Private equity partnerships face 'Orwellian' offshore tax

The name that Republican tax writers gave to a new, multibillion-dollar business levy implies that it targets foreign earnings from "intangible" intellectual property — hitting tech firms and drugmakers like Apple Inc. and Pfizer Inc.

But experts agree that the little-understood "global intangible low-taxed income" levy will also apply to earnings that go far beyond patents, royalties and licensing, and could end up snaring many global firms that earn little such income. Private equity partnerships that aren't publicly traded — including Bain Capital LP, TPG Holdings LP and Warburg Pincus LLC — stand to pay rates three times as high as corporate competitors, tax lawyers say. Law and advertising firms with overseas offices may also be hit — as will many U.S. companies that make "excess" profit from foreign plants, equipment and inventory.

The name is "Orwellian," said James Duncan, a tax partner at the law firm Cleary Gottlieb Steen & Hamilton LLP, in a Dec. 20 webcast. "Its most significant effect is on income that is neither intangible nor low-taxed."

GILTI has been commonly viewed as a minimum tax on foreign earnings from intangible property, one that's meant to prod American technology and pharmaceutical companies into holding their valuable intellectual properties in the U.S. Currently, many hold their patents in subsidiaries in Ireland or other low-tax countries.

Yet the tax "doesn't attempt to actually characterize income as tangible or intangible," said David Miller, an attorney with Proskauer Rose LLP. It'll apply to both, Mr. Miller and others said.

In writing the biggest tax overhaul in three decades — a revamp that's estimated to cut taxes by $1.5 trillion over 10 years — congressional Republicans made two major changes for corporate income taxes: They cut the rate to 21% from 35% and they ended the tax's "global" reach.

For years, the American system has taxed corporations on their foreign profits, but allowed them to defer paying that tax until they brought their overseas earnings back to the U.S. The new system ends that deferral — and will require companies to pay a cut-rate tax on an estimated $3.1 trillion in income that they've stockpiled offshore.

At the same time, the legislation's drafters sought new ways to prevent companies from shifting profit offshore — to countries with tax rates even lower than the new 21% corporate rate. The GILTI is key to that effort; for corporations, the tax applies only in cases where a company's cumulative overseas tax bill is below a minimum threshold.

The new tax applies to excess foreign profit, and it allows significant deductions that — for those eligible — take its effective rate to 10.5% through 2025. After that, the rate increases to a little over 13%. Next year, corporations could take a 50% deduction and an 80% credit for foreign taxes they've paid. Together, the provisions mean that any corporation that pays foreign taxes at a rate of at least 13.125% could avoid the GILTI entirely before the rate rises in 2026.

But those low rates are available only for corporations. Partnerships and other so-called pass-through entities would face much higher rates on some of their foreign income — they wouldn't get the deduction, experts say. Pass-through entities don't pay taxes themselves, but pass their income to their owners, who pay tax at their ordinary rates. As of Jan. 1, the top individual income rate is 37%.

In effect, experts say, a corporation would pay no more than $10.50 on every $100 of income that's hit by the GILTI. A pass-through would pay as much as $37.

"The reality of this is going to sink in in the next month," said Channing Flynn, an international tax partner and global technology industry tax leader at Ernst & Young LLP.

Three other tax experts — Proskauer Rose's Mr. Miller; David Sites of Grant Thornton LLP; and Robert Scarborough of Freshfields Bruckhaus Deringer LLP — agreed that global private equity partnerships that aren't publicly traded wouldn't be eligible for the GILTI deduction. Moreover, a separate tax break for partnerships and other pass-throughs applies to domestic income only — not to the global earnings caught up by the GILTI, according to the bill.

Mr. Scarborough said the tax will hurt such firms as Bain, TPG Holdings and Warburg Pincus, which are all private. By contrast, he said, publicly traded firms like Blackstone Group LP, Apollo Global Management LLC and Carlyle Group LP — all partnerships that are traded like corporations — would get the GILTI deduction.

Charlyn Lusk, a spokeswoman for Bain Capital, declined to comment. So did Luke Barrett, a spokesman for TPG Capital, and Mary Armstrong, a Warburg Pincus spokeswoman.

The differing treatment could prompt Bain and others to consider forming so-called C corporations to hold their foreign assets, Mr. Scarborough said. "I'm sure people are running the numbers and thinking about this alternative," he said.

Generally speaking, the GILTI will apply to many companies that might not immediately leap to mind as depending on intellectual property, experts agreed. The levy's potential payers "will include lots of other businesses that don't depend on factories or turbines to make money," said Cleary Gottlieb's Mr. Duncan.

One example: banks. While they're typically structured as corporations — and thus entitled to the deduction and the initial rate of 10.5% — the result would still be an increase over their previous tax bills, said Mitch Thompson, a tax partner at Squire Patton Boggs U.S. LLP. That's because as of Jan. 1, they and other corporations will lose the ability to defer paying taxes on income that will now fall under the GILTI, he said.

The GILTI levy was envisioned as a guardrail to ensure companies pay at least a minimum amount of U.S. tax. It's estimated to raise $112.4 billion over a decade — receipts that would help underwrite the permanent corporate rate cut and other temporary cuts for individuals.

Another change to international taxation will also disadvantage pass-throughs, according to Grant Thornton's Mr. Sites. A separate deduction sets up an effective tax rate of 13.1% on "foreign-derived intangible income" – that is, excess returns earned by U.S. companies on foreign sales. Only domestic corporations get the deduction. Closely held partnerships don't; for their owners, the rate could be as high as 37%.

"Partnerships get slammed," said Michael Kosnitzky, a tax partner at Pillsbury Winthrop Shaw Pittman LLP. "They're not being as treated as well as C corporations."