TAX ISSUES IN PRIVATE EQUITY TAX ISSUES IN PRIVATE EQUITY
& VENTURE CAPITAL& VENTURE CAPITAL
TAX ISSUES IN PRIVATE EQUITY TAX ISSUES IN PRIVATE EQUITY
& VENTURE CAPITAL& VENTURE CAPITAL
ABA Section of Business LawABA Section of Business LawAugust 12, 2007August 12, 2007
Julie Divola Jonathan Axelrad Julie Divola Jonathan Axelrad Pillsbury Winthrop Shaw Pittman LLP Wilson Sonsini Goