Tax reform deal has few answers, many questions

Institutional investors and their asset managers held their collective breaths as a Republican-controlled Congress worked madly last week to pass a massive tax reform package that, for many of them, is notable for what was left out. Others, including large endowments and private equity firms, are bracing for change.

At the beginning of the tax legislation debate, retirement plan executives were on high alert that the tax-deferred advantage of contributions would be too tempting a target as Republicans looked for ways to offset $1.5 trillion in tax cuts. That mobilized the Save Our Savings Coalition of retirement advocates and providers to head off the feared changes, which were not in the final measure signed by President Donald Trump on Dec. 22.

"The big news is what's not there," said Lynn Dudley, senior vice president, global retirement and compensation policy for the American Benefits Council in Washington. "They gave a lot of thought to the value of employer-based plans and didn't undermine them ​ because now would be a terrible time to do that." Still, said council President James A. Klein, "the need for federal revenue is sure to continue."

Public pension fund officials had even more to worry about, as a provision to impose a new tax on direct investment income lasted until the final round of negotiations between the Senate and House of Representatives before being dropped.

Leigh Snell, director of federal relations for the National Council on Teacher Retirement, Washington, credits "a full-court press" from public pension executives around the country meeting with members of Congress and key tax negotiators, including Senate Finance Committee Chairman Orrin Hatch, R-Utah, House Speaker Paul Ryan, R-Wis., and House Ways and Means Chairman Kevin Brady, R-Texas.

"It was a great example of public plans' ability to respond quickly and to comprehend the implications here," said Mr. Snell, who added investment firms and groups like the Institutional Limited Partners Association in Washington helped Congress appreciate the potential negative impact on public funds.

Theresa Whitmarsh, executive director of the $120 billion Washington State Investment Board, Olympia, said officials are "extremely pleased" the idea was dropped. Ms. Whitmarsh, who chairs the Council of Institutional Investors in Washington, credits "a facts-driven, fully bipartisan effort (that) helped members of Congress protect our beneficiaries' long-term investments."

Large private university endowments still have every reason to worry because the final tax deal will impose a new 1.4% tax on net investment income beginning in 2018. It applies to those with at least 500 students and assets of at least $500,000 per full-time student, with 50% or more U.S. students, and was seen as a warning shot to affluent endowments over whether their tax advantages serve the greater good.

Endowments and nonprofit organizations where the top five executives get more than $1 million each in compensation will also see a new 21% excise tax on that.

That will affect the largest educational institutions' endowments and other asset pools, said Tracy Filosa, who heads Boston-based Cambridge Associates LLC's enterprise advisory practice. How it affects their investment strategies remains to be seen, she said.

"Our clients are either going to spend less toward their mission or they're going to have to take more money out of their endowments each year. It does add up to real people not having as much. I think there are some difficult choices," said Ms. Filosa, who expects to get a better sense of the operational impact after the first quarter of 2018.

Commonfund CEO Catherine Keating, Wilton, Conn., said the 30 to 40 private colleges affected by the new tax will be watching as regulations are issued, including as to how "endowment assets" are defined, because the tax will apply to interest, dividends and realized gains on endowment assets. Many endowments might have large unrealized gains due to the long bull market, "and every basis point matters. This tax will be 140 basis points."

Philosophically, she said, the tax plan "suggests a strong preference for businesses to drive economic growth" even though their investment represents roughly 13% of the U.S. economy. "As long-term investors, we think about sustainability of growth. Legislation passed along party lines can be less sustainable. It will take time to measure the sustainability of corporate profits and economic growth," said Ms. Keating.

Private equity firms had a mix of victory and defeat.They saw their ability to deduct interest shrink significantly, to 30% of adjusted income from the current 100% . But a feared ban on carried interest paid by partners in private firms was softened to require that investments be held for at least three years, up from one year, to be eligible for the lower capital gains rate. The firms themselves will also benefit from the package's new 21% corporate tax rate, down from 35%.

Partnerships, including real estate and private equity firms, gained a 20% deduction for pass-through business income, until the provision expires after 2025.

Keith Mannor, a tax partner at accounting and consulting firm BDO USA LLP in Chicago who consults with private equity-backed portfolio companies, said many firms structured as corporations will benefit from the lower rate and the ability to immediately write off capital expenditures on new and used assets, but will be hurt by the reduced interest deduction. "The flip side of that is where they have invested. Part of it will depend on what industry their investments are in, and part will be how much they are leveraged," he said. For their investors, "it is going to be a facts-and-circumstances scenario for each one."

One winner was commercial real estate, hurt by tax bills passed in previous years, but this time gaining several exclusive carve-outs. "I think what we're seeing this year is the pendulum swinging back," said Steven Rosenthal, a tax lawyer and visiting fellow at the Urban-Brookings Tax Policy Center at the Urban Institute in Washington. "It's clear that the real estate investors and constituents benefit disproportionately. If I were to pick one winner, I'd say real estate did really, really well."

Real property businesses won an exception to the interest deductibility income restrictions and kept a tax advantage for like-kind exchanges. They also gained a shorter amortization option for deducting interest and an avenue for deducting loan interest for inventory, and did not lose the tax advantage of tax-exempt private-activity bonds used to finance major projects.

Mr. Rosenthal, who spent six years with the Joint Committee on Taxation drafting tax legislation, worries about technical mistakes made during what many consider a rushed process.

"This tax bill has been moving so quickly with so little input from the outside that it's just littered with glitches," he said. Another concern is that repealing the corporate alternative minimum tax will undermine the international tax regime, while 35% of the benefits of the lower corporate income tax rates will go to foreign investors, he said. As corporate share prices increase, they would be largely tax-free to foreign investors at the shareholder level, while U.S. taxpayers pay 23.8% on long-term capital gains or dividends received.

The tax package left many unanswered questions, starting with varying projections of cost offsets coming from economic growth, and the impact on the federal deficit of a $1.5 trillion cut in tax revenue.

A macroeconomic analysis done by the independent Tax Policy Center projected a modest 0.8% boost to gross domestic product in 2018, and little effect at the end of the tax package's 10-year horizon. What will grow is U.S. debt, many economic experts worry. Including macroeconomic effects and interest costs, the Tax Policy Center projects debt as a share of GDP will increase 5 percentage points in 2027, reaching 97% of GDP, and 117% in 2037.

While the country truly needed tax reform, said Maya MacGuineas, president of the non-partisan Committee for a Responsible Federal Budget in Washington, the final deal could ending up costing $2 trillion in tax cuts "with far too few reforms." The deal "opens the door to further debt-financed legislation this year and in the future," said Ms. MacGuineas, who is bracing for trillion-dollar deficits as soon as the next fiscal year, barring emergencies that could make it worse.