The Bracewell Tax Report is a periodic publication focused on developments in federal income tax law, including the recently enacted Tax Cuts and Jobs Act (TCJA), with emphasis on how such developments impact the energy, technology and finance industries. The publication provides summaries of changes in tax law and its interpretation, as well as related practical guidance critical to making strategic business decisions and negotiating transactions.
Week of March 26
The New Partnership Audit Rules, Part 2: The Election Out
By Liz McGinley and Steven Lorch
This is the second of several installments of Bracewell Tax Report articles describing the new rules applicable to partnership audits under the Internal Revenue Code and the related proposed and final Treasury regulations. Each installment focuses on certain aspects of these rules and the practical implications to partners and partnerships, particularly as they relate to negotiating and drafting partnership agreements.
On November 2, 2015, President Obama signed into law the Bipartisan Budget Act of 2015, which included a new federal audit regime for partnerships and entities classified as partnerships for tax purposes (the New Rules). The New Rules, effective for audits of partnership tax years beginning on or after January 1, 2018, generally allow the IRS to adjust items of income, gain, loss, deduction or credit of a partnership, and collect any resulting underpayment of tax, at the partnership level. Click here for more background on the New Rules.
The New Rules include a special election (the Election Out) that allows certain partnerships to choose not to be subject to the New Rules. If a partnership makes the Election Out, any federal audit of the partnership must be conducted at the partner level, on a partner-by-partner basis, under the audit procedures applicable to each partner. With a valid election, the partnership would not be subject to audit adjustments or the imputed underpayment regime of the New Rules and, therefore, would avoid any risk that a federal audit liability would be imposed at the entity level.
A partnership is permitted to make the Election Out for any taxable year if, at all times during the year, the partnership has 100 or fewer partners and all of such partners are eligible partners. An eligible partner is any individual, C-corporation (including certain foreign entities that would be treated as C-corporations if domestic), S-corporation or an estate of a deceased partner. For purposes of the 100 partner limitation, the partnership must count each partner to which the partnership is required to send a Schedule K-1, plus, in the case of any S-corporation that is a partner, each shareholder to which such S-corporation is required to send a Schedule K-1. Partnerships and disregarded entities are not eligible partners for purposes of the Election Out. Accordingly, many partnerships—from partnerships in complex structures with multiple tiers of partnership owners, to relatively simple partnerships with even a single partner that is a partnership or disregarded entity—would be unable to make the Election Out. The New Rules give authority to the Treasury Department, however, to issue future regulations to expand the types of entities that could qualify as eligible partners.
The Treasury Department and the IRS issued final regulations concerning the Election Out on January 2, 2018 (the Final Regulations). Prior to the release of the Final Regulations, commentators suggested that the definition of eligible partner be broadened to include partnerships and disregarded entities, which would greatly expand the population of partnerships that could make the Election Out. Some commentators also made the request to include disregarded entities that are owned by persons or entities that would otherwise be eligible partners under the New Rules. The Treasury Department and the IRS, however, chose not to expand the scope of the definition of eligible partner. In the preamble to the Final Regulations, the Treasury Department explained that an expansion of this definition would ultimately result in fewer partnerships being subject to the New Rules and therefore require the IRS to perform more audits at the partner level, which the IRS considers to be less efficient than audits under the New Rules. The Treasury Department, however, expressed that it is willing to consider changes to this definition after the Treasury Department and the IRS gain experience implementing the New Rules. Under current guidance, however, partnerships with even a single ineligible partner for any taxable year should expect to be subject to the New Rules for such year.
A partnership must make the Election Out separately for each taxable year by claiming the election on its timely-filed federal income tax return. In addition, the electing partnership must provide to the IRS, for each person or entity that was a partner (and each person that was a shareholder in an S-corporation partner) at any point during the taxable year, such person’s name, U.S. tax classification and taxpayer identification number, along with a statement that each partner is an eligible partner, and the partnership must notify each partner within 30 days after making the election. Commentators expect that the IRS will take steps to invalidate an Election Out if any of the required information relating to a partnership’s eligible partners is missing or incomplete, but they are not expecting the IRS to invalidate the election if the partnership fails to provide the proper notification to each partner.
Partnerships have taken a wide variety of drafting approaches with respect to the New Rules since they were enacted in 2015. With respect to the Election Out, however, partnership agreements almost uniformly include a covenant that the partnership representative will make the election, if available, without the consent of, or any consultation with, the partners. The prevailing view is that opting out of the New Rules would, on balance, be beneficial to the partnership in nearly all scenarios. In addition, partnership agreements generally include a covenant requiring all partners to cooperate with the partnership representative to effectuate the Election Out.
Our next installment will focus on the push-out election under the New Rules, which permits a partnership to allocate any partnership-level adjustments to its partners in the year under review, rather than cause the assessment to be borne at the partnership level.
From Hollywood to the Gray Lady: The Impact of Tax Reform on Film, Television and Print Media
By Michele Alexander and Ryan Davis
While the media has been reporting on recent tax reform since before the first draft of the bill was introduced, tax reform also will impact the media industry itself, in ways both expected and unexpected. As we will explore here and in future installments, the industry may be impacted in many ways, from a reduction in tax rates and new deductions, to the loss of important deductions and new international regimes that have kept tax experts waiting in anticipation of further guidance.
Considered some of the biggest winners as a result of the reduced corporate tax rate, media companies stand to reap billions from the 40% decrease (from 35% to 21%) provided for in the Tax Cuts and Jobs Act (TCJA). Most of the largest companies in this space operate as corporations (such as Disney, Comcast, and 21st Century Fox) and, as a result, the industry paid one of the highest effective tax rates of any sector.1 Moreover, media companies operating in corporate form will be able to take advantage of the new 100% dividends received deduction (DRD) for distributions from a foreign subsidiary to its 10% U.S. shareholders. This deduction applies only to the foreign-source portion of dividends received from a foreign corporation by its U.S. corporate shareholders and is therefore not available to companies which operate as partnerships (or other entities treated as pass throughs, such as LLCs), resulting in an advantage for media companies over their competitors operating in these non-corporate forms. As a result of these factors, the media and entertainment industry is expected to see one of the largest windfalls as a result of the TCJA's passage. This newfound surplus comes at a particularly precarious time for these media companies, as cord-cutting, competition from internet-based streaming and other services and the multiplication of alternative news sources have cut into the revenues of film, television and print media.2 Consequently, these companies may use this income to reinvest in capital and labor, as many claim was evidenced by the widely publicized bonuses both Disney and Comcast paid to employees in the immediate aftermath of the TCJA's passage.3 However, some argue that companies will not use the windfall for compensation but rather for stock buybacks and other actions to benefit stockholders.4 These additional funds also may lead to an increase in M&A activity, as companies attempt to use the extra cash to fund both mergers and acquisitions in order to better secure their place in an increasingly difficult market.
Owners of smaller media companies that operate as partnerships also may benefit from the new qualified business income (QBI) deduction (click here for more). New Code Section 199A generally permits a 20% deduction against taxable income for QBI, which, broadly-speaking, is taxable income earned through partnerships from certain U.S. trades or businesses. Under prior law, an individual taxpayer’s QBI would have been subject to the ordinary federal income tax rates applicable to individuals, with a maximum rate of 39.6%. Under the TCJA, unless limitations apply, the QBI deduction could reduce the maximum effective rate imposed on an individual’s share of a partnership’s QBI to 29.6% (or 80% of the new maximum ordinary rate of 37%). However, new Code Section 199A seems to come at the cost of former Code Section 199, which provided a deduction for domestic production activities (the Domestic Production Activities Deduction or DPAD) and was relied upon heavily in the media and entertainment industry, most notably for film and TV production. This incentive brought film and TV production back from Canada and other jurisdictions that had initially lured companies abroad with low cost and tax incentives. U.S. states, such as Georgia, New York and North Carolina, and U.S. cities, such as New York City, followed suit by implementing incentives of their own. With the repeal of the DPAD, it remains to be seen if state and local incentives will be sufficient, along with lower tax rates and a new expense deduction (discussed below), to keep media production on shore or whether they will have to add new incentives and/or augment existing ones.
As noted, the loss of the DPAD may be partially counteracted by new production incentives for domestic film, television and live theater. The immediate expensing provision contained in Code Section 168(k) allows businesses to immediately deduct the full cost of new and used property placed into service between September 27, 2017 and (generally) January 1, 2023, at which point the percentage that may be expensed begins to be phased down through January 1, 2027. Code Section 168(k) specifically permits film and theater production companies to take advantage of this new immediate expensing with respect to their capital investment in projects where 75% of the compensation for services occurs in the United States, with the intention of increasing the number of projects undertaken domestically. The extent to which this new deduction mitigates the effect of the DPAD’s repeal thus depends in part on how capital intensive a company’s production activities may be.
Media companies debating the pros and cons of keeping production activities in the United States certainly will have to consider the implications of the TCJA’s international tax reform provisions. In addition to the decreased corporate rate, the second primary aim of corporate tax reform was bringing the U.S. federal tax system more in line with the territorial model. These provisions seek to accomplish this by both encouraging the repatriation of income held abroad and punishing companies that refuse to do so. In order to encourage the return of this capital to the United States, the TCJA provides for a low one-time repatriation tax on income previously kept offshore (15.5% on foreign cash and other liquid assets and 8% on all residual assets, in each case, to the extent of earnings and profits). This will provide domestic media companies with much-desired access to money that has been kept offshore due to the high cost of repatriation before the passage of the TCJA.
Taxpayers operating in this sector will be further encouraged to take advantage of this one-time repatriation opportunity as a result of certain punitive measures found within the TCJA’s international provisions. The new Base Erosion Anti-Abuse Tax (BEAT) generally operates to limit deductibility of payments to affiliates of U.S. taxpayers that are in low- or no-tax jurisdictions (click here for more). The BEAT generally requires corporations with average annual gross receipts of $500 million to pay a tax on deductible payments made to foreign affiliates equal to 10% for years before 2025, with a phase in at 5% for 2018. Worldwide media companies might find themselves unexpectedly hit by BEAT, depending on the residency of their affiliates (i.e., in low-tax jurisdictions) as BEAT does not require an intent to evade tax.
Another new international provision in the TCJA, the global intangible low-taxed income (GILTI) tax, is designed to impose a tax on companies that hold valuable intangible assets offshore, a particularly important provision for a global industry reliant on licenses, copyrights and royalties. This requires U.S. shareholders holding at least a 10% share of a controlled foreign corporation to include in gross income for the tax year such corporation’s income from intangible assets held abroad that would not otherwise be taxable in the United States (click here for more). Although there are deductions available that will allow corporations to be taxed on intangibles at an effective rate of 10.5% through 2025 and at 13.125% beginning in 2026, this still presents a liability that may push media companies to repatriate offshore assets. As we have noted in previous installments, these rules are under intense scrutiny for certain potential unintended consequences, so future guidance and regulations that could impact how this provision is interpreted and/or enacted may be forthcoming.
In addition to the benefits of reform described above, media companies—particularly television and print media which depend heavily on advertising dollars—dodged a bullet when Congress decided not to use the TCJA to remove certain advertising deductions.5 Aside from its effect on the largest media corporations, the removal of these deductions would have had a particularly negative impact on local television and print media, which rely heavily on small business advertising. The possibility of removing this deduction in order to pay for other tax decreases in the bill was openly discussed throughout the drafting process, with many proponents of local media outlets claiming that its removal would prove to be a death knell for these already struggling enterprises.6 To the relief of these advocates, the deduction’s removal did not find its way into the bill’s final form.
1 See here
2 See here and here
3 See here
4 See here
5 See here
6 See here
Financing Renewable Energy Projects: The Interest Deductibility Limitation
By Vivian Ouyang and Liam Donovan
As we have previously discussed (please see here for a more detailed discussion), the Tax Cuts and Jobs Act (TCJA) limits a taxpayer’s interest deductions in a taxable year to the sum of (A) the taxpayer’s business interest income for the year and (B) 30% of such taxpayer’s adjusted taxable income for the year. Through the taxable year of 2021, the adjusted taxable income calculation allows a taxpayer to add back depreciation, amortization and depletion, thereby increasing the interest deduction limitation. After 2021, the adjusted taxable income will not be increased by depreciation, amortization and depletion, resulting in a lower interest deduction limitation. For interest expenses incurred by a partnership, the limitation is first determined at the partnership level. Any excess interest expense of the partnership is allocated among the partners and suspended at the partner level until such partner is allocated excess taxable income from the same partnership in a later year.
The renewable energy industry relies on both tax equity investment and traditional debt financing to help fund project constructions. The lower corporate tax rate established by the TCJA will decrease both the number of tax equity investors and the amount of income taxes a tax equity investor needs to shield. In addition, the lower corporate tax rate will also reduce the value of tax deductions and thereby increase the cost of tax equity capital. The potential limit on tax equity capital imposed by the base erosion anti-abuse tax provisions (please see here for a more detailed discussion) will put additional pressure on the availability of tax equity capital. All of these factors are expected to reduce the availability of tax equity capital for renewable energy projects. Since tax equity investments will constitute a smaller portion of the required capital for renewable energy projects in the post-TCJA environment, traditional debt financing will likely play a bigger role in funding renewable energy projects.
For renewable energy projects with debt financing at the project company level, any interest deduction limitation will first be determined at the project company level. Any excess interest expense of the project company is allocated among the developer and the tax equity investor. Since renewable energy projects typically incur significant amount of depreciation deductions, especially in the early years, the interest deduction limitation is less likely to affect a new project company through 2021, when the adjusted taxable income is increased by depreciation. However, after 2021, the limitation is more likely to come into play for such project companies. In addition, since there is no grandfather relief for existing indebtedness, existing project companies that are highly leveraged may also be subject to the limitation. If interest deductions allocated to the tax equity investor are subject to the limitation, the after-tax yield of the tax equity investor will decrease, requiring the project company to distribute additional cash to compensate the tax equity investor.
Renewable energy projects often rely on back-levered debt. A back-levered debt is an indebtedness incurred by the developer to fund its equity investment in the project company. In such a structure, the developer would use back leverage to borrow against its share of the project company cash flow. Since back-levered debt is incurred by the developer, not the project company, the limitation of the interest expense deduction should be determined at the developer level.
The decrease in the tax equity capital and the limit on debt financing may be good news for cash equity investors. Developers that otherwise would not be looking for cash equity may now seek capital from cash equity investors including preferred equity. Alternatively, developers may also consider alternative structures such as sale-leaseback, since rental payments are not subject to interest deduction limitations.
Media Companies Could Reap Billions From Tax Overhaul
US edition: Global entertainment and media outlook 2017-2021
Despite subscription surges for largest U.S. newspapers, circulation and revenue fall for industry overall
Should Media Firms Spend Their Tax Windfall or Save for a Rainy Day?
IRS Would More Easily Audit Large Partnerships Under Proposal
The Game Has Changed: Partnerships Could Be Subject To Income Tax Under New Partnership Audit Rules