On March 27, 2020, Congress passed, and President Trump signed into law, the Coronavirus Aid, Relief, and Economic Security Act (the Act). While the Act includes economic relief through a variety of means, this alert focuses on the significant business tax provisions that are specifically relevant to the private equity industry.
- Temporary relaxation of rules limiting the business interest expense deduction. Section 163(j) of the U.S. Internal Revenue Code (Code) limits a taxpayer’s deduction for business interest expense to its annual business interest income plus 30 percent of the taxpayer’s “adjusted taxable income” (ATI) for such year. The Act provides for a temporary relaxation of these rules by increasing the 30 percent threshold to 50 percent for taxable years 2019 and 2020. By including taxable year 2019, the Act potentially reduces the amount of tax that taxpayers have to remit in 2020. In addition, the Act permits a taxpayer to elect to use its 2019 ATI rather than its 2020 ATI in calculating the limitation amount for 2020, potentially increasing the deductible amount for taxpayers that see a business contraction of ATI in 2020 due to the COVID-19 pandemic. The Act also allows taxpayers to elect out of these reduced limitation rules.
- Special Rules for Partnerships - This relaxation of the business interest expense limitation does not apply to partnerships for taxable years beginning in 2019. Instead, 50 percent of a partner’s allocable share of the partnership’s excess business interest in 2019 is allowed as an interest deduction in 2020 without limitation. The remaining 50 percent of such excess business interest remains subject to the Code section 163(j) limitation. The Act still allows partnerships to elect to use 2019 ATI for the purpose of calculating its 2020 limitation.
- Observation - Portfolio companies that have already filed U.S. federal income tax returns for 2019 may want to consider filing amended U.S. federal income tax returns to take advantage of the increased business interest expense limitation. In addition, this provision may result in additional liquidity to portfolio companies that expect large tax losses in 2020 (although such liquidity may not be realized until 2021, when they file 2020 tax returns).
- Temporary relaxation of rules limiting net operating loss deductions. Prior to adoption of the Act, the deduction for net operating losses (NOLs) was generally limited to 80 percent of a taxpayer’s taxable income (computed without regard to NOLs), and taxpayers could not carryback NOLs to claim a refund for taxes paid in prior years. The Act generally (a) eliminates the 80 percent taxable income limitation for NOLs utilized in taxable years beginning in 2018, 2019, or 2020, and (b) provides a five-year carryback for NOLs arising in such years (unless waived by the taxpayer). For taxable years after 2020, the 80 percent taxable income limitation is reinstated with modifications that increase taxable income by the amount of any deductions under Code section 199A (relating to the 20 percent qualified business income deduction for non-corporate taxpayers) and Code section 250 (relating to the deduction with respect to foreign-derived intangible income and global intangible low-taxed income for domestic corporate taxpayers). The combined effect of these two temporary changes is that NOLs incurred in these years could fully offset current and prior-year taxable income. Portfolio companies with NOL carrybacks as a result of these new rules will be able to immediately file amended returns and seek a refund of taxes paid.
- Observation - While the relaxed limitation and carryback provisions of the Act will permit portfolio companies to utilize NOLs more quickly, it may also impact the rights and obligations of buyers and sellers under acquisition agreements. For example, most acquisition agreements include provisions relating to tax refunds, often requiring the buyer to obtain and pay to the seller tax refunds for pre-closing tax periods (including as a result of a carryback of NOLs). Accordingly, private equity sponsors should carefully review transaction agreements for acquisitions and dispositions made during 2018 through 2020 to assess how this change in law may affect their rights and obligations with respect to tax refunds.
- Observation - An additional benefit of the five-year carryback provision is that corporations can potentially utilize the NOL carryback in pre-2018 taxable years, when the U.S. corporate income tax rate was 35 percent (as compared to the current rate of 21 percent), thereby increasing the aggregate amount of tax savings generated by the NOL.
- Observation - Taxpayers looking to take advantage of the five-year carryback provision should consider accelerating deductible payments into 2020 (rather than deducting such payments in future taxable years) to create or increase 2020 NOLs that can be carried back to prior taxable years without limitation.