Roundtable Weekly - April 6, 2018

Trade Policy

Trump Administration Announces Tariffs on China Imports; China Responds Swiftly With Similar Duties Targeting American Imports

On Thursday, President Trump escalated ongoing trade tensions with China by instructing U.S. trade officials to consider tariffs on an additional 100 billion dollars in imports from China, in addition to the tariffs issued earlier this week— totaling 150 billion dollars in Chinese imports across 1,300 categories of products.  This action prompted a swift response from the Chinese government, with import levies on American soybeans, cars, chemicals and airplanes. (The Washington Post, April 4)

President Trump escalated ongoing trade tensions with China by instructing U.S. trade officials to consider tariffs on an additional 100 billion dollars in imports from China, in addition to the tariffs issued earlier this week— totaling $150 billion in Chinese imports.

This decision by President Trump comes a month after he authorized levies of 25 percent on imported steel and 10 percent on aluminum, while exempting Canada, Mexico and potentially other countries, based on a country-by-country review of bilateral security agreements. President Trump justified the tariffs by citing alleged violations of U.S. intellectual property laws and unbalanced trade practice. (Roundtable Weekly, March 9)

Roundtable President and CEO Jeffrey DeBoer noted the commercial real estate industry’s concerns, stating, “These proposed tariffs, coupled with the earlier tariffs on steel and ongoing dispute with China could have unfortunate and unintended effects on the U.S. economy by raising construction costs, and reducing jobs in real estate development.  China has continually taken advantage of trade practice laws, particularly intellectual property—vital for the U.S. to continue developing new technology, whether it be machinery, software, or energy efficient building solutions and should be held accountable but in a measured way.” (The Washington Post, April 5)

Since the announcement last month, along with the addition of more tariffs this week, U.S. and global market volatility show no signs of letting up, leaving two of the world’s largest economies on the brink of a possible trade war that could negatively impact U.S. agriculture and industry.

Newly appointed National Economic Council  Director and Assistant to the President for Economic Policy, Larry Kudlow, said that he expected the U.S. and China to resolve their issues, noting that the announcements by both countries where just “proposals.” (Financial Times, April 5)

Kudlow, who comes to the Trump administration as a former Wall Street economist, CNBC commentator and advocate of free trade, still believes that the U.S. can strike a deal with China—anticipating continued trade will eventually lead to faster growth and higher wages in the U.S. (Politico, April 4; BNA, April 6)

Commerce Secretary Wilbur Ross echoed Kudlow’s reassurance, noting that the U.S. tariffs won’t take effect before the end of May, after a period for public comment, and that the administration may seek to resolve the trade dispute at the bargaining table. The next opportunity for both parties to discuss the ongoing dispute will be later this month at the meeting of the International Monetary Fund and World Bank and in Washington, D.C. (The Washington Post, April 4; Reuters, April 4)

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Interest Deductibility - Tax Policy

Treasury Releases Guidance on New Business Interest Deduction Limit, but Questions for Real Estate Investment Remain

On Monday, the Treasury Department and the Internal Revenue Service (IRS) released Notice 2018-28, which provides guidance on the new limitation on the deductibility of business interest, (Section 163(j)), enacted in the Tax Cuts and Jobs Act.

In the Feb. 21 letter the Roundtable asked Treasury to clarify     that interest on debt incurred by an owner to fund an investment in a partnership or other entity engaged in a real property trade or business, constitutes interest on debt properly allocable to that real estate business 

The Notice focuses on interest expense carryforwards from prior years, corporate interest deductions, and consolidated corporate groups, while leaving unresolved certain key questions for real estate investors.  Taxpayers can rely on the guidance at least until proposed regulations are issued.

In general, for taxpayers with revenue over $25 million, the Tax Cuts and Jobs Act capped the amount of business interest that a business can deduct annually to no more than 30 percent of earnings before interest, taxes, depreciation, and amortization.  The provision includes several exceptions, including an exception critical to real estate for an “electing real property trade or business.”  

Notice 2018-28 addresses a concern that partners in partnerships could effectively double-count certain interest income when calculating the limitation on partner-level borrowing.  Other highlights of the Notice include:

  • Carryforward of interest expense.  The Notice states that forthcoming regulations will allow taxpayers with disqualified interest under the old law to carry forward such interest as business interest under the new law.  Such interest could be disallowed under the new limitation in the same manner as any other business interest. 

  • Corporate business interest.  The Notice clarifies that interest paid by a C corporation is business interest for purposes of the interest limit.  Forthcoming regulations will address whether and when interest paid by a partnership, including a partnership with a corporate partner, should be treated as business interest for the corporate partner. 

