Newsflash: Proposed Tax Legislation - Highlights for Investment Funds

The final version of the proposed Tax Cuts and Jobs Act (the “Act”) was released on December 15, 2017. This legislation, unless amended again, is expected to be voted on this week in the U.S. House of Representatives and the U.S. Senate. Below are the highlights of the proposed legislation that are of the most direct interest to investment funds and investment fund managers. These provisions would go into effect if both the House and the Senate approve the legislation without change and the President signs the legislation. Please note that the listed highlights do not reflect many important details of the relevant provisions and also that there are many other significant provisions not included below. 

The section numbers and page numbers listed below relate to the Conference Report version released by the Senate-House Conference Committee on December 15, 2017.¹

1. Corporate income tax rate. The Act would provide for a reduction in the corporate income tax rate from 35% to 21%, generally effective for taxable years beginning after December 31, 2017. This rate reduction would affect the effective tax rate applicable for, among many other entities, taxable blocker corporations used in certain investment fund structures. In addition, this provision includes several conforming amendments to the regulated investment company (“RIC”) tax provisions, including the substituting "section 11(b)" for "section 1201(a)" in section 852(b)(3)(A). The last sentence of section 852(b)(1), which relates to personal holding companies that fail RIC status and become subject to tax, would be stricken. (§13001, p. 115). 
   
   
2. Pass-through income 20 percent deduction. The Act would create a 20 percent deduction for "qualified business income" from pass-through business entities. There are many complexities not detailed here with respect to this provision. Of particular note, however, is that taxable dividends, other than capital gain dividends or qualified dividend income, paid by real estate investment trusts (“REITs”) and taxable income allocated from master limited partnerships (“MLPs”), which generally are “qualified publicly-traded partnerships” for RIC tax purposes, would be entitled to the 20 percent deduction as well. However, the Act does not include a provision specifically providing a pass-through mechanism for RICs invested in REITs or MLPs. (§11011, p. 23). 
   
   
3. Limitation of deduction for business interest. The Act would limit the amount of interest expense allowable as a deduction to the sum of the taxpayer’s (a) business interest income, (b) 30 percent of the “adjusted taxable income”, plus (c) certain other “floor plan financing” interest expense. “Adjusted taxable income” is defined as taxable income for the taxable year excluding (i) income or expenses not related to the applicable trade or business, (ii) business interest income or other interest income, (iii) net operating loss, (iv) any interest deduction allowed under the provisions, and (v) (if before 2022) deduction for depreciation, amortization or depletion. Disallowed amounts could be carried forward under certain rules. Special detailed rules would apply to amounts accrued by partnerships. (§13301, p. 172). 
   
   
4. Net operating losses. The Act would modify the use by corporations of net operating losses (“NOLs”) to offset taxable income, by (i) limiting to 80 percent the amount of any one year’s taxable income that could be offset by an NOL, (ii) by repealing the ability to carry an NOL back to offset a previous year’s taxable income, and (iii) by repealing the 20-year expiration date for NOL carryforwards. (§13302, p. 184). 
   
   
5. Carried interest. To the extent that an investment manager receives a partnership interest in connection directly or indirectly with the performance of managing investment assets, then any capital gains from such interest of three years or less shall be taxable as short-term capital gain rather than potentially long-term, after 2017. (§13309, p. 207). 
   
   
6. Highest individual income tax rate. The highest individual tax income rate would be lowered from 39.6 percent to 37 percent, effective for taxable years 2018 through 2025 only. This rate would be used for those years to calculate after-tax return as reported in prospectuses for investment companies registered under the Investment Company Act of 1940, including open-end mutual funds and exchange-traded funds. (§11001, p. 1). 
   
   
7. Section 529 plans available for elementary and secondary school tuition. Code section 529 Plans, which are used by investors to save tax-free for college tuition and related expenses, would be available to pay for elementary and secondary school tuition and expenses, with an annual limit of US$10,000. (§11032, p. 75). 
   
   
8. Estate and gift tax exclusion. The estate and gift tax exclusion is generally increased from US$5,000,000 to US$10,000,000 (with inflation adjustments, approximately US$5,500,000 to US$11,000,000) for deaths or gifts made during 2018 through 2025. (§11061, p. 101). 
   
   
9. Dividends received deduction. The dividends received deduction is being adjusted downward from 70 percent to 50 percent (from 80 percent to 65 percent in certain cases) to reflect the lowering of corporate income tax rates. (§13002, p. 126). 
   
   
10. Timing of deductions. The acceptable timing of certain deductions for tax purposes would be generally delayed in certain cases so as to coincide to the timing of when expenses would be recognized for financial accounting purposes, effective for taxable years beginning after 2017. (§13221, p. 163). 
    
    
11. SBIC rollovers. The tax deferral currently allowed for certain transfers of publicly traded securities to small business investment companies (“SBICs”) would be repealed, for sales after 2017 (§13313, p. 216). 
    
    
12. Tax credit bonds. Tax credit bonds, including clean renewable energy bonds, qualified tax credit bonds as defined in Code section 54A(d), and Build America Bonds, would not be issuable after 2017. (§13404, p. 229). 
    
    
13. Transfers of partnerships with U.S. ECI. To the extent that a non-U.S. person transfers in a taxable transaction an interest in a partnership that is engaged in a U.S. trade or business, any resulting gain or loss to the extent attributable to the U.S. trade or business, under certain detailed provisions, would be generally taxable in the U.S. as income effectively connected with a U.S. trade or business (“U.S. ECI”). The U.S. Department of the Treasury would be authorized to issue regulations regarding how this provision applies to certain types of transfers. Detailed withholding tax rules would apply. These provisions would be generally effective for sales, exchanges and dispositions after November 27, 2017, with the withholding tax requirements generally applicable after December 31, 2017. (§13501, p. 230). 
    
    
14. Partnerships with substantial built-in loss. The Act would amend the calculation of "substantial built-in loss" for purposes of certain transfers of interest in partnerships, for transfers made after 2017. (§13502, p. 237). 
    
    
15. Partnership technical terminations. The Act would repeal the "technical termination" rules that apply to partnerships experiencing a sale or exchange of 50 percent or more of the total interest in partnership capital or profit, for partnership taxable years beginning after 2017. (§13504, p. 239). 
    
    
16. Sales of life insurance contracts. Certain information reporting requirements would apply to the acquisitions of life insurance contracts or interests in such contracts, for sales made after 2017 and death benefits paid after 2017. (§13520, p. 259). Certain tax basis calculations requirements for such contracts are clarified for transactions entered into after August 25, 2009. (§13521, p. 265). 
    
    
17. Advance refunding bonds. Advance refunding bond provisions would be repealed for bonds issued after 2017 (§13532, p. 273). 
    
    
18. Roth IRA conversions. Certain Roth IRA (individual retirement account) conversions would be restricted after 2017 (§13611, p. 304). 

For a separate OnPoint that discusses the key highlights of the Final Tax Reform Bill more generally, please click here. 

Footnotes 

_{1) View The Conference Report. Sections listed in this summary are generally with respect to the Tax Cuts and Jobs Act (if using “§”), or to the Internal Revenue Code of 1986, as amended (the “Code”) (if using “section”), as applicable.}