A host of regulatory and legislative issues could affect middle-market dealmakers in 2015, chiefly in the tax arena. And with Republicans taking control of both the U.S. Senate and House of Representatives in the New Year, the political calculus on legislative issues will change. Here are some developments to watch closely. (For more coverage on what to expect in 2015, see the feature 15 Trends to Track.)
Some regulatory developments will have an impact on specific industry sectors for M&A, such as the Federal Communications Commission's decision-making on Internet regulation and the reauthorization of the Higher Education Act. In November, President Obama said that the FCC should regulate the Internet like public water and electric utilities to ensure net neutrality. Technology startups and other business interests have voiced support for net neutrality, saying that allowing broadband providers to charge different rates for fast lanes and slow lanes of Internet traffic would make it difficult or impossible for many new companies to launch and small companies to grow. Opponents say the public utility approach will stifle investment in the sector. Already, net neutrality has become a potential issue in an M&A deal-the acquisition by Comcast of Time Warner for $45.2 billion. The FCC must approve the deal, and is considering requiring a net neutrality agreement from Comcast as a condition of its approval.
For the Higher Education Act reauthorization proposals moving through Congress, the change of control in the Senate is expected to lead to less regulation for the for-profit college sector. Sen. Lamar Alexander (R-Tennessee), the presumptive new chairman of the Senate committee overseeing education and an advocate of fewer regulations for higher education in general, will control how the legislation is drafted. He also opposes the U.S. Department of Education's proposed regulations that would rate colleges and tie federal funding for career-training colleges to the employment status of their graduates. Those proposals are seen as potentially damaging to for-profit colleges.
Corporate Tax Rate
One area where Republicans in Congress say they have a significant chance of reaching agreement with the President is tax reform, says Steven Schneider (pictured), an attorney and tax expert with Goulston & Storrs in Washington, D.C. There seems to be a widespread acknowledgement that U.S. corporate tax rates are too high when compared to competing countries.
As a part of corporate tax reform-presumably lowering the corporate tax rate while eliminating certain deductions-middle-market advocates will push Congress to make sure that limited liability corporations and other flow-through partnership structures aren't left behind in the tax reform efforts, Schneider said.
"From a middle-market standpoint, it has to be done in the context of a broader tax reform that actually benefits companies that are flow-through," he said. "Congress will do something for them. The question is whether they will get the full consideration, because they're not big business."
Adding another layer to the corporate tax reform debate is the Obama Administration's past proposal to add a tax to the partnership structures that are currently flow-through entities, which would make them like C corporations-taxed at both the firm level and at the individual level, said Gary LaBranche, chief executive of the Association for Corporate Growth.
Accomplishing some type of comprehensive tax reform will be a political challenge, even with a Republican-controlled Congress, said Scott Gluck (pictured), attorney with Venable in Washington and legal affairs adviser to ACG. "A lot of people think that it's not going to happen until 2017, but tax reform could have a big impact on middle-market dealmaking," he said.
Some of the proposals would limit the deductibility of interest on corporate debt, which would have a negative impact on dealmaking, because debt is such an important component of deals, Gluck said. If the tax incentive to issue debt is reduced, then it could cause a decrease in middle-market dealmaking.
Carried interest, or the profits share received by private equity managers, could also be a target of tax reform legislation, said Amber Landis, senior director of public policy for ACG. Carried interest is now treated as capital gains, with a top basic tax rate of 20 percent instead of the 39.6 percent rate for ordinary income. Early in 2014, Rep. David Camp (R-Michigan), the chairman of the House Ways and Means Committee, proposed taxing carried interest as ordinary income.
Carried interest taxation is an important issue for the middle market, despite the common misconception that it only affects the giant private equity managers, Landis said. (For more, see the January 2013 cover story Carried Interest in the Crosshairs.)
"Our members are not the people who are getting these $700 million bonuses," she said. "These are people who are being rewarded for the intellectual and sweat equity that they're putting into the investment and growing the middle-market businesses within their portfolio companies."
