Latest Trends in Tax Structures and Execution - PEI Media

Latest Trends in Tax
Structures and Execution
Panel Members:
Warren D. Abkowitz, Partner
J.H. Cohn LLP
James K. Wall, Principal
J. H. Cohn LLP
July 17, 2008

Carried Interests
• Profits Interest vs. Capital Interest
• Requirements:
– Received for past or future services.
– Not a capital interest.
• Exceptions:
– Substantially certain income stream
– Interest disposed of within two years
– Interest is in publicly traded partnership
• Revenue Procedures 93-27 (vested interest) and 2001-43
(Non-vested interest) (Current law).
1

Carried Interests
• Sol Diamond case – 1971 Partnership
interest is taxable upon receipt.
• Campbell case – 1990 Partnership interest
would be taxable but can’t accurately value
profits interest.
• IRS tried to use liquidation value as taxable
value but profit interest holders do not receive
proceeds upon immediate liquidation.
2

Publicly Traded Partnerships
• Publicly Traded Partnerships (PTP) --
–Traded on established securities market or readily tradable on
secondary market (i.e., interest has liquidity)
–Taxed as a corporation – current 35% federal income tax rate.
•Exceptions.
–Private Placements: Unregistered Offering and Less than 100
partners.
–Qualifying Income Exemption: If 90% or more of gross income
of entity is certain qualifying income including income from real
estate and natural resource activities as well as from interest,
dividends and sale of capital assets (cap gains).
3

Legislative Proposals
•Recent Rangel Tax Bills:
- H.R. 3970 (Tax Reduction and Reform Act of
2007) (October 25, 2007) (a.k.a. “Mother of All Tax
Legislation”).
- H.R. 3996 (Temporary Tax Relief Act of 2007)
(October 31, 2007).
- H.R. 6275 (June 17, 2008).
4

Legislative Proposals
GOOD NEWS
•Repeal (H.R. 3970) or Reduction (H.R. 3996)
of AMT for individuals.
•Unrelated Business Taxable Income (UBTI).
5

Legislative Proposals
BAD NEWS
•Carried Interests (and Other Services Interests).
•Self-Employment Taxes.
•Unrelated Business Taxable Income (UBTI).
•Section 197 Intangible Amortization.
•Dividend Received Deduction.
6

Legislative Proposals
CARRIED INTERESTS
•Any allocable net income or gain attributable to an “investment
services partnership interest” (i.e. carried interest) would be
ordinary income.
•A partner is treated as holding an “investment services
partnership interest” if (i) the person renders investment advisory
services (advising as to purchase or sale, management, financing
or any activity in support of the foregoing) to the partnership (ii)
with respect to stock, publicly-traded partnership interests, debt
instruments, notional principal contracts, currency or interest rate
contracts/swaps, real estate, actively-traded commodities and
options or derivative contracts with respect to the above.
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Legislative Proposals
CARRIED INTERESTS
•Invested Capital Exception. An exception applies where the
investment service partner invests capital for the interest and the
person is allocated income with respect to the capital portion on a
pari passu basis with other the invested capital by other partners.
•Invested capital for a service partner excludes proceeds of a loan
or debt guaranteed by another partner.
•Invested capital for a non-service partner includes any loan made
or guaranteed by such non-service partner; (affects income
allocated to invested capital).
8

Legislative Proposals
MANAGEMENT SERVICES INTERESTS
•Any income or gain recognized with respect to a “disqualified
interest” would be ordinary income where the taxpayer renders
“investment management services” to the entity and the value of
the interest is substantially related to the amount of income or gain
from the assets with respect to such services performed.
•Disqualified Interest mean any interest in any entity other than a
partnership interest or stock in a domestic C Corporation or certain
foreign corporations.
•Investment Management Services means a substantial quantity of
any of the advisory services noted above under Investment
Services Partnership Interests.
9

Tax-Exempt Investors
•Income of US tax-exempt investors generally not
subject to US federal income tax, except for “unrelated
business taxable income” (UBTI), which is subject to
tax at regular corporate rates.
•UBTI is gross income derived from any “unrelated
trade or business… regularly carried on” by the taxexempt,
less any deductions associated with such
trade or business.
10

Tax-Exempt Investors (cont’d)
•Certain “passive” income items, including dividends, interest and
capital gain, are excluded from UBTI.
•Income otherwise taxable to “US shareholders” of CFCs is also
excluded from UBTI.
•However, if investment property yielding dividends, interest or
other excludable income is leveraged, it may result in such income
becoming “unrelated debt financed income” which is a separate
category of UBTI.
11

Tax-Exempt Investors (cont’d)
•Thus, allocable share of income from PE Fund
potentially taxable to tax-exempt investor if: (1)
Portfolio Company is in “pass-through” form
(e.g., partnership, LLC) and engaged in nonexempt
business OR (2) Portfolio Company is
in corporate form, but investment therein is
leveraged.
12

Tax-Exempt Investors (cont’d)
Potential solutions to UBTI:
•Imposition of additional capital contribution obligations on taxexempt
investors, instead of proportionate share of debt leverage
otherwise used by PE Fund to invest in Portfolio company.
–Frequently impracticable, imposes additional capital burden on taxexempt
investor, with resulting drag on cash flow/IRR
•Use of “blocker corporation” to shelter UBTI otherwise earned at
PE Fund level.
13

Tax-Exempt Investors (cont’d)
•Foreign blocker corporation in effect “blocks” the
income and activities of the PE Fund or its Portfolio
companies from giving rise to UBTI.
•Provided a tax-favorable offshore jurisdiction is
chosen, the blocker corp should not be subject to non-
US corporate level taxation.
•Blocker corp may be subject to US tax (at corporate
rates) in respect of its share of income from Portfolio
Company.
•Blocker structures frequently organized as “above-thefund”
or “below-the-fund”.
14

Tax-Exempt Investors (cont’d)
Blocker Corporation Structure (“above-the-fund”)
Taxable US
Investors
Blocker
Corporation
Tax-Exempt
Investors
Fund
Portfolio
Companies
15

Tax-Exempt Investors (cont’d)
•“Above-the-fund” blocker structure contemplates
investment of tax-exempts’ capital into Blocker Corp,
which then contributes to PE Fund.
•This structure protects tax-exempts from potential
UBTI resulting from:
–PE Fund investments in pass-through entities,
whose unrelated business status would otherwise
pass through to tax-exempt.
–Debt leverage imposed at the PE Fund level.
16

Tax-Exempt Investors (cont’d)
Blocker Corporation Structure (“below-the-fund”)
Taxable US
Investors
Tax-Exempt
Investors
Fund
Blocker
Corporation
Portfolio
Companies
17

Tax-Exempt Investors (cont’d)
•“Below-the-fund” blocker structure contemplates investment by
tax-exempts directly into PE Fund, which reinvests that capital into
a wholly-owned Blocker Corp. PE fund and Blocker Corp then coinvest
aggregate capital (from taxable and tax-exempt investors,
respectively) into Portfolio Companies.
•This structure permits direct investment by PE Fund into passthrough
Portfolio Companies, as well as incurrence of debt
leverage at Portfolio Company level, without creating UBTI to taxexempts.
18

Tax-Exempt Investors (cont’d)
Parallel Fund Structure
Taxable
Investors
General
Partner
Tax-exempt
Investors
Fund
(Delaware)
Fund
(non-US)
Portfolio
Company
Portfolio
Company
Portfolio
Company
19

Tax-Exempt Investors (cont’d)
•A Parallel Fund structure essentially permits tax-exempt investors
to invest in a PE fund “side-by-side” with taxable investors, through
an offshore entity designed to act as a conduit for the tax-exempts’
capital contributions and investment returns.
•The offshore investment vehicle will frequently be a “reversehybrid”
entity that is treated as a pass-through for local tax
purposes, but is treated as a corporation for US tax purposes.
•This structure in effect uses a blocker entity that is utilized in a
fund that is exclusively devoted to the tax-exempt investors.
20

Foreign Investors in PE/Hedge Funds – General Concepts
•Investment Funds are most typically organized as pass through entities for US tax
purposes (LP’s or LLC’s); If the Investment Fund is organized outside the US, the
entity classification rules and entity classification considerations are critical
- Allows for single level of tax for US investors
- Allows for pass through of lower tax rate income
-LTCG
- Qualified dividends
•If the Investment Fund is engaged in a US trade or business (“ETB”), foreign
partners will be as well (Section 875)
•Foreign Investors in such structures are subject to US Federal income tax (and
allocable State taxes) on their share of income effectively connected with such
trade or business (“ECI”)
- 1446 withholding applies
- Branch tax may apply
- US Tax Return filings required
•Any gain realized on the disposition of a partnership interest is also ECI (See Rev
Rule 91-32)
- This Revenue Ruling has been widely criticized
21

Foreign Investors in PE/Hedge Funds – US Source FDAP
•In cases where Investment Funds do not generate ECI, direct foreign investors are
generally only subject to US withholding taxes on US source FDAP income.
–This may arise where the activities of the fund fall within the 864(b)(2) trading
in securities or commodities exception
•Withholding taxes can be reduced or eliminated via treaty or statutory exemptions
(e.g. portfolio debt instruments).
–Note that procedural requirements must be complied with in order for the
exemptions to apply
•The administrative burdens of complying with US Source FDAP withholding
requirements can be burdensome for both withholding agents and foreign
investors.
–W-8BEN forms and W-8IMY for foreign flow through entities
–US Source FDAP withholding applies on a cash basis generally but must be
completed even without a payment by the time a K-1 is due (see 1.1441-5(2))
22

Foreign Investors in PE/Hedge Funds – ECI
•Investment income generally does not create ECI (e.g. dividends, interest
and most capital gains).
–Capital gains involving USRPIs are a major exception
•Fee income is one of the primary sources of ECI.
–Debt or equity commitment fees
–Break-up fees
–Transaction Fees
–Guaranty Fees
–Monitoring fees
•If the Investment Fund invests in another pass-through entity that is ETB,
the Investment Fund’s foreign investors may realize ECI.
23

Foreign Investors in PE/Hedge Funds – Planning
•How do foreign investors in investment funds with ECI minimize exposure
to US tax?
–Blocker companies
–US Blocker companies eliminate 1446 withholding but may lead to
double level tax (US corporate tax at the blocker company level and
withholding taxes on distributions)
–Foreign Blocker companies insulate foreign shareholders but the
foreign Blocker company will suffer entity level taxes (branch tax may
be an issue)
–Blocker Companies may be above the fund, below the fund or
parallel blocker structures (the structures are often used for both
foreign and tax exempt investors)
•Management fee offsets allow the fund Manager to take all the “bad” fee
income (rather than the investment fund itself) with a compensating
adjustment to the periodic management fee payable to the fund Manager.
–Assignment of income may be an issue
24

Foreign Investors in PE/Hedge Funds – Planning
•Blocker companies can be combined with leverage structured as portfolio
debt.
–This type of structure makes it difficult for foreign investors to share
in profits equally with US investors
–Need to be mindful of contingent debt rules and 10% shareholders
that could cause portfolio debt requirements not to be met.
•Options and swaps are often considered as planning techniques to avoid
ECI and US withholding taxes but many technical issues need to be
addressed.
–An option on an LLC interest (that itself would generate ECI) would
need to be a capital asset and the sale of the option not treated as
the sale of the LLC interest itself
–Total Return Swaps generally need to be structured as notional
principal contracts and certain other requirements met
25

Foreign Investors in PE/Hedge Funds – Planning
•US Real estate funds have special issues because dispositions or
USRPI’s generate ECI under the FIRPTA rules.
–REIT structures may be advantageous for foreign investors
–Shared Appreciation Loans also have advantages since
FIRPTA only “kicks in” on the disposition of the loan.
•Treasury is considering changes to the ECI rules.
–It is not clear, if and when such changes would be made and
what they would ultimately look like
–ECI planning is likely to continue to be important to foreign
investors in Investment Funds
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Investments in Foreign Portfolio Companies
• The goal is generally to reduce the overall effective
tax rate (US and Foreign)
– Less tax means better returns for investors
• Common planning techniques include:
– Basis step-up
• 338 elections
• Local country step-up planning
– Leverage
• Need to be mindful of “thin cap” rules
• License intangibles to high tax jurisdictions
– Achieving local country consolidation
– CTB elections to minimize subpart F
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