Blocker Corporation Structures in Private Equity Funds ...media.straffordpub.com/products/blocker... · 4/22/2020 · : Tax-exempt orgs can treat unrelated businesses held through

Blocker Corporation Structures in Private

Equity Funds: Tax and Other Considerations

for Fund InvestorsAvoiding UBTI and ECI; Entry and Exit Strategies

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WEDNESDAY, APRIL 22, 2020

Presenting a live 90-minute webinar with interactive Q&A

Jace E. Clegg, Attorney, Gunderson Dettmer Stough Villeneuve Franklin & Hachigian, New York

Brian D. Huber, Partner, Gunderson Dettmer Stough Villeneuve Franklin & Hachigian, Boston

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SILICON VALLEY ANN ARBOR BEIJING BOSTON LOS ANGELES NEW YORK SAN DIEGO SAN FRANCISCO SINGAPORE

Blocker Structuring in the Wake of U.S. Tax Reform

Brian [email protected]

Jace [email protected]

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Agenda

• General Overview of Funds and Investor Types

• Fund activities that generate UBTI and/or ECI

• Blocker Strategies to Mitigate UBTI/ECI exposure

• Domestic v Foreign Blockers

• Practical Tax Considerations in Employing Blockers for Investments

• Additional Mitigation Strategies

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General Overview

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Fund Overview

• Form - Funds generally organized as limited partnerships

– Under US tax law, partnerships are “flow-through” entities (aka, “tax transparent”)

➢ Generally not subject to US federal income tax at partnership level

➢ Partners taxed on distributive share of partnership income based on character of income earned by partnership

– Limited liability for investors

– Broad flexibility in terms (economic and otherwise)

• Jurisdiction (generally) won’t impact tax-transparency

– US (specifically, Delaware) generally favored for US VC funds because of familiarity, FATCA compliance, control of PFIC elections

– Non-US jurisdiction (e.g., Cayman) may be used for funds with significant non-US investments in order to mitigate CFC exposure BUT as a result of tax reform and corresponding regulations, this strategy may be shifting

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Investor US Tax Concerns – A (Very) General Overview

Category US Taxable Investors

US Tax-Exempt Investors

Non-US Investors

Common Examples

• Family offices

• Funds of funds

• High net worth individuals

• US managers and carry recipients

• US charities and foundations

• US universities and endowments

• US pension funds

• Foreign charities and foundations

• Foreign pension plans

• Foreign government investors

• International organizations

Primary

US Tax Concerns

• Tax efficiency

• Reporting obligations

• UBTI/UDFI

• US filing obligations

• ECI/FIRPTA

• FDAP

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US Taxable Investors

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• Timing → when is income included/taxable and how much

• Character → capital gain vs ordinary income

• Anti-Deferral Regimes →

– special rules for investment in certain types of non-US corporation classified as either “Passive Foreign Investment Companies” (PFICs) or a controlled foreign corporations (CFCs)

– Expanded in scope as a result of tax reform

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US Tax-Exempt Investors

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US Taxation of US Tax-Exempt Investors

• General Rule: Tax Exempt Investors are generally exempt from US tax

• Exception: subject to tax on “unrelated business taxable income” (UBTI)

• Modifications of Exception: certain passive investment income (dividends, interest, capital gains) is excluded from UBTI

• Exceptions to Modifications: “unrelated debt-financed income”

• Special Classes of Tax-Exempt Investors

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Unrelated Business Taxable Income – Basic Elements

• Unrelated business taxable income (UBTI) is income derived by any organization from any unrelated trade or business…regularly carried on by it

UNRELATED

TRADE OR BUSINESS

REGULARLY CARRIED ON

not “substantially related” (aside from the need for funds) to the performance of the charitable, educational or other activities that are the basis of its exemption

activity carried on for the production of income

activities manifest a frequency and continuity, and are pursued in a manner, generally similar to comparable commercial activities of non-exempt organizations

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UBTI – Rates and Modifications

• UBTI Rates

– UBTI generally taxed at corporate rate (21%)

– But: tax-exempt trusts are taxable at trust rate (max 37%)

• Modification

– most passive investment income (e.g., dividends, interest, rents, royalties, capital gains) is generally excluded from UBTI

• Exception to Modification: passive investment income that is unrelated debt-financed income (see next slide)

contractual description of income may not match tax characterization (e.g., “royalties”)

Beware

15

certain transactions that may appear passive in nature with respect to digital assets may in fact be active in nature (e.g., “staking,” “mining”).