For private equity funds, legislation that passed the House of Representatives this year that would exempt them from having to register with the SEC as investment advisers could be revived in the Republican-controlled Congress next year, Gluck said.
SEC officials have indicated that the commission may consider requiring private equity fund staff to register as investment advisers, said LaBranche.
"Depending on how they view it, they could decide that every single person who works for a private equity firm, or every single person above a certain level, or any person involved in any aspect of marketing might actually be required to be a registered investment adviser," LaBranche said. "We think that is completely inappropriate." (For more coverage on carried interest, see
A bill making technical corrections to the Dodd-Frank Wall Street Reform and Consumer Protection Act is also likely to pass Congress, considering that the House passed a bill with bipartisan support for minor Dodd-Frank changes during the latest term, Gluck said.
On the issue of M&A broker registration, the House unanimously passed a bill in 2014 to make M&A brokers exempt from registration generally if they work on deals involving private companies with gross annual revenues of less than $250 million.
Also, the U.S. Securities and Exchange Commission issued a no-action letter in February that spelled out certain criteria that would allow M&A brokers to be exempt from registration. With the SEC stance and the Republican-controlled Congress, M&A broker registration is an issue likely to get some attention from Congress in 2015. (Click here for coverage on the SEC's recent efforts to regulate the private equity industry.)
Another issue that could affect middle-market M&A players is the SEC's budget. This year, the Democratic-controlled Senate's proposed budget for the SEC was about $1.4 billion, roughly $300 million higher than the GOP-controlled House's proposal. With Republicans controlling both legislative bodies, federal spending will likely be reduced for the SEC, as well as other federal regulatory agencies.
"One of the things that the SEC wants to do with that budget is hire more examiners to examine investment advisers, including private equity funds. So they're not going to have all the money that they would like," Gluck said.
Another priority of the SEC is cybersecurity, so there is concern that the commission could impose cybersecurity-related regulations, Gluck said. (For more coverage on cyber security M&A, see Hacked Sony Movies Highlight Opportunities for Buyers.)
The Internal Revenue Service has several proposed rules about taxing partnerships that should be expected in final form in 2015, Schneider said. The biggest regulatory change for middle-market players, because they use limited liability corporations and partnerships so often, would be on partnership debt regulations.
With partnerships, partners receive a share of the partnership's debt in their basis, and the debt helps deductions flow through to them, Schneider said. The debt is also important to avoid taxes when people pull cash out of partnerships, he said.
"People may have been using that tool a little too much, and so the IRS wrote regulations that swing the pendulum too far in the other direction," Schneider said. The proposed rules include some unreasonable assumptions that would make it very difficult for accountants to even fill out tax returns, he said.
The proposed rules have been assailed harshly through the public comment period, but the U.S. Department of the Treasury hasn't yet indicated how they will change the rules. Schneider said he hopes to see an indication of what changes will be made within the next several months.
"I think they realize they have to change the approach they started with," Schneider said.
Another important regulatory area to watch is proposed IRS rules on so-called hot assets, which are assets that create ordinary income instead of capital gains, Schneider said. The proposed rules are designed to prevent partners from shifting higher-tax ordinary income assets between themselves to minimize their tax bills.
Because partnerships are pretty easy to get in and out of, partners could gain a tax advantage by distributing the capital gain assets to the individuals in a particular partnership and shifting the ordinary income assets to corporations in the partnership, he said. Corporations don't get a capital gains tax preference, but individuals do-basically half the tax rate they would pay on ordinary income.
The rules that existed basically didn't make any sense, so people have been routinely ignoring them, Schneider said. The proposed rules are reasonable, and the IRS is expected to enforce them, so taxpayers should be aware of them and apply them.
Middle-market players should also keep an eye on IRS audits of partnerships, which the agency is looking to step up its efforts, including auditor training, Schneider said. Some tax reform proposals in Congress would make it easier for the IRS to examine partnership arrangements.
"There's a big push to revamp the rules for auditing partnerships," Schneider said. "They're just so hard to audit, because there are so many tiers, particularly in the fund context." (For more public policy coverage, read Huron Capital Partners' Gretchen Perkins update on ACG's policy initiatives.)