The Tax Cuts and Jobs Act
(TCJA) was highly anticipated by the private equity community because of the potential impact on funds themselves. The TCJA is the most significant tax reform legislation in decades and does indeed have far-reaching implications for private companies structured as private equity (PE) firms. At each level, there are key provisions that require evaluation and assessment of the impact on the business at both the fund and portfolio. The TCJA creates tremendous opportunities for funds that are adjusted to incorporate the changes.
Portfolio investmentsNet operating loss changes
The TCJA eliminates the previously allowed two-year carryback period on net operating losses (NOLs) but now allows NOLs to be carried forward indefinitely. Previously, carryforwards were limited to 20 years. However, the amount of NOL carryforward that can be used in any given year is now limited to 80% of taxable income.
Immediate expensing of capital expenditures
Under the TCJA, private companies can expense 100% of the purchase price of both new and used equipment. This is a significant improvement over previous bonus depreciation rules and may make asset deals more attractive.
Interest expense limitations
Private companies will now be able to deduct net business interest expense only up to 30% of the equivalent of earnings before interest, taxes, depreciations, and amortization (EBITDA). After 2021, that limit will be tightened even further, to 30% of the equivalent of EBITDA.
Repatriation toll tax
The TCJA requires a deemed-income inclusion to impose a one-time tax on previously unrepatriated earnings of 15.5% for cash and cash equivalents and 8% for other assets. After the tax is imposed, the foreign earnings can be brought back tax-free. There is a significant amount of deferred U.S. business earnings currently held in foreign jurisdictions, so there will likely be significant capital returning to the United States, although some private companies will be facing steep tax bills from the transition tax itself.
Funds and ownershipCarried interest
The holding period necessary for carried interest to qualify for long-term capital gains treatment has been increased from one year to three years. Given that the highest individual rate is 37%, while long-term capital gains are taxed at 20%, recipients of carried interest should carefully examine the underlying investments to ensure proper timing.
While this change hasn’t been widely publicized, private company owners of pass-through entities face new, stricter limits on their ability to use losses to offset other types of income.
Owners of certain pass-through entities are now entitled to a deduction of up to 20% of their flow-through income. However, private equity investors and portfolio companies should consider that many service businesses — including legal, financial services, accounting, consulting and investment businesses — may not qualify for this deduction.
TCJA effects on transaction modeling
To begin with, a reduction in the corporate tax rate from 35% to 21% means that your investment in any given deal will likely generate additional cash flow. Start from there and consider the following questions.
How will rate changes impact pricing multiples?
Fund managers that fail to consider the cash increase could lose deals to others that understand more funds will be available to pay for step-ups and gross-ups.
Significantly lower corporate tax rates may boost cash flow in many cases
Given the new lower rates, fund managers may also wish to look at the value of on-shoring versus off-shoring — is it time to think about bringing overseas operations back to the United States to take advantage of lower rates? Of course, your modeling needs to consider your entire tax picture. For example, while the TCJA provides for 100% depreciation at the federal level, states may not necessarily follow suit. Models need to consider overall effective tax rates, not just the federal rate.
How will tax attributes like NOLs and interest limitations affect your deal?
While the use of NOL carryforwards going forward is limited to 80% of taxable income, there is no such limitation on pre-2018 NOLs.
Given the new limit on the interest expense deduction, it will take robust modeling to determine what, if any, limit you may face and how to address it. Should you put more equity into a deal? Could leasing be an alternative to debt? If an opportunity you are modeling includes foreign operations, do push-down options make sense? Can a foreign subsidiary, which won’t have the U.S. interest limitation, service some of the debt?
Fund managers will need to rethink how they model the impact of transaction costs, as they can no longer be used to create significant NOLs, for example through stock options, and then carry them back. You can carry NOLs forward indefinitely, but given the significantly lower tax rates, the future value of NOLs is lower. One more NOL issue to consider: While the use of NOL carryforwards going forward is limited to 80% of taxable income, there is no such limitation on pre-2018 NOLs.
How does immediate expensing affect models?
The asset-versus-stock transaction structure deserves a new level of consideration.
Because the TCJA allows the immediate expensing of all capital equipment, including used equipment, if you buy a company and make a Section 338(h)(10) election, where you make a deemed purchase of assets, you could be looking at a significant immediate tax deduction. This means that the asset-versus-stock transaction structure deserves a new level of consideration. It also means that, when considering the purchase price allocated to fixed assets as part of your modeling, you should no longer just assume that book value is sufficient. It’s worth taking a closer look.
Interest expense limitations could play a larger role for one company while the expensing of capital expenses could result in a larger role for another.
TCJA effects on valuations
While the significant reduction in tax rates will affect valuations, private company PE fund managers must remember to examine all of the underlying inputs into their valuation models to capture all of the nuances driven by the TCJA. Not all industries, or all companies within an industry, will be affected the same way. For example, interest expense limitations could play a larger role for one company while the expensing of capital expenses could result in a larger role for another.
With that caveat, here’s how the new rules could affect some common valuation methods and issues.
It’s obvious that the significant reduction in tax rates will affect valuations, but every company’s tax situation is unique — you need to consider the company’s overall effective tax rate, not just the effect of the Act. Also, comparable transactions completed prior to the TCJA are going to be less relevant as their values would be based, in part, on outdated tax information. To the extent you rely on transactions that predate it, you will have to adjust their values accordingly.
The income approach focuses primarily on cash flow and discount rates, so the TCJA does have an impact. However, you are also considering the cash flow and discount rates over time, so you need to consider the likelihood that some of the provisions of the TCJA may be repealed or changed over time and to reflect that likelihood in your terminal value assessment. You also need to consider whether and how the target is likely to reinvest additional cash flow due to the TCJA. Will they hire more people? Increase R&D? Step up sales and marketing efforts? Buy back shares? How will those actions affect value?
Cost of debt
Be sure to consider the true cost of debt. The new limitations on interest deductibility may impact your after-tax calculation when developing your average weighted cost of capital. You may have a pre-tax and an after-tax portion.
Beta calculations are typically derived using a monthly five-year average, so de-leveraged betas will be based on the old historical rates while re-leveraged betas will be based on the new rates.
Additional risk premium
The presumption in a discounted tax flow model is that rates will stay the same forever, especially if you’re using a Gordon Growth Model to derive terminal value. But is that realistic? Rates under the TCJA are the lowest they have been in many years, so should you consider the chance that they will rise over time? What other provisions of the TCJA might be modified or revoked? Finally, make sure you properly reflect new NOL requirements and limitations.
TCJA effects on deal structuring
Various aspects of the TCJA are likely to exacerbate the existing tension between buyers and sellers when it comes to deal structuring. For tax and nontax reasons, buyers typically prefer to buy assets while sellers prefer to sell stock. Given the new ability to immediately expense the full cost of new and used assets, buyers will prefer asset purchases even more strongly, particularly with manufacturing companies or other businesses with heavy property, plant and equipment elements. It is usually easier for buyers and sellers to agree on a deal structure when the company involved is a pass-through entity.
When it comes to entity selection, and given the decreased corporate tax rate and the inherent complexities that result from owning its portfolio investments through flow-throughs (e.g., effectively connected income [ECI], UBIT, and state and local considerations), fund managers should reassess their investment thesis as it relates to pass-through versus C-corporation entity status. Also, international operations might drive the investment decision toward a particular corporate form to minimize the adverse rules related to several new international tax provisions, such as the Global Intangible Low Taxed Income (GILTI) tax.
The gain from the sale of many types of self-created intellectual property, such as patents, designs and secret formulas, will now generally be considered ordinary income.
The TCJA changes the treatment of certain intangibles, which could complicate some deals. In an industry such as software, where such assets can account for a significant portion of an entity’s value, the owner of a flow-through entity who now will face an ordinary tax bill instead of long-term capital gain is likely to want a gross-up as part of the deal.
As mentioned previously, deals involving foreign business may be structured in such a way as to push debt down to foreign subsidiaries in order to avoid the new interest expense limitations.
TCJA effect on fund operations and portfolio companies
Under the TCJA, the holding period necessary to secure long-term capital gains treatment for carried interest increases from one to three years. In order to determine the holding period, you need to examine both how long the partner has held the interest and how long the partnership has held the underlying asset. The change in holding period is unlikely to affect most private equity investments as they tend to hold their investments for more than three years. But you will still need to consider add-on acquisitions and the timing and hold period for those investments. In addition, the statute is unclear in some areas, and guidance may affect whether the extended holding period applies to Section 1256 contracts, Section 1231 gain, limited partner interests and/or other situations.
Two issues will affect tax-deferred and foreign investors: unrelated business income, and 10% withholding on the gross transaction price.
First, the tax-deferred investors will no longer be able to aggregate unrelated business income from a private equity fund with unrelated business income from other trades or businesses. Second, for foreign partners, on the sale of a partnership interest, any ECI, no matter how many tiers down, triggers 10% withholding on the gross transaction price. Unlike withholding under Sections 1441 or 1442, this provision will also require the investor to file a U.S. tax return. Using a blocker corporation for U.S. investments is an effective way for tax-deferred and foreign investors to address both the aggregation and ECI issues.
Fund managers with accumulated foreign earnings held in a foreign subsidiary will have to deal with the transition tax at a rate of 15.5% for cash and 8% for noncash assets.
Fund managers will need to revisit multinational structures for both themselves and their portfolio companies.
Controlled foreign corporation (CFC) structures may make sense, provided there is no Subpart F income. But you will also need to consider the new Base Erosion and Anti-abuse Tax (BEAT) and the GILTI. Are you using offshore entities to manage taxation related to your intellectual property? Have you used tax structuring to inappropriately reduce your global tax exposure? If so, BEAT and GILTI may come into play.
Finally, the new foreign derived intangible income (FDII) provisions of the TCJA may provide benefits to corporate entities that keep their intellectual property in the United States and use them to generate income in foreign jurisdictions.
Fund managers will have to consider their unique facts and circumstances and those of their portfolio companies along with the interplay of all these issues to make the right decisions.
The TCJA has far-reaching implications for all U.S. businesses. Those implications will evolve as the IRS and other authorities offer guidance going forward. Private company PE fund managers will need to continue to track these issues for themselves, their partners, their investors and their portfolio companies.
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