Beware


UBTI – Unrelated Debt-Financed Income

• Unrelated debt-financed income (UDFI) is taxed as UBTI

• Very generally, UDFI is certain income and gains from property that is “debt-financed”

– Overrides general modification for dividends, interest, etc.

• Amount of UDFI based on debt-outstanding:

– during the calendar year (for UDFI that is current income)

– within prior 12-month period (for UDFI that is capital gains)

• Fractions Rule

– a limited (and highly technical) exception to UDFI in connection with acquiring/improving real property

– only certain qualified educational organizations and trusts are eligible

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UBTI - New Law

• IRC 512(a)(6): UBTI losses from one trade or business cannot be used to offset gains from another unrelated trade or business.

– Special transition rule permits carryforward of NOLs arising in a taxable year beginning before January 1, 2018.

• IRS Notice 2018-67: Tax-exempt orgs can treat unrelated businesses held through multiple partnerships as a single trade or business

– “Qualifying partnership interests”

– 2% capital and profits threshold

– 20% capital threshold where tax-exempt lacks “control or influence”

– Transition rule: Existing partnership interests (i.e., those acquired prior to August 21, 2018) carved out of above rule

– Determining an “unrelated trade or business”

➢ NAICS codes

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Tax-Exempt Investors – Special Classifications

• “Super” Tax-Exempts

– Governmental entities (e.g., state retirement plans) claiming exemption from all income (including UBTI) as instrumentalities of US states under Code Section 115

– Not concerned with UBTI mitigation

• Private Foundations

– Privately supported charitable organizations (e.g., family foundations)

– Excise tax on net investment income and certain prohibited activities

– In addition to UBTI mitigation, may seek covenants related to overall percentage ownership and activities of the Fund

• Charitable Remainder Trusts

– A tax-exempt irrevocable trust designed to reduce the taxable income of individuals by first dispersing income to the beneficiaries of the trust for a specified period of time and then donating the remainder of the trust to the designated charity

– 100% excise tax on UBTI

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Non-US Investors

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Non-US Investors

• Three main US tax regimes impacting Non-US Investors that aren’t otherwise U.S. tax residents:

– US sourced “fixed or determinable, annual or periodic” income

– Income Effectively Connected to a US trade or business

– Foreign Investment in Real Property Tax Act

• Otherwise, non-US persons generally are not subject US income tax on capital gains (unless the person is present in the US for 183 days or more or is otherwise treated as a US tax resident (e.g., green card holder)).

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Fixed Determinable Annual or Period Income

• “Fixed or Determinable, Annual or Periodic” (FDAP) Income

– Includes US source dividends, interest, rents and royalties

– 30% withholding tax on gross amount of US source FDAP

➢ 30% withholding can be reduced by treaty reduction (assuming qualification for treaty benefits) and certain other exceptions (e.g., portfolio interest exemption)

• FDAP in the Fund Context

– Dividends and royalties from US portfolio companies and interest on lending arrangements

• Form W-8 used to claim treaty reductions or otherwise qualify for certain exemptions

contractual description of investment may not match tax characterization (e.g., convertible debt in an LLC, SAFEs)

Beware

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certain investment activities that may appear passive in nature with respect to digital assets may in fact be active in nature (e.g., “staking,” “mining”).

Beware


Income Effectively Connected to a US Trade or Business

• Non-US Investors “engaged in the conduct of a US trade or business” are required to

– file US federal (and, potentially, state) income tax returns, and

– pay tax at regular rates on income that is “effectively connected” with such trade or business (ECI) – currently 21% for non-US corporations

– additional “branch profits” tax for corporate Non-US Investors

➢ 30% on their ECI that is repatriated to them, resulting in an effective tax rate of approximately 44.7%

• Technical filing requirements

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Income Effectively Connected to a US Trade or Business

• “Trade or business”

– facts and circumstances analysis

➢ Income-producing activity that is considerable, continuous, and regular

➢ lending → consider factors such as (1) total number of loans made, (2) time and effort expended, (3) loans to unrelated borrowers, and (4) active solicitation of borrowers

– Some overlap with concepts from UBTI, but no statutory exception for interest, dividends, etc.

➢managing one's own investments in securities generally not a US trade or business

➢ Securities trading safe harbor

• ECI from disposition of interests in partnership engaged in a US trade or business

– Buyer and partnership withholding obligations

– certifications

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Foreign Investment in Real Property Tax Act

• Foreign Investment in Real Property Tax Act (FIRPTA)

– Exception to general rule that non-US persons are not subject to US tax on capital gains

– Gain from disposition of a “United States real property interest” (USRPI) treated as ECI

– USRPI

➢ Interests directly in US real property

➢ Interests in domestic “US real property holding corporation” (USRPHC)

» USRPHC → 50% (or more) of value of operating assets attributable to USRPIs

– FIRPTA tax is initially collected by withholding at 15% of gross proceeds

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Non-US Investors – Special Classifications

• Foreign Sovereign Investors

– Governmental entities

– Generally not concerned with FDAP or USRPHC mitigation

• Foreign Tax-Exempt Investors

– Generally not concerned with FDAP

– Qualified Foreign Pension Funds generally not concerned with USRPHC mitigation

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Common Fund Activities Generating UBTI and/or ECI

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UBTI ECI

INVESTMENTS IN FLOW-THROUGH OPERATING COMPANIES

BORROWING

GUARANTEES

CERTAIN “ROYALTIES”

LOAN ORIGINATION IN THE US

FEE OFFSET ARRANGEMENTS

US REAL PROPERTY & INFRASTRUCTURE

INVESTMENTS(including companies with substantial value

derived from US real property, such as manufacturing plants, windfarms, cell towers)

DIGITAL ASSET MINING/STAKING


Common Fund Strategies to Mitigate UBTI and/or ECI

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UBTI ECI

INVESTMENT RESTRICTIONS

BORROWING RESTRICTIONS

CORPORATE BLOCKER VEHICLES

LENDING RESTRICTIONS

OPT-OUT RIGHTS


Blocker Strategies

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Legend

Partnership for US tax purposes

Investor grouping

Corporation for US tax purposes

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Basic Fund Structure

Overview• All investors participate directly in a single Fund,

classified as a partnership for US tax purposes, so Fund income and activities flow through

SpecificRequirements

• None. Fund may borrow freely, invest unblocked in flow-through portfolio companies and engage in continuous loan origination within the US

Investor Type

Pros Cons

USTaxable

• Simple structure minimizes costs of organization and maintenance

• Tax efficiency

• Possible State and Local (“SALT”) filings

US Tax-Exempt

• Simple structure minimizes costs of organization and maintenance

• No UBTI/UDFI mitigation

• Possible SALT filings

Non-US• Simple structure minimizes

costs of organization and maintenance

• No ECI or federal filing mitigation

• Possible SALT filings

Fund

US Tax Exempt

Non-US

US Taxable

OpCoOpCo

Unrestricted debt financing Unrestricted lending activities

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Basic Fund Structure w/ Permanent Blocker Feeder

Overview

• Non-US and tax-exempt investors participate through Blocker, a feeder entity classified as a corporation for US tax purposes, which in turn invests as an LP in Fund

• US taxable investors participate directly in Fund


• Structuring done up front

• No UBTI or ECI covenants

• No restrictions on borrowing or lending activity

Investor Type

Pros Cons

USTaxable

• Same as basic • Same as basic

Blocker US Tax-Exempt

• Eliminates UBTI/UDFI

• Tax-inefficiency of blocker level taxes

• Loss of UBTI deductions (but note new 512(a)(6))

• Increased expense of additional vehicle

Blocker Non-US

• Eliminates ECI and filing obligation

• Tax-inefficiency of blocker level taxes

• Increased expense of additional vehicle if opting to be blocked

Fund

US Tax Exempt

Non-US

US Taxable

OpCoOpCo

Blocker

Unrestricted debt financing Unrestricted lending activities

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Basic Fund Structure w/ Investment Restrictions

Overview• All investors participate directly in a single Fund

• Flow-through investments blocked for all investors


• UBTI and ECI Covenants

• Guidelines impose restrictions on borrowing and lending activities

Investor Type

Pros Cons

USTaxable

• Same as basic

• Increased expense of additional vehicle(s)

• Loss of deductions from flow-through investments

• Tax leakage if exit structured as asset sale

US Tax-Exempt

• UBTI/UDFI mitigation


• Loss of UBTI deductions (but note new 512(a)(6))


Non-US• ECI and filing

mitigation



Fund

US Tax Exempt

Non-US

US Taxable

OpCoOpCo

Restricted US operationsRestricted debt financing

Blocker

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Parallel Fund (or AIV) Structure

Overview• Each investor participates directly in either Fund A or Fund B

• Fund B blocks flow-through investments


• Fund A – no UBTI and ECI Covenants, no restrictions on borrowing or lending

• Fund B – UBTI and ECI covenants and guidelines imposing restrictions on borrowing and lending activities

Variation• Implement Parallel AIV structure in connection with flow-

through investments (if any)

Investor Type

Pros Cons

USTaxable

• Same as basic • Same as basic

ParallelUS Tax-Exempt

• UBTI/UDFI mitigation


• Loss of UBTI deductions (but see new 512(a)(6))


Parallel Non-US

• ECI and filingmitigation



FundA

US Tax Exempt

Non-US

US Taxable

OpCoOpCo

Restricted US operations

Restricted debt financing

Blocker

FundB

Unrestricted US operations

Unrestricted debt financing

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Foreign v. Domestic Blockers

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FOREIGN DOMESTIC

Jurisdiction• Low/No tax jurisdiction

• Treaty relevant?• Delaware

Entity type

• Flexible, with US check the box election

• Consider relevance of tax transparency for treaty claims

• C-corp v. LLC checked as a corporation

• Consider impact on non-US investors

Common use

• Non-US investments

• UDFI mitigation

• Treaty structures

• US flow-through investments

• Leveraged blocker

Additional considerations

• PFIC/CFC mitigation

• US filings

• Non-tax implications (e.g., privacy laws)

• Nature of returns (current income v. gain on exit)

• Nature of Exit (stock sale v. asset sale)

• Controlled entity under 512(b)(13)?


Practical Tax Considerations in Employing Blockers for Investments

35


Practical Blocker Considerations- Pre-Exit

• Change in entity classification/restructuring

– Issue: potential that portfolio company could change its tax classification to corporation

➢ Creates potentially material tax inefficiency while simultaneously eliminating need for blocker

– Solution: contractually require within operating agreement that restructuring be effected in tax-free manner + contribution of blocker shares to successor corporation

• Tax Distribution Trapped Cash

– Issue: portfolio company operating agreement provides for tax distributions at an assumed tax rate in excess of blocker needs (e.g. 45% tax distribution where blocker effective tax rate is 28%)

– Solution:

➢ Leveraged structure?

➢ Tailored tax distributions?

➢ Contractual requirement that any acquiror “buy” cash?

36


Practical Blocker Considerations- Exit Scenario

• Sale of Portfolio Company – Blocker Shares vs. Portfolio Company Equity

– Issue: potential asymmetry between Buyer and Seller in acquisition of Blocker

➢ Purchase of blocker not tax optimal for a Buyer, and may result in a material reduction of purchase price to other portfolio company equityholders due to loss of basis step up

– Solution: contractually require within operating agreement that sale of portfolio company include a concurrent sale of blocker shares

➢ Considerations:

» Equalization of purchase price between portfolio company equity and blocker equity? Or does blocker equity bear diminution of purchase price?

» Will Buyer be willing to purchase “trapped cash”?

» “Clean” blocker?

» Does Fund’s upstream structuring accommodate “blocker sale”?

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Practical Blocker Considerations- Exit Scenario

• IPO of Portfolio Company

– Issue: tax inefficiencies where blocker no longer necessary

– Solution: contractually require within operating agreement that any IPO or public offering effected in tax-free manner + contribution of blocker shares to public company (or utilizing blocker as public company)

➢ Considerations:

» “Clean” blocker?

» Does Fund’s upstream structuring accommodate using blocker as IPO entity?

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Additional Mitigation Strategies

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Tax-Exempt Investors

Non-US Investors


PREFERRED EQUITY

LEVERAGED BLOCKERS

INSURANCE DEDICATED FUNDS

DONOR ADVISED FUNDS

SEASON & SELL

TREATY STRUCTURES

QEF ELECTIONS

Documents

Blocker Corporation Structures in Private Equity Funds ...media.straffordpub.com/products/blocker... · 4/22/2020 · : Tax-exempt orgs can treat unrelated businesses held through