Funds fighting effort to add UBIT measure

As Congressional Republicans rush to pass tax reform before 2018, public pension plan officials are determined to see one new idea not make it to the finish line: the House plan for a new tax on unrelated business income from direct investments, such as real estate and private equity.

Chris Phillips, director of institutional relations for the $120 billion Washington State Investment Board, Olympia, said that as officials there get up to speed on what is at stake, they are networking with their investment partners, peer funds and trade associations to be heard in Washington, and have already written their state delegation to make sure the specific provision in the House bill goes no further. The proposed retroactive tax that would even apply to current investments "severely changes the rules of the game after the game already is being played," WSIB Executive Director Theresa Whitmarsh wrote.

"There is definitely a reason for public pension plans to communicate with congressional leadership," said Mr. Phillips.

"There's a states' right issue, first and foremost. That could set a dangerous precedent. Also, it could take money out the pockets of our beneficiaries — people like teachers, firefighters and other public employees," he said.

At WSIB, which has nearly a 40% exposure to private markets, "we're still trying to figure out the tax impact, but it's significant," he said.

"We certainly don't view this as a political issue as much as a fiscal one."

The Internal Revenue Service already applies the unrelated business income tax, known as UBIT, to state colleges and universities. But its longstanding silence on application of that tax to other state entities has led public pension plans to believe it does not apply to them, particularly since their gross income already is excluded under another part of the IRS code.

Under the House bill, being exempt under one section of tax code would not spare entities from UBIT on income from direct investments. With no grandfathering period, public pension funds would be facing a whole new world in January if the measure is passed.

"They're trying to get their arms around a tax that's never applied to them before," said Jeannine Markoe Raymond, director of federal relations for the National Association of State Retirement Administrators.

"Plans are not just concerned about the tax, but also the considerable complexity, including new accounting and auditing, and the legal restructuring that this would require of their investments going forward. We are also very concerned about the precedent this sets for federal taxation of state and local investments," said Ms. Raymond.

Application of the tax "would have a deterrent effect against these types of investments," said Hank H. Kim, executive director and counsel of the National Conference on Public Employee Retirement Systems in Washington. "And just to report it would cost a lot of manpower and resources."

The bigger issue involves the constitutional question of whether the federal government can tax state and local entities, Mr. Kim said. While states are distracted by both chambers' plan to do away with deductions for state and local taxes and other proposed changes, "when we raise this issue and they understand the constitutional implications, I think this will rise to the top," he said.​

In a recent letter to House leaders, Ms. Raymond, Mr. Kim and Leigh Snell, director of federal relations for the National Council on Teacher Retirement, also point out that taxing investment earnings, which pay for roughly two-thirds of state and local government pension benefits, will hurt the participants that pay taxes on them, while reduced investment earnings would increase costs to taxpayers by requiring greater contributions.

Other provisions in the tax bills spark additional concerns among investors and plan sponsors.

House and Senate tax negotiators have significantly altered the tax treatment of large private endowments and money managers such as private equity firms. They are also tightening the tax advantages of many types of bond issuers and highly compensated employees.

The House finished its tax reform package on Nov. 16, followed days later by the Senate Finance Committee, which will soon send its version to the full Senate.

After that, the real negotiating begins, making the target date for passage of a tax bill by Jan. 1 increasingly unlikely, Capitol Hill watchers said.

Because promised tax breaks for corporations and individuals must cost no more than $1.5 trillion over the 10-year legislative budgeting window, the pressure is on to find more sources of tax revenue to offset the tax breaks. That means pre-tax retirement savings accounts are still at risk, sources said.

"There are some pretty big difference between the House and Senate bills," said Geoffrey Manville, Washington-based principal, government relations at Mercer LLC. While some of the biggest fears, starting with a threatened shift to post-tax retirement accounts as a way to pay for tax cuts, did not materialize, "there's still a huge worry. Most of us in the retirement world are very happy that Rothification is out, but we're not entirely out of the woods yet."

While plan sponsors might still be in those trees, "you can see a clearing ahead," said Lynn Dudley, senior vice president, global retirement and compensation policy for the American Benefits Council in Washington.

Her employer members were relieved that both the House and Senate dropped ideas to drastically change tax advantages of retirement contributions to non-qualified plans made for plan participants that max out on regular plans.

That sort of spillover can happen without participants being aware of it, disrupting plan sponsors and participants alike, said Ms. Dudley. "It would have completely restructured non-qualified plans as we know it."

Employers also welcomed a House plan to allow distributions to employees at age 59 1/2, which will help them manage phased retirement programs.

"It's something large companies would all use," said Ms. Dudley. With a projected $13 billion revenue boost over 10 years, it is also likely to stay in the final version.

Large private university endowments also have a fight on their hands with the plan for a new 1.4% tax on net investment income. Private colleges — those with at least 500 students and endowments of more than $250,000 per student — that are targeted for the new tax warn it will crimp their ability to fund core school programs.

However, Thomas Gilbert and Christopher Hrdlicka, assistant professors of finance at the University of Washington, Seattle, argue that taxing large endowments will be better in the long run if it slows the trend for endowments to take bigger risks in securities, hedge funds and private equity.

Republican leaders are trying to use tax incentives to reward companies that help grow the economy. They also need new revenue sources, like the proposed endowment tax, to pay for them.

That is the reasoning behind both the House and Senate plans for restricting the use of carried interest, which call for limiting the ability of firm partners to pay a lower capital gains rate on investments held for at least three years.

That should not be much of a stretch for private equity and venture capital firms, many of which hold investments for more than three years, sources said.

About 15% of hedge fund firms that have longer-term gains eligible for carried interest "are probably going to be impacted by this," said Steven Nadel, a Seward & Kissel LLP partner in the firm's New York headquarters. "This change is really only impacting adversely hedge funds."

While carried interest used to be a perennial Washington topic for private equity and other private funds, tax reform created a new topic on which to play defense: the deductibility of interest, which many use to finance acquisitions. Both House and Senate plans would cap that at 30% of adjusted income, although real estate firms won several exceptions.

House and Senate tax writers are further apart on how to treat partnerships' pass-through income. The House lowers the rate on pass-through income to 25% from the current individual rates that top out at 39.4%, but the version passed by the Senate Finance Committee calls for a 17.4% tax deduction on up to 50% of certain wages, with a not-so-simple formula for calculating it.