United States: Carried Interest And Other Tax Reform Highlights For Investment Funds And Asset Managers

Key Points

  • Significant corporate and potential individual tax rate reductions and a 25% individual tax rate on certain "qualified business income" would be introduced (although many fund investors and sponsors would not be eligible for the 25% rate). The deduction for state and local taxes (SALT) available under current law would be reduced significantly for individuals.
  • The grant of a carried interest without liquidation value would continue to be tax-free, but holders would need to take into account a three-year holding period to obtain the preferential tax rate of long-term capital gains treatment.
  • Leveraged U.S. "blocker" structures would need to be revisited and potentially optimized taking into account the post-reform tax regime.
  • State pension plan investors that take the view that they are "super" tax-exempt investors would be subject to unrelated business taxable income (UBTI) rules, which may result in significant restructuring of existing fund structures and managed accounts for such investors who desire to block such UBTI.

On November 2, 2017, the House of Representatives released the first draft of the Tax Cuts and Jobs Act (the Bill), which could result in the most significant overhaul of the U.S. federal tax system since 1986. Subsequently, two substantive amendments were introduced by the Chairman of the House Ways and Means Committee. While the Bill is expected to change substantially and the Senate version remains to be unveiled, the Bill provides certain indications as to how tax reform may affect investment funds and asset managers. Significant aspects can be summarized as follows:

Tax Rate and Business Tax Reform

  • The Bill would consolidate the tax brackets for all individual taxpayers and reduce the maximum corporate tax rate to 20%. The rate reductions would also be available for U.S. tax-exempt investors subject to tax under the UBTI rules. The alternative minimum tax (AMT) would be repealed for all taxpayers. The 3.8% tax on net investment income (aka the Medicare tax) would continue to apply.
  • A maximum 25% individual tax rate would be introduced for certain qualified business income, which is intended to capture trade or business income from "passive" activities and a portion of income derived from "active" activities (i.e., a capital percentage). Income arising from investment or trading activities (such as long- and short-term capital gains, dividends, non-business interest and derivative income) would generally be excluded. However, certain income derived from direct lending activities and portfolio investments in pass-through entities may be eligible. Thus, U.S. individual investors and carry recipients would be eligible for the reduced rate only in specific circumstances. Further, management fee and other service income realized by fund managers would be specifically excluded from the scope.
  • Fund managers would no longer benefit from the "limited partner" exception of the self-employment tax. Instead, they would be subject to such tax on the basis of their "labor percentage," which would be defined by reference to the new rules applicable to qualified business income for purposes of calculating the 25% rate.
  • The Bill would disallow the SALT deduction for non-corporate taxpayers, with a limited exception for property taxes. On the other hand, the overall limitation on miscellaneous itemized deductions (which may include management fees) for individual investors would be repealed, although the 2% floor applicable to such itemized deductions would remain.
  • The estate tax would be repealed effectively in 2023, following a phase-out period.

Carried Interest Reform

  • Under the Bill, the concept of an "applicable partnership interest" (API) would be introduced in the Code, which is generally intended to capture the profits interest (aka "carried interest") held by the sponsors of private equity, hedge, venture capital and other investment funds that are structured as flow-through entities. An API would cover any interest held in connection with the performance of substantial services in a trade or business that involves both capital raising or returning and investing or trading in securities, commodities, real estate and/or certain other assets (i.e., very generally, an asset or portfolio management business).
  • The grant of an API would not be subject to Section 83 (and generally be tax-free as under current law), but holders would be eligible for the preferential tax rate of long-term capital gains only with respect to gains realized on a disposition of a capital asset held for more than three years, although it is unclear whether such minimum holding period requirement also applies for items of income that may be characterized as long-term capital gains other than by reference to the fund's holding period in the relevant asset (e.g., qualified dividend income). However, such treatment would not result in nonqualifying income for publicly traded partnerships (PTPs) or UBTI for U.S. tax-exempt investors. The Bill is not entirely clear, however, on how it would treat gains realized upon a disposition of the API itself (other than upon transfer to a related person).
  • The reform would likely leave unaffected many carry recipients in funds that focus on asset classes with a longer holding period (e.g., private equity and venture capital). Asset managers that have an investment horizon of less than three years should however consider how the Bill would apply in their particular circumstances. Since grandfathering would not apply, fund sponsors should also consider the implication for profits interests currently held that would likely be treated as APIs under the Bill before it enters into effect.