  • Consolidated groups.  The Notice confirms that the business interest limit properly applies at the level of a consolidated group.  Forthcoming regulations will address how the interest limit applies to a consolidated group when one of the members is an electing real property trade or business, and to a consolidated group in which a member holds an interest in a partnership that is engaged in a real property trade or business.

  • Earnings and profits.  The Notice clarifies that a disallowed business interest deduction will not affect whether or when the interest expense reduces a C corporation’s earnings and profits.

For real estate investors, however, the Notice leaves unanswered some of the key issues related to the financing of real estate.  For example, The Real Estate Roundtable has asked Treasury to clarify that interest on debt incurred by an owner to fund an investment in a partnership or other entity engaged in a real property trade or business, constitutes interest on debt properly allocable to that real estate business (Comment Letter, Feb 23; Roundtable Weekly, Feb. 23).

The Treasury Department and the IRS are expected to issue additional guidance and regulations in the future, and request comments on the rules described in the notice and what additional guidance should be issued to assist in computing the business interest expense limitation under Section 163(j). (IRS, April 2)

Depending on the outcome of the rule-making process, the new limitation on business interest expense (Section 163(j)) could have significant implications for real estate markets and the financing of real estate transactions.  Clarifying the rules for real estate in the context of tiered arrangements will help avoid potential disruptions.

The Roundtable and TPAC will continue to play an active role in seeking appropriate clarifications affecting the most significant changes to the tax code.

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Partnership Law

New York’s High Court Upholds Sanctity of Partnership Contracts, Confirms “Goodwill” Value for Real Estate Assets

New York’s highest court issued a significant decision on March 27 regarding the governance, operation and dissolution of businesses structured as general partnerships; the value of “goodwill” that can inure to real estate assets; and the discounts that apply when valuing the stake of an investor with only a minority position in an enterprise.

As the vast majority of U.S. general partnerships are real estate enterprises, The Roundtable filed an amicus brief last year supporting the continuing partners.

Congel v. Malfitano concerns a general partnership formed to build, own and operate a 1.2 million square foot retail mall in upstate New York.  A 58-page agreement executed when the partners formed their business covers all aspects of its operations.  For example, the agreement prescribes two, sole means to dissolve the concern, either by (1) a majority vote of the partners, or (2) by the occurrence of an event that makes it unlawful for the business to carry on.

After negotiations to buy-out the defendant’s 3.08 percent minority stake failed, he sent a notice letter to unilaterally dissolve the partnership.  Concerned that the letter could force liquidation and preclude refinancing the asset, the remaining partners continued the business and filed suit.  They alleged that the minority partner committed a “wrongful dissolution” that breached their written agreement. 

The Court of Appeals agreed with the ongoing partners on the dissolution issue.  It re-affirmed prior holdings that, while “partners are statutorily empowered [under New York law] to dissolve the partnership at any time, wrongfully dissolving partners may be liable to the expelled partner for breach of the partnership agreement.”  Moreover, the minority partner could not obtain recourse to “default” statutory standards for dissolving “at will” partnerships – which can be unwound unilaterally by any single partner – because the written agreement at issue left “no room for other means of dissolution” and the parties “clearly specified under what terms [their partnership] could be dissolved.”  Accordingly, the court deemed the minority partner’s dissolution letter as wrongful.  

Congel further addressed key principles to ascertain the value of the minority stake owed to the defendant by the partners who continued operations, including:

  • Goodwill Value:  New York law provides that a wrongfully dissolving partner should not benefit from the enterprise’s “goodwill,” an intangible asset attributable to the “patronage and support of regular customers” and the “positive advantage … acquired by a proprietor in carrying on a business.”  The appeals court thus affirmed the trial court’s factual finding “that the shopping mall and the mall’s tenants attract regular loyal, shoppers” – such that the value of partnership’s goodwill component (aside from its real property and cash holdings) should be deducted from the defendant’s minority interest.

  • Minority Discount: The Congel decision acknowledged that “a minority discount is a standard tool in valuation of a financial interest, designed to reflect the fact that the price an investor is willing to pay for a minority ownership interest in a business, whether a corporation or a partnership, is less because the owner of a minority interest lacks control of the business.”  It held that a minority discount applied here, to reflect a “determination of the fair market value of the wrongfully dissolving partner’s interest as if that interest were being sold piecemeal and the rest of the business continu[ed] as a going concern.”

As the vast majority of U.S. general partnerships are real estate enterprises, The Roundtable filed an amicus brief last year supporting the continuing partners.  The Building Owners and Managers Association (BOMA) International, CRE Finance Council, International Council of Shopping Centers, Nareit®, National Association of Home Builders, National Multifamily Housing Council, New York State Association of REALTORS®, and the Real Estate Board of New York also joined the amicus brief.

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