is also predicted to positively impact corporations’ balance sheets and shareholders.
It is also fair to assume that businesses that are net exporters should benefit from any border-adjustment or similar tax. However, as certain commentators have noted, when tax rates have risen in the past, real exchange rates adjusted in a corresponding fashion—ultimately having no effect, or even benefitting importers.
Capital Intensive Domestic Businesses—Notably Energy
Though absent from the April 26th outline, earlier versions of the Plan incorporated an elective immediate expensing of capital investment for U.S. producers with an attendant loss of the business interest rate deduction. If included, this deduction should fuel greater manufacturing and infrastructure investing, in particular with respect to capital intensive oil and gas businesses already primed to benefit from other non-tax related policies driven by the administration’s pro-energy posture.
Other Questions Alternative Asset Managers Should Consider
Moving past the impacts of the Plan described above, several crucial questions remain for alternative asset managers. Most notably: How will carried interest ultimately be treated under the Plan? Recharacterization would almost certainly prove costly for alternative asset managers and result in significant business and legal restructuring.
Despite failing to address this reform on April 26th, the administration has continued to be vocal about reforming what is, at least in the President’s view, an unfairly favorable tax benefit for alternative asset managers. However, as discussed in more detail below, it is also conceivable that the new, preferential tax treatment of pass-through businesses could minimize the economic impact of the elimination of capital gains treatment of carried interest and may even produce a better result in certain instances.
Another important item note is that there is a significant amount of uncertainty surrounding the “business” tax rate and its application to pass-through entities. Will private investment funds—the majority of which are structured as limited partnerships or limited liability companies—be classified as businesses, potentially resulting in an alternative asset manager’s management fee income qualifying for the 15 percent tax rate available to small businesses? If so, it is conceivable that certain alternative asset managers would be subject to a more favorable rate regardless of the recharacterization or non-recharacterization of carried interest.
Also, will there be an additional layer of individual taxation after withdrawal of capital from the fund? If so, the sting of the elimination of carried interest’s current tax treatment would become even more severe. Given the present circumstances, there are various positive and negative scenarios imaginable, which renders more detailed analysis murky at best.
Final Thoughts
Despite numerous uncertainties about both the implementation and collateral impact of tax reform, one area is clear for alternative asset managers: sound business judgment and the high standard of care owed to clients should prompt a critical focus on, and adaptive approach towards, the Plan’s effects.
In fact, even before the formal announcement on April 26th, many industry professionals were already assessing and reacting to the potential influence of President Trump’s campaign tax reform proposals on their businesses. For instance, in a January 2017 interview, the global head of private equity for the Blackstone Group, the world’s largest alternative investment firm, candidly disclosed that the President’s proposed legislation (including tax reform), was “creeping” into the firm’s investment decision-making.
Given the far-reaching and diverse nature of President Trump’s proposed reforms, all alternative asset managers would be wise to follow Blackstone’s lead. Most importantly, they should be keenly aware of any potential negative impacts—in particular those that would prompt investment strategy changes, restructuring of businesses practices and of course amended disclosures to clients (e.g. tax disclosures in an investment fund’s offering documents).
Carl Seiler is a Managing Director and Michael Cramer is a Manager at Blue River Partners, LLC (www.blueriverpartnersllc.com). Blue River Partners is a provider of a variety of outsourced solutions to alternative asset managers including: regulatory compliance program design, implementation and ongoing management; private equity administration; CFO services; fund launch services; tax services; CFO and controller services; and IT and cybersecurity services.
© 2017 The Texas Lawbook. Content of The Texas Lawbook is controlled and protected by specific licensing agreements with our subscribers and under federal copyright laws. Any distribution of this content without the consent of The Texas Lawbook is prohibited.
If you see any inaccuracy in any article in The Texas Lawbook, please contact us. Our goal is content that is 100% true and accurate. Thank you.