How the Tax Reform Is Affecting U.S. Hedge Funds Investments
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Hedge Fund Managers
Changes in the taxes of carried interests.
There is now a three-year holding period on capital gains in order to qualify for the long-term capital gains rates. The gains which have been recharacterized by this new rule are now considered to take on the short-term capital gains rate. Also, a manager’s carried interest in a hedge fund will eventually be subject to this new rule. The strategy that the hedge fund manager chooses will determine the effect of this rule.
Other rules under new 1061
Partnership interests held by corporations are not limited. Code Section 1061 exempts and corporation from this rule. The IRS has stated that they will provide some guidance to prevent fund managers from skirting this limitation using S corporations. Managers may consider incorporating their businesses as C corporations to qualify for the 21% flat corporate tax rate. There are provisions that cover transfers to “related parties” as well. This rule does not seem to apply to long-term capital gains.
Practical observations for the new 1061
The hedge fund managers investment strategy will affect this limitation. However, regardless of the strategy used, the new carried interest three-year holding period rule will potentially impact the fund’s manager through the sale of the fund management business. The specifics on the application to sale of carried interests in not completely clear.
Potential structuring opportunity for the new 1061
Funds that don’t produce significant amounts of long-term capital gains might consider restructuring. For U.S. individual fund managers, the 37% tax for short-term capital gains and ordinary income is the same, while allocated short-term capital gains are subject to the 3.8% Medicare contribution tax. There are some potential issues with respect to restructuring. As stated in Code Section 409A/457A there may be some issues if the performance fee is deferred for 12 months or more. Also, for managers based in New York City a performance fee would be subject to unincorporated business tax.
Exception to new 1061 for non carried interests
The three year holding period doesn’t apply with respect to capital interest in a fund, which gives the manager the right to issue the funds capital commensurate with the amount of capital contributed. Actual capital contributions may be required for this exception. If the fund managers increase interest in a fund’s capital, due to a carried interest, it will not be reflected by a separate contribution most of the time.
New 1061 – state and local tax considerations
There may be some variation in how state and local jurisdictions distinguish between the taxation of long-term and short-term capital gains. Treatment could also depend on if a state automatically conforms its tax laws to the new tax codes.
Executive compensation deduction
Code section 162(m) was modified by the new tax bill and limits deductions of “remunerations” paid to “covered employees” of “publicly held corporations” to $1,000,000. There was also a revised definition of “covered employee” and also makes anyone who was a covered employee after December 31, 2016, remain that was for all future years. The definition “publicly held corporation” was expanded to include all domestic publicly traded corporations and also foreign companies that are publicly traded through ADRs.
Tax treatment of sales of patents and trade secrets
Code Sections 1221(a)(3) was changed to exclude trade secrets and patents held and created by a taxpayer from the definition of “capital asset.” Now the sale of any such item will result in ordinary income. Fund managers with valuable trade secrets or patents should focus on this rule in the context of sales of fund management business. There is a greater importance of purchase price allocation because the capital gain treatment will continue to apply to going concern value, goodwill, and other intangible assets.
Implications For Hedge Funds
Revised 163(j) limits the deductibility of business interest
The new tax code limits the deduction for business interest to the sum of business interest, and 30% of adjustable taxable income.”Adjustable taxable income” approximates EBITDA for 2018-2021, and EBIT for 2022 and later.
Additional rules for new 163(j)
Businesses are exempt if their annual gross receipts are $25M or less. Also disallowed business interest can be carried forward indefinitely. Real property businesses or trades can usually elect out.
Considerations for new 163(j)
Deduction limitations of business interest could be significant for leveraged hedge funds that participate in active trading. The limitation could reduce the economic return to such funds and their investors. The partnership level is usually where the limitation is applied. However, “excess business interest” of a fund may be allocated to its investors and cause adjustments to the basis of interests held by shareholders. There are also complexities regarding the application of the limitation to tiered partnerships.
Tax accounting- tax/book conformity
After December 31, 2017, an accrual taxpayer could be required to take an item of gross income into account for tax purposes in the year the taxpayer takes the item into account as revenue for two things. Either an applicable financial statement or, and other financial statement specified by the IRS. an “applicable financial statement” is a financial statement certified as being prepared in accordance with GAAP. That includes and 10-K or yearly statement to investors required to be filed with the SEC. Second, and audited financial record used for credit purposes or reporting to partners, shareholders, or other proprietors or beneficiaries.
Implications For Taxable U.S. Investors
Pass through deduction
There is a significant change to the basic treatment of income from pass-through entities. There is a deduction of up to 20% for “qualified business income” allocated to noncorporate partners. There are also formula limitations on amount deductible. However, Code Section 199A specifically states that “qualified REIT dividends” and “qualified publicly traded partnership income” do not count as “qualified business income.”
The dividends that count as “qualified REIT dividends include ordinary REIT dividends but exclude capital gain dividends.
Disallowance of miscellaneous itemized deductions
There are certain noncorporate taxpayers as well as individuals that are not allowed to deduct miscellaneous itemized deductions for tax years after December 31, 2017, and before January 1, 2026. The fund expenses for nontrader funds are likely treated as miscellaneous itemized deductions.
Disallowance of excess business deductions
Under Section 461(I) of the code, noncorporate taxpayers whose trade or business activity generates losses in excess of a taxpayer’s trade or business income, a maximum of $250,000 of the losses can be used to offset investment income for the year. Excess business losses are that are disallowed by this rule cannot be used to offset tax liability on investment income. Although, it can be carried forward as net operating losses that can then be utilized in years after.
Effect on blocker Entities
Effect of new rules on U.S. and offshore blocker structures.
U.S. blocker corporations are typically used to shield non- U.S. and U.S. tax-exempt investors from direct U.S. tax filing. They may be utilized in conjunction with the debt and equity of investors. The new restriction on interest deductions could reduce the blocker-level tax benefits for this leverage. With respect to non-U.S. investors, leverage may still be helpful to allow distributions without the U.S. withholding tax of principal interest. Going forward, the U.S. corporate tax leakage of a U.S. blocker will be reduced. The reason for this is because of the now-reduced 21% federal corporate tax rate.
Effect on U.S. Tax exempt Investors
Unrelated business taxable income
With the new tax law, a tax-exempt entity has to calculate UBTI differently for each unrelated trade or business activity. Now a tax-exempt entity cannot offset expenses or losses from one business or trade with income gained from another trade or business. These changes take effect for taxable years after December 31, 2017. However, there is a transition rule that allows a tax-exempt entity to carry forward net operating losses that were created by UBTI-producing investments in a taxable year before January 1, 2018, and against UBTI-producing investments in subsequent years. Most likely more guidance will be required to determine how to separate unrelated trades or businesses.
Tax on “applicable educational institutions”
The new law states that a 1.4% tax will generally apply to the net investment income of “applicable educational institutions.” Applicable educational institutions include accredited institutions of higher learning that had a daily average of at least 500 students during the previous tax year. Half of those students must be located in the United States.
To compute its net investment income, an applicable education institution will usually take into account its allocable share of a hedge fund’s capital gain net income and gross investment income.
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