Blocker Tax Efficiency

  • Inbound tax planning for non-U.S. investors via U.S. "blocker" corporations would likely change significantly in light of the reduced 20% corporate tax rate that is imposed on a net income basis (especially taking into account the disparity with the 30% gross-based rate of U.S. withholding with respect to U.S. source passive income directly realized by foreign investors, regardless of whether such investors are individuals or corporate taxpayers). Similar planning opportunities may be available for U.S. tax-exempt investors otherwise subject to individual rates of taxation.
  • U.S. blockers would also be able to immediately and fully expense the cost of certain qualified property placed in service between September 27, 2017, and January 1, 2023. However, the use of net operating losses (NOLs) carryovers and carrybacks would be limited to 90% of a blocker's taxable income.
  • The "earnings stripping" rules that limit the deduction of interest expense arising from shareholder loans under current law would be repealed (Section 163(j)). Instead, the deduction of any business net interest expense would be limited to 30% of a U.S. blocker's "adjusted taxable income," irrespective of the debt-to-equity ratio of such blocker. A limited carryforward would be available. Grandfathering would not be available, suggesting that a review of any pre-existing blocker leverage would be required. However, the new limitation would not apply to blockers with less than $25 million of average gross receipts, or blockers utilized in the context of direct lending opportunities or engaged in the active conduct of a real estate business.

International Tax Reform

The taxation of multinational corporations and certain other non-U.S. investors would change dramatically and would lean towards a territorial system of U.S. taxation:

  • A 100% participation exemption would apply for dividends from foreign subsidiaries received by U.S. corporations that qualify as U.S. shareholders under existing controlled foreign corporation (CFC) rules. A minimum holding period would apply. During a phase-in period, a reduced tax would be imposed on such U.S. shareholders (but not limited to domestic corporations) in respect of earnings currently deferred in foreign subsidiaries on a deemed-repatriation basis.
  • The indirect foreign tax credit (Section 902) and the deemed repatriation of earnings upon reinvestment in the United States (Section 956) would be repealed.
  • The CFC and passive foreign investment company (PFIC) regimes would generally be preserved, although the availability of the active insurance company exception under the PFIC rules would be restricted.

Increased Efficiency of Management Fees and Incentive Fees

The Bill may increase the likelihood that certain asset managers would be compensated via management and incentive fees:

  • The deduction of fee payments by individual taxpayers would no longer be limited under the overall limitation for miscellaneous itemized deductions or under the AMT rules. However, the 2% floor for such deductions would remain (Section 67).
  • Certain existing deferral rules (including Sections 409A and 457A) would be repealed and replaced with a new Section 409B. Deferred incentive compensation would be taxable at the time of vesting rather than at the time of payment. For this purpose, only service based conditions would be used. The definition of deferred fees is very broad and would likely encompass performance fee arrangements that may not otherwise be thought of as deferred compensation (e.g., realization-based fees and other multi-year performance fee arrangements).

Real Estate Funds

  • The Bill would introduce a UBTI override rule for tax exemptions otherwise available under other Sections of the Code (including the exemption for state and local pension plans). This provision may present a significant change for certain governmental investors in real estate and other industries who heavily rely on the use of leverage.
  • The new limitation on the deduction of business interest to 30% of adjusted taxable income would not apply to interest expense accrued in the conduct of a real estate business.
  • Certain dividends paid by real estate investment trusts (REITs) would be subject to a new 25% preferential tax rate for individual taxpayers.

Provisions Remaining Unaffected – For Now

The Bill would leave many provisions that were previously targeted for potential change unaffected. These include:

  • the preferential individual tax rates applicable to net capital gains and qualified dividend income
  • the timing and character aspects of notional principal contract and other derivative income
  • the 3.8% net investment income tax (aka the Medicare tax)
  • the partnership audit regime introduced under the Bipartisan Budget Act of 2015 (BBA).

Reform Process

Under the ambitious timeline set by the Republican leadership, the mark-up of the Ways and Means Committee is expected to be completed in the course of this week. The Bill could move to the House for a vote as early as mid-November. Congress intends to enact the Bill by Thanksgiving using the "reconciliation" procedure which requires a simple majority vote so long as the Bill remains within the parameters set forth in the recently agreed upon Federal Budget.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

In association with
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .


    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions