INCOME TAXES AND RELATED PAYMENTS
Oaktree is a publicly traded partnership and Oaktree Holdings, Inc. and Oaktree AIF Holdings, Inc., two of its Intermediate Holding Companies, are wholly-owned corporate subsidiaries. Income earned by these corporate subsidiaries is subject to U.S. federal and state income taxation and taxed at prevailing rates. Income earned by non-corporate subsidiaries is not subject to U.S. federal corporate income tax and is allocated to the Oaktree Operating Group’s unitholders. The Company’s effective tax rate is dependent on many factors, including the estimated nature of many amounts and the mix of revenues and expenses between the subsidiaries that are or are not subject to income tax; consequently, from period to period the effective tax rate is subject to significant variation.
Tax Legislation
On December 22, 2017, the Tax Act was enacted. The Tax Act reduced the corporate income tax rate from 35% to 21%, and included significant changes to other domestic and international corporate income tax provisions. The rate change resulted in a net reduction to net income attributable to Oaktree Capital Group, LLC of $33.2 million, comprised of $178.2 million in additional tax expense due to a reduction in the Company’s deferred tax assets and a $145.1 million benefit to other income due to a reduction in the Company’s tax receivable agreement liability. The U.S. Securities and Exchange Commission (“SEC”) Staff issued Staff Accounting Bulletin No. 118 in December 2017, which provides that in situations where a financial statement issuer does not have all necessary information to fully account for the income tax effect of the Tax Act, the issuer may record a provisional amount in its financial statements that may be subject to adjustment during a subsequent measurement period. The Company has assessed the impact of the Tax Act on its December 31, 2017 consolidated financial statements and believes the material impacts of The Act have been reflected in the above provisional amounts. The Company will continue to evaluate the impact of the Tax Act with respect to certain international provisions as well as provisions that have been identified as requiring additional technical guidance. The Company expects to complete its evaluation of the provisional amounts during the second half of 2018 as technical guidance is released and as it completes its 2017 federal and state income tax returns.
Income tax expense from operations consisted of the following:
|
| | | | | | | | | | | |
| Year Ended December 31, |
| 2017 | | 2016 | | 2015 |
Current: | | | | | |
U.S. federal income tax | $ | 4,085 |
| | $ | 10,268 |
| | $ | 1,478 |
|
State and local income tax | 2,687 |
| | 6,154 |
| | 1,650 |
|
Foreign income tax | 5,907 |
| | 1,436 |
| | 2,621 |
|
| $ | 12,679 |
| | $ | 17,858 |
| | $ | 5,749 |
|
Deferred: | | | |
| | |
|
U.S. federal income tax | $ | 191,488 |
| | $ | 23,835 |
| | $ | 11,306 |
|
State and local income tax | 10,928 |
| | 2,110 |
| | 786 |
|
Foreign income tax | 347 |
| | (1,284 | ) | | (292 | ) |
| $ | 202,763 |
| | $ | 24,661 |
| | $ | 11,800 |
|
Total: | | | |
| | |
|
U.S. federal income tax | $ | 195,573 |
| | $ | 34,103 |
| | $ | 12,784 |
|
State and local income tax | 13,615 |
| | 8,264 |
| | 2,436 |
|
Foreign income tax | 6,254 |
| | 152 |
| | 2,329 |
|
Income tax expense | $ | 215,442 |
| | $ | 42,519 |
| | $ | 17,549 |
|
The Company’s income (loss) before income taxes consisted of the following:
|
| | | | | | | | | | | |
| Year Ended December 31, |
| 2017 | | 2016 | | 2015 |
Domestic income (loss) before income taxes | $ | 894,911 |
| | $ | 623,712 |
| | $ | (1,518,108 | ) |
Foreign income (loss) before income taxes | 10,013 |
| | (15,090 | ) | | 2,695 |
|
Total income (loss) before income taxes | $ | 904,924 |
| | $ | 608,622 |
| | $ | (1,515,413 | ) |
The Company’s effective tax rate differed from the federal statutory rate for the following reasons:
|
| | | | | | | | |
| Year Ended December 31, |
| 2017 | | 2016 | | 2015 |
Income tax expense at federal statutory rate | 35.00 | % | | 35.00 | % | | 35.00 | % |
Income passed through | (31.61 | ) | | (30.31 | ) | | (35.91 | ) |
State and local taxes, net of federal benefit | 0.38 |
| | 1.28 |
| | (0.17 | ) |
Foreign taxes | 0.23 |
| | 0.89 |
| | (0.09 | ) |
Deferred tax adjustment | 19.76 |
| | — |
| | — |
|
Other, net | 0.05 |
| | 0.13 |
| | 0.01 |
|
Total effective rate | 23.81 | % | | 6.99 | % | | (1.16 | )% |
The components of the Company’s deferred tax assets and liabilities were as follows:
|
| | | | | | | | | | | |
| As of December 31, |
| 2017 | | 2016 | | 2015 |
Deferred tax assets: | |
| | |
| | |
|
Investment in partnerships | $ | 191,713 |
| | $ | 386,796 |
| | $ | 414,142 |
|
Equity-based compensation expense | 3,537 |
| | 4,449 |
| | 3,773 |
|
Other, net | 9,311 |
| | 14,329 |
| | 9,675 |
|
Total deferred tax assets | 204,561 |
| | 405,574 |
| | 427,590 |
|
Total deferred tax liabilities | 2,101 |
| | 960 |
| | 1,792 |
|
Net deferred tax assets before valuation allowance | 202,460 |
| | 404,614 |
| | 425,798 |
|
Valuation allowance | — |
| | — |
| | — |
|
Net deferred tax assets | $ | 202,460 |
| | $ | 404,614 |
| | $ | 425,798 |
|
When assessing the realizability of deferred tax assets, the Company considers whether it is probable that some or all of the deferred tax assets will not be realized. In determining whether the deferred tax assets are realizable, the Company considers the period of expiration of the tax asset, historical and projected taxable income, and tax liabilities for the tax jurisdiction in which the tax asset is located. The deferred tax asset recognized by the Company, as it relates to the higher tax basis in the carrying value of certain assets compared to the book basis of those assets, will be recognized in future years by these taxable entities. Deferred tax assets are based on the amount of the tax benefit that the Company’s management has determined is more likely than not to be realized in future periods. In determining the realizability of this tax benefit, management considered numerous factors that will give rise to pre-tax income in future periods. Among these are the historical and expected future book and tax basis pre-tax income of the Company and unrealized gains in the Company’s assets at the determination date. Based on these and other factors, the Company determined that, as of December 31, 2017, all deferred tax assets were more likely than not to be realized in future periods.
The Company recognizes tax benefits related to its tax positions only where the position is “more likely than not” to be sustained in the event of examination by tax authorities. As part of its assessment, the Company analyzes its tax filing positions in all of the federal, state and foreign tax jurisdictions where it is required to file income tax returns, and for all open tax years in these jurisdictions. As of December 31, 2017, the total reserve balance, including interest and penalties, was $7.5 million.
The following is a reconciliation of unrecognized tax benefits (excluding interest and penalties thereon):
|
| | | | | | | | | | | |
| Year Ended December 31, |
| 2017 | | 2016 | | 2015 |
Unrecognized tax benefits, January 1 | $ | 5,768 |
| | $ | 4,956 |
| | $ | 5,575 |
|
Additions for tax positions related to the current year | 350 |
| | 350 |
| | 1,156 |
|
Additions for tax positions related to prior years | — |
| | 2,121 |
| | 109 |
|
Reductions for tax positions related to prior years | (412 | ) | | (79 | ) | | — |
|
Settlements | — |
| | — |
| | — |
|
Lapse in statute of limitations | (1,340 | ) | | (1,580 | ) | | (1,884 | ) |
Unrecognized tax benefits, December 31 | $ | 4,366 |
| | $ | 5,768 |
| | $ | 4,956 |
|
If the above tax benefits as of December 31, 2017 were to be recognized in 2017, the $4.4 million would impact the annual effective tax rate.
The Company recognizes interest and penalties related to unrecognized tax positions in the provision for income taxes in the consolidated statements of operations. As of December 31, 2017 and 2016, respectively, the aggregate amount of interest and penalties accrued was $3.2 million and $3.1 million. The Company recognized a net expense of $0.1 million and $1.6 million in 2017 and 2016, respectively, and no net change in 2015. There was no net change in the amount of interest and penalties accrued between December 31, 2014 and December 31, 2015, because the $0.9 million charge for interest and penalties in 2015 was fully offset by a $0.9 million benefit from the reversal of prior-year accruals upon the lapse in the statute of limitations.
The Company files its tax returns as prescribed by the tax laws of the jurisdictions in which it operates. In the normal course of business, the Company is subject to examination by federal, state, local and foreign tax regulators. With limited exceptions, the Company is no longer subject to income tax audits by taxing authorities for periods before 2014. Tax authorities currently are examining certain income tax returns of Oaktree, with certain of these examinations at an advanced stage. Over the next twelve months ending December 31, 2018, the Company believes that it is reasonably possible that one outcome of these current examinations and expiring statutes of limitation on other items may be the release of up to approximately $5.2 million of previously accrued Operating Group income taxes. The Company believes that it has adequately provided for any reasonably foreseeable outcomes related to its tax examinations and that any settlements related thereto will not have a material adverse effect on the Company’s consolidated financial statements; however, there can be no assurances as to the ultimate outcomes.
Exchange Agreement and Tax Receivable Agreement
Subject to certain restrictions and the approval of the Company’s board of directors, each holder of OCGH units has the right to exchange his or her vested units for, at the option of the Company’s board of directors, Class A units, an equivalent amount of cash based on then-prevailing market prices and/or other consideration of equal value. Certain of the Oaktree Operating Group entities made an election under Section 754 of the U.S. Internal Revenue Code, as amended, which may result in an adjustment to the tax basis of the assets owned by the Oaktree Operating Group at the time of an exchange. These exchanges may result in increases in tax deductions and tax basis that would reduce the amount of tax that Oaktree Holdings, Inc. and Oaktree AIF Holdings, Inc. would otherwise be required to pay in the future.
Oaktree Holdings, Inc. and Oaktree AIF Holdings, Inc. have entered into a tax receivable agreement with OCGH unitholders that, as amended, provides for the payment to an exchanging or selling OCGH unitholder of 85% of the amount of cash savings, if any, in U.S. federal, state, local and foreign income taxes that they actually realize (or are deemed to realize in the case of an early termination payment by Oaktree Holdings, Inc. or Oaktree AIF Holdings, Inc., or a change of control) as a result of an increase in the tax basis of the assets owned by the Oaktree Operating Group. When an exchange of OCGH units results in an increase to the tax basis of the assets owned by the Oaktree Operating Group, a deferred tax asset and an associated liability for payments to OCGH unitholders under the tax receivable agreement are recorded, subject to realizability considerations. The establishment of a deferred tax asset increases additional paid-in capital because the transactions are between Oaktree and its unitholders.
Assuming no further material changes in the relevant tax law and that the Company earns sufficient taxable income to realize the full tax benefit of the increased amortization of the assets, the expected future payments to OCGH unitholders under the tax receivable agreement, as of December 31, 2017, are estimated to aggregate $17.3 million over the period ending approximately in 2029 with respect to the 2007 Private Offering, $36.8 million over the period ending approximately in 2034 with respect to the initial public offering, $51.1 million over the period ending approximately in 2035 with respect to the public offering in May 2013, $38.6 million over the period ending approximately in 2036 with respect to the public offering in March 2014, $32.5 million over the period ending approximately in 2037 with respect to the public offering in March 2015, and $34.3 million over the period ending approximately in 2040 with respect to the public offering in February 2018. Future estimated payments to OCGH unitholders under the tax receivable agreement are subject to increase in the event of additional exchanges of OCGH units.
In the years ended December 31, 2017, 2016 and 2015, respectively, $20.0 million, $18.8 million and $15.7 million were paid under the tax receivable agreement.