Newly inaugurated President Trump has promised significant tax reform with the goal of making U.S. business taxation more competitive in the global economy. The Republican-controlled Congress has similar goals. While the exact details will be ironed out over the upcoming months, any changes enacted may have a significant impact on corporations, including Master Limited Partnership (MLP) funds taxed as corporations. Below are some items fund managers and boards should consider related to their MLP funds, with a particular focus on FASB Accounting Standards Codification 740, Income Taxes (ASC 740).
Pursuant to ASC 740, the effects of changes in tax rates or tax laws are recognized upon enactment. For most corporations, this means that any changes will need to be considered in the same quarter in which the laws are enacted. For MLP funds that strike a daily net asset value (NAV) that considers tax rates, fund management and boards should consider carefully the timing impact of any relevant tax changes on the horizon.
Corporate Tax Rates/Structural Reform
The tax proposal item of greatest impact to MLP funds is the proposed reduction of corporate tax rates. President Trump’s proposal calls for a reduction in corporate tax rates from the current 35% level to 15%. The House of Representatives’ blueprint, “A Better Way,” proposes a 20% rate, coupled with a destination-based cash-flow tax (DBCFT). The DBCFT would tax a corporation based upon the destination of where the goods or services of the corporation are used and not where they are produced.
Focusing exclusively on a potential reduction of corporate tax, MLP funds need to consider how this may impact the daily NAV process and, on a cumulative basis, any deferred assets or liabilities on the date of enactment. Consider this simple example: Assume a fund has deferred tax liabilities of $10 million of unrealized gains and accordingly has a $3.5 million deferred tax liability on its books (using a 35% tax rate). If the corporate tax rate is reduced to 15%, the fund would need to assess the liability on the books and potentially adjust the deferred tax liability to $1.5 million and increase the fund’s NAV by $2 million. Conversely, if the fund has a net deferred tax asset (without a full valuation allowance), there may be a reduction of NAV. Of course, the timing of enactment and effective date of laws may have an impact. If a law enacted to change the corporate tax rate to 15% is effective in a future year, the fund may have to bifurcate its tax liability based upon estimated current taxable liability for the current period (35%) versus estimated taxable income in the future periods at reduced rates (15%).
Both President Trump and the House have provisions that would repeal corporate alternative minimum tax (AMT). Several MLP funds have paid AMT and may have minimum tax credit carryforwards as a deferred tax asset of the fund. Accordingly, funds should consider what type of impact a repeal on corporate AMT and transition rules would have.
Net Operating Losses
The House plan would restrict the deduction for net operating losses (NOLs) to 90% of net taxable income, allow losses to be carried forward indefinitely and eliminate NOL carryback ability. Current rules allow corporations to apply NOL to 100% of net taxable income, carryforward NOLs for 20 years and carryback NOLs for two years. MLP funds would need to consider this potential reduced benefit in consideration of their deferred tax assets associated with NOLs.
Expensing of Assets
As opposed to depreciating assets over a period of time, President Trump and the House proposals support the immediate deduction of capital investments. Trump’s proposal would disallow interest expense deductions for any capital investments expensed. Given that MLPs are highly capital intensive businesses, this provision would have a significant impact to MLP investors, including MLP funds. MLPs may have significantly increased losses flowing through in early years of investments, but the disallowed interest expense seemingly would create a potential offset to the tax benefit and may create a permanent book versus tax item for funds to consider. Furthermore, as earnings and profit rules currently do not allow accelerated depreciation, this tax expensing of assets may not change the tax character of distributions funds pay their investors.
Dividends from Foreign Subsidiaries
House proposals would create a territorial tax system exempting 100% of dividends from foreign subsidiaries from U.S. tax. As many MLP funds have foreign subsidiaries, this may create tax-exempt income from the foreign subsidiaries. Also, the House proposal enacts a deemed repatriation of currently deferred foreign profits at reduced rates, creating another potential tax rate difference on current income in the year of effectiveness.
Tax Rate for Passthroughs
President Trump has mentioned his desire to mirror any corporate tax rate reductions with a corresponding reduction of tax rate applicable to flow-through income from passthrough entities (partnerships and S Corporations). His proposal would subject owners that make an election for preferred tax rates to pay a second layer of tax on distributions (similar to the double taxation of a C Corporation). The House proposal would cap tax on flow-through income at 25%. There will be significant complexities to passthrough owners if these rules are enacted, and there may be related impact on MLPs and MLP investors to consider if these provisions come to fruition.
There is much yet to be seen on which proposal, or a combination of them both, actually results in what’s likely to be the first version of tax reform. Stay tuned…
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.