The 5 tax issues keeping deal-makers up at night

IRC Section 163(j) and its proposed regulations are imposing limitations on business interest expense deductions. For most businesses, the amount of deductible business interest expense in a taxable year may now not exceed the sum of the taxpayer’s business interest income for the year, 30% of the taxpayer’s adjusted taxable income (ATI) for the year, and the taxpayer’s floor plan financing interest expense (if applicable) for the year.

In the past, most companies could fully deduct business interest expense. The rule changes, which impact tax years beginning after December 31, 2017, are viewed by some as creating greater parity for debt versus equity financing and causing private equity and other investors to reassess the way they structure their deals moving forward.

The definition of interest under Section 163(j) has broadened, now including amounts that customarily were not deemed as interest under the tax code. Capital markets participants need to understand this expanded definition of business interest and how the new limitation on deductibility impacts their business operations and the financing decisions for their transactions.

The tax treatment of carried interest continues to be an unresolved topic. Practitioners are currently applying carried interest laws with very little guidance while fund managers must prepare for the fact that the favorable tax treatment of carried interest could go away at any time.

While Section 1061 of the tax code increased the long-term capital gains holding period of an applicable partnership interest (API) from more than one year to more than three years, it still permits the favorable tax rate that partnerships currently enjoy for carried interests or other grants of profits interests for disposition of assets held over three years. 

Earlier this year, members of Congress reintroduced The Carried Interest Fairness Act of 2019 which would change the treatment of carried interest income for investment firms, taxing it at a higher, ordinary income level instead of as capital gains regardless of the holding period.  With the treatment of carried interest still being debated, investment firms should act now to formulate a proactive, comprehensive tax strategy as they await a decision by Congress on what Damon Silvers, director of policy and special counsel for the AFL-CIO, has called “… the single most outrageous loophole in the tax code.” 

The two-year NOL carryback was eliminated in 2018. However, these losses may be carried forward indefinitely, instead of expiring after 20 years, with some exceptions. Also, beginning in 2018, an excess business loss (more than $250,000 for a single filer or $500,000 for a married joint-filer) cannot be deducted in the current year. Instead, losses above these threshold amounts are carried over to the following tax year and can be deducted under rules applying to net operating loss (“NOL”) carry-forwards. Finally, NOLs may now only offset 80% of taxable income going forward.  

Private equity firms and other financial sponsors should pay close attention to new NOL regulations in 2020 when forecasting their cash flow, determining estimated tax payments, and preparing financial statements. In prior years, under the former corporate alternative minimum tax (AMT) regime, corporations could offset 90% of AMT income with AMT NOLs. The new 80% limitation on the use of regular NOLs will probably have negative repercussions for the capital markets, offset somewhat the lower overall corporate tax rate. 

Global intangible low-taxed income (GILTI) regulations have been finalized for U.S. taxpayers owning an interest in controlled foreign corporations (CFCs). CFCs are defined as multinational companies with more than 50% of the total voting power or stock value owned by U.S. shareholders. New GILTI regulations allow CFCs to allocate a portion of specified domestic expenses to their foreign subsidiaries and employ unused foreign tax credits, thereby lowering their overall tax burdens.

More and more companies are being defined as CFCs subject to GILTI and subpart F regulations as the procedures and calculations surrounding GILTI and other international tax law changes will continue to evolve. Every fund manager involved with offshore investments needs to understand the potential impact of GILTI and develop a comprehensive tax strategy for these investments moving into 2020.

The 2018 South Dakota v. Wayfair decision by the U.S. Supreme Court enables states to use a lower threshold in determining if a company has a filing responsibility. Today, sales tax nexus can be created through economic activity, whereas prior to the Wayfair decision a physical presence in a state was generally necessary for sales tax nexus to exist. 

Financial sponsors involved in a transaction must understand that the Wayfair decision could significantly impact the financials of the transaction. If the company being acquired owes tax due to the identification of nexus in states where it has not been collecting sales tax, the tax liability, penalties, and interest can be significant.