Obama's Tax Plan To Hit Private Equity
Private equity-backed multinationals are gearing up for new taxes on foreign subsidiary income
By Kelly Holman May 15, 2009
Just when private-equity executives got used to the idea of having to pay higher taxes on their fund profits, President Obama unleashed another broadside against the buyout community in the form of more taxes for financial sponsors that own U.S. companies with foreign subsidiaries.
The president's $210 billion tax proposal, set to be unveiled Monday, is expected to levy additional taxes on multinational U.S. corporations and private equity-backed companies with foreign business units.
Under the present system, corporations are able to secure a tax credit for income taxes imposed on business units in which a parent company owns a stake of 10% or more, if the division distributes income back to the domestic parent. At present, businesses that earn foreign income are not immediately taxed until that income is repatriated.
Businesses with subsidiaries abroad traditionally have avoided being taxed through a "check-the-box" method, allowing them to make deductions of foreign intercompany exchanges of interest or royalties, for example. But the new rules would tax at U.S. rates.
"The administration is concerned that the check-the-box rules give U.S. multinationals the ability to reduce non-U.S. taxes significantly, thereby encouraging U.S. multinationals to locate operations overseas," says Gary Friedman, a tax partner at Debevoise & Plimpton LLP, which recently issued a client alert about the impending tax changes.
What is unclear, the law firm points out, is whether the new restrictions would pertain to companies that use intercompany charges as a way to reduce foreign taxes, or whether the check-the-box system will be broadly reformed.
The proposal takes aim at subsidiaries located in different countries, for example, that deduct intercompany charges, such as royalties, between themselves. The new proposal would eliminate that option.
The current tax code lets claimants deduct expenses that are incurred in the United States, including interest, though the earnings of their foreign subsidiaries are not taxed in this country until repatriation.
However, a foreign subsidiary tax hit would also make transaction structuring more difficult for buyout shops, particularly since they would no longer be able to deduct interest associated with leverage put on overseas businesses. In short, it would make LBO transactions more costly.
That prospect hardly thrills merger and acquisition participants in the deal community, which is expected to begin lobbying heavily soon against the new tax plan alongside U.S. corporations.
"There will be significant discussions not just from private-equity firms, but multinationals that have a lot of properly structured operations where they reinvest income in their operations overseas without incurring U.S. taxes," says William Kirsch, chairman of the global private-equity practice at Paul, Hastings, Janofsky & Walker LLP.
As it stands now, cross-border subsidiaries of U.S. parent companies are not taxed until funds are repatriated.
Kirsch says that the administration's proposal is likely to impact the after-tax net income of the nation's companies with overseas business operations.
"This would hurt American industry as well as private-equity firms," he said.
Jim Connor, a managing director at the Southfield, Mich., international business consultancy BBK, agrees with that. "It's very concerning that a lot of these points are not very well thought through. A lot of these statutes were put into place years ago to help facilitate U.S. investment in overseas companies," he says.
Connor, the former chief executive of the heavy truck parts supplier Newcor Inc., says the proposal would drive the nation's domestic private-equity firms to rethink their transactions in such a way as to avoid getting hit with taxes. "By eliminating that deferral, I think you're going to see funds go overseas and make investments where you're never going to get that income [taxed]."
One New York private-equity executive, who spoke on the condition of anonymity, called the plan "very, very dangerous."
The LBO dealmaker said it could well spur U.S. businesses to relocate overseas. "The tax implications are significant, and being able to avoid double taxation in an enterprise makes sense."
It would be remiss to say the entire buyout firm community would be affected by the foreign business unit-oriented proposal. It would largely affect the after-tax income for large businesses and big buyout firms like Carlyle Group, for example, instead of middle-market private-equity firms.
Obama says the current 2% tax rate on foreign profits costs taxpayers tens of billions of dollars annually. The administration says its plan, which would remove the check-the-box election, would generate an additional $86.5 billion of tax revenue by 2019.
It should be noted that the proposal makes an exception for the deduction of research and experimentation expenses, whereby companies that claim R&D expenses would receive a credit equal to 20% of their qualified research expenses above a base amount, according to Debevoise & Plimpton.
The plan would make the credit a permanent fixture, which is expected to cost $74.5 billion within the next decade.
It also has European countries whetting their chops at cutting big tax deals with big multinationals to secure their relocation. After all, U.S. tax rates exceed those of many European countries, already leaving the nation's businesses on an uneven playing field when it comes to being competitive.
"Business advocacy groups make the point that the U.S. already has a high tax rate relative to many European countries. The business groups argue that the U.S. is already at a disadvantage in attracting investment and competing in a global marketplace," says Friedman.
Private-equity executives have a two-year reprieve from being taxed on carried interest or profits from their limited partnerships. However, in 2011 buyout groups and other private investment groups could experience tax increases of 35% to 39% on their long-term profits, compared with the 15% rate under the current taxation system.
"I'm hopeful they see the current tax law on carried interest is a sensible one," says Kirsch. "If they were to change it, it would do damage to the intent and practice of the U.S. tax code and the economic concepts upon which it is based."
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