Some Unexpected Impacts of Proposed Tax Bill: REITs Could Be Big Winners, Impact on MLPs Mixed and Complicated, and Threat to Certain Multinationals from New Related-Party Payment Excise Tax
By Stuart E. Leblang, Michael J. Kliegman, and Amy S. Elliott
The many proposed tax changes contained in the 429-page Tax Cuts and Jobs Act of 2017 1 (TCJA) released November 2 will have far-reaching impacts on a diverse population of companies if the proposals are enacted. While it is still too soon to tell if we could have a much-revised tax code in 2018, we wanted to share with you some preliminary thoughts on three types of publicly traded entities that—at first blush—would appear to be profoundly impacted by the bill, were it enacted in its current form.
#1: REITs stand to be the biggest winners.
Real estate investment trusts (REITs) won the Triple Crown by scoring big on like-kind exchanges, the pass-through rate and the interest expense deduction. TCJA preserved the third largest corporate tax expenditure—Section 1031 like-kind exchanges—but only for real property. That means businesses including REITs can continue to swap a piece of real estate without triggering gain. In addition, REITs get special treatment under TCJA’s new pass-through rate. REITs are C corporations that can effectively zero out their corporate tax liability by paying dividends. But under current law, REIT investors do not benefit from the preferential dividend rate. TCJA provides that REIT dividends are taxed at only 25 percent. Finally, while TCJA limits the deductibility of interest expense for most businesses, it provides a carve-out for real property trades or businesses defined in a way that is likely to include most REITs.
#2: Disparate effect on MLPs/PTPs.
One of the more nuanced provisions in the bill, the pass-through rate appears to benefit investors in certain master limited partnerships (MLPs) and publicly traded partnerships (PTPs), but not others. In general, if a unitholder is simply a passive investor (as most are, tested under the material participation rules of Section 469), the full distributive share of the income of the MLP/PTP should benefit from the 25 percent rate. However, they excluded from the lower pass-through rate entities that earn investment income such as capital gains, dividends and interest. They also excluded entities that engage in “specified service activities,” including investing, trading and dealing in securities.
That means that MLPs that operate in the oil and gas space (such as pipeline owners and operators as well as exploration firms) that earn active business income should get the benefit, and their investors who are not active in the business should benefit from the 25 percent pass-through rate rather than having to pay individual ordinary rates on their distributive shares.
Oil and gas MLPs will further appreciate TCJA’s new expensing rules that allow businesses to immediately write off the cost of certain capital purchases. However, they could be impacted negatively by the net interest expense limitation. Even with the lower 25 percent rate, the interest expense cap could change the calculus for some MLPs that might fair better as C corporations with a 20 percent rate. MLPs will have to be evaluated on an individual basis to see which is preferable.
Financial PTPs (such as some private equity firms) are in a much different position. Because they are investing and dealing in securities and because they earn investment income (capital gain on their portfolio investments), they are unlikely to get the benefit of the 25 percent rate. Their unitholders—no matter whether they are considered active or passive—would likely have to pay tax on the distributive share at the higher, individual rates.
Not only do financial PTPs not get the pass-through rate, they also (unlike real estate businesses) would be subject to the new interest expense limitations. We suspect that these factors, including the reduction in the corporate rate, could induce some financial PTPs to consider converting to C corporations (effectively abandoning their exception from corporate taxation under Section 7704(c)).
#3: Taxing Deductible, Related-Party Payments at 20 percent
We knew the tax bill would contain numerous anti-base erosion measures. Tax writers had even previously telegraphed that they were considering something novel that would level the playing field between U.S. and foreign firms. 2 But while we may have had clues as to where they might be headed, the sweeping nature of the new excise tax on certain related party payments may concern not only foreign-parented multinationals, but also certain U.S.-parented multinationals.
In its Section 4303, “Excise tax on certain payments from domestic corporations to related foreign corporations; election to treat such payments as effectively connected income,” TCJA was apparently trying to target firms that use transfer pricing strategies to shift income to low-tax jurisdictions outside the United States. The provision is very complicated. For a more in-depth description of it and other major provisions in the bill, see our November 2, 2017, alert, “House Ways and Means Committee Releases Comprehensive Tax Reform Bill.”
The new excise tax will not only hit firms that re-domiciled for tax purposes (inverters that put a foreign parent on top of their structures), but also firms that simply set up U.S. affiliates to manage imports into the United States. This new excise tax could hit many payments from U.S. firms to foreign affiliates—whether they be cost-sharing, royalty or service agreement payments—that have nothing to do with base erosion and are not tax motivated.
The Internal Revenue Service has struggled to enforce the transfer pricing rules and the arm’s-length standard, and an approach that effectively disallows all deductions associated with certain deductible, related-party payments or forces foreign affiliate recipients of such payments to claim them as effective connected income (ECI) subject to U.S. tax is significant. Traders with sizeable positions in affected companies need to pay close attention to this provision as tax reform makes its way through Congress. If enacted, it could have a profound impact on particular companies and is estimated to raise a substantial amount of revenue.
We will keep an eye on these and the many other interesting proposals in TCJA as the tax reform train starts picking up speed. But it is still early days. Comprehensive tax reform is far from passage and it is unclear whether the provisions described above stand much chance of actually making it into law.
[1] Four primary documents associated with the reform plan were released November 2. They are: 1) the draft legislative text of the bill (available at https://waysandmeansforms.house.gov/uploadedfiles/bill_text.pdf); 2) a section-by-section summary of the major provisions of the bill, produced by Ways and Means (available at https://waysandmeansforms.house.gov/uploadedfiles/tax_cuts_and_jobs_act_section_by_section.pdf); a shorter descriptive summary of the bill produced by Ways and Means (available at https://static1.squarespace.com/static/598e0867be42d6f782347394/t/59fb4a0b27ef2d9f3f9a0a12/1509640715893/WM_TCJ A_PolicyOnePagers%5B7%5D.pdf); and a preliminary revenue table (the so-called score) produced by the Joint Committee on Taxation (available at https://www.jct.gov/publications.html?func=download&id=5026&chk=5026&no_html=1).
[2] The very last line of the “Unified Framework for Fixing our Broken Tax Code” released by the so-called “Big Six” tax writers on September 27, 2017, states that “the committees will incorporate rules to level the playing field between U.S.-headquartered parent companies and foreign-headquartered parent companies.”
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