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Trump’s sweeping tax reform proposals and the possible impact on managers of hedge funds and private equity funds

By A J Alex Gelinas (pictured), Sadis & Goldberg LLP – President Trump has made tax reform a priority and the election of a Republican-controlled Congress has created the possibility for major changes in federal income tax and estate taxes. Despite the current in turmoil in Washington DC, there is a general belief that some sort of major tax reform will be enacted in 2017 or 2018. 

On April 26, President Trump unveiled a one-page summary of the “2017 Tax Reform for Economic Growth and American Jobs” (the Trump Proposal). The President’s press release described the Proposal as the “biggest individual and business tax cut in American history” but the press release was somewhat short on the details. The Republicans in the House of Representatives had earlier crafted their own more detailed tax reform proposal (referred to below as the “House Blueprint”). This article considers the tax proposals in the Trump Proposal and portions of the House Blueprint from the perspective of the managers of hedge funds and other private investment funds. 

1. Tax relief for individuals and tax simplification

The Trump Proposal would reduce the maximum federal income tax rate for individuals and other non-corporate taxpayers from 39.6 per cent to 35 per cent, and reduce of the number of individual tax brackets from seven to three. Effectively, these changes would reduce income taxes for most individuals though no determination has been made on the income levels where these brackets would be set. In addition, the Proposal would double the standard deduction used by lower income taxpayers (so no married couple would pay tax on the first USD24,000 of income). The Trump Proposal would also repeal (1) the Alternative Minimum Tax; (2) the 3.8 per cent tax on Net Investment Income (the NIIT) which was added to the tax law to pay for the Obama Administration’s Affordable Care Act; and (3) the federal estate tax. (The federal gift tax would remain in effect.)

The Trump Proposal would also retain the current maximum tax rate of 20 per cent on qualified dividends and long-term capital gains (exclusive of NIIT). The Trump Proposal addresses simplification goal by doubling the standard deduction and eliminating most of the itemised deductions for individual taxpayers. However, the Trump Proposal would retain the deduction for home mortgage interest and charitable contributions. 

The Trump Proposal makes no mention of tax changes relating to carried interest, though he had taken the position in his campaign that the low rates currently available to individuals receiving carried interest should be eliminated from the federal tax law. 

2. Major reduction of the income tax rates on business income

Under the Trump Proposal, the corporate federal income tax rate would be reduced from the current 35 per cent rate to 15 per cent. In addition, individuals reporting business income from S corporations, partnerships and other pass-through entities would be subject to the same 15 per cent rate (instead of the current 39.6 per cent maximum rate). It is uncertain whether this 15 per cent rate would apply to all pass-through income. The corporate tax rate reduction would make US tax rates more comparable to other countries, such as the United Kingdom (which has a 19 per cent tax rate) or Canada (which has a 15 per cent federal tax rate and 11-16 per cent provincial rates). The House Blueprint proposes a 20 per cent corporate tax rate.

A proposed tax reduction of this magnitude would have a significant impact on multinational businesses operating inside and outside the United States. For example, US-based multinational corporations would have less incentive to shift profits overseas to avoid higher US income taxes. Similarly, foreign based companies previously apprehensive about forming subsidiaries in the United States are likely to be less hesitant if the US tax rate were as low as 15 or 20 per cent. Also, such a tax rate reduction could cause US companies to repatriate foreign operations and assets to the United States.

3. Establishing a territorial tax system for corporations

The Trump Administration would also switch the United States to a territorial tax system, as a way to “level the playing field” for US companies. This was also advocated in the House Blueprint. Under a territorial tax system, only income sourced domestically (ie, in the US) would be taxable to corporations. Foreign-earned income of corporations would be excluded from US income taxation. The current tax system of taxing US corporations on their “worldwide income” is out of step with the territorial tax systems used by countries which are the major trading partners of the United States. 

4. One-time opportunity to repatriate trillions of dollars held overseas at a low tax rate

US multinational corporations currently have approximately USD2.6 trillion dollars held in overseas subsidiaries that have not been repatriated to the US because any amounts repatriated under current tax law would be generally subject to a 35 per cent federal corporate income tax. The Trump Proposal includes a one-time repatriation tax on the foreign earnings of US companies currently held in foreign subsidiaries. The Trump Proposal does not specify the specific repatriation tax rate even though the Trump Administration in prior comments had advocated a 10 per cent repatriation tax rate. The repatriation tax is a revenue raiser which helps reduce the potential budget impact of the entire tax reform proposal. It should be noted that the House Blueprint suggested bifurcated rates of 3.5 per cent for foreign earnings and profits invested in “hard assets” and 8.75 per cent for earnings and profits held as cash equivalents. The rate used when former President George W. Bush provided a similar incentive in 2004 was 5.25 per cent. Treasury Secretary Mnuchin has stated that the applicable rate would be determined after discussions with members of Congress.

The Trump Administration views the tax revenues that would be generated under this “tax holiday” proposal as a windfall for the United States that could stimulate the economy and drive the growth objectives underlying the President’s tax reform proposals. Conceptually, such revenues could be available to fund various job creation initiatives and infrastructure projects.

5. Key differences between the Trump Proposal and the House blueprint version of tax reform

In contrast to the House Blueprint, the Trump Proposal does not contain a commitment to budget-neutral tax reform. One reason for this was the fact that the Trump Proposal does not contain any discussion of a cash flow tax or the border adjustment approach which were contained in the House Blueprint. The Trump Proposal also contains no commitment to implement permanent tax reform, as opposed to tax cuts that would sunset in ten years (unless extended by new legislation). 

Neither the Trump Proposal nor the House Blueprint addressed the various transitional problems that result from a change in tax law. Deferred effective dates and phase-in provisions were a significant part of the work involved in crafting the landmark 1986 tax reform legislation. 

6. Impact of tax law changes on valuation of corporate stock and other financial assets

Fund managers should note that dramatic changes in federal tax laws can have very positive or negative effects on the fair market value of stocks, securities or other investment property. For example, a change in the applicable income tax rates would cause changes in the financial statements of corporations and other businesses. Thus, a corporation with a tax asset on its balance sheet, e.g., for a net operating loss carryover, could have to reduce the valuation of such tax asset by reason of the rate reduction. Similarly, the adoption of a low rate of tax on repatriation of offshore cash could provide a boost to a corporation’s balance sheet since the deferred tax liability has been reduced by a significant amount. There could also be unintended economic problems resulting from major tax reform. For example, the tax reform legislation in 1986 dramatically curtailed the ability of high income taxpayers to shelter their compensation income or passive investment income. Such changes impacted the values of buildings as tax sheltered investments and caused a disruption in the real estate industry and financial problems for savings and loan associations and other banks that had been engaged in aggressive lending to real estate ventures.

7. Prospects for industry winners and losers in the tax reform process? 

Multinational businesses have been able to keep their foreign earnings outside the US income tax net thanks to lots of aggressive cross-border tax planning. However, there are certain industries, such as service businesses or retail sales business that operate only in the United States, that currently pay the full 35 per cent corporate income tax rate on their net income. Such high tax rate companies would derive the most benefit from a dramatic reduction in the corporate tax rate from 35 per cent to 15 or 20 per cent. The large tech companies would primarily benefit from the ability to repatriate their large offshore cash holdings from their foreign subsidiaries at a very favourable tax rate. Certain industries, such as the companies engaged in oil and gas production or mining, and the real estate businesses may not derive a significant benefit from the tax reform legislation if their traditional tax breaks (e.g., for intangible drilling costs and percentage depletion in the case of the natural resource companies, and generous depreciation rules for debt-financed real property) are removed from the tax law or phased out over a specified period.

8. Prospects for an infrastructure boom?

As divided as the US population may be on political issues, one issue on which there appears to be strong bipartisan support is the need to rebuild our nation’s infrastructure. Democrats have supported this for years, and President Trump made it one of the centerpieces of his domestic program. The revenues from a relatively low rate repatriation tax on the two to three trillion dollars sitting offshore in foreign subsidiaries of US corporations could provide a source of funds to pay for the infrastructure program.

9. What about a possible M&A boom?

It has been suggested that some companies may use the repatriated cash to fund dividend increases and/or stock buybacks. Some companies would have much more funds available for repatriation than others. For example, it has been reported that Apple Computer has offshore cash held in its foreign subsidiaries that would be enough to purchase several other companies that are big enough to be included in the S&P 500. One should expect that some repatriated money would find its way into M&A transactions. While the top five overseas cash holders are technology companies, such as Apple and Microsoft, the pharmaceutical industry also account for a big chunk of such cash. The repatriation of offshore funds by Big Pharma or the largest biotech companies could cause such companies to go on the hunt for smaller companies with drugs in clinical trials that could replenish the acquirer’s product pipelines.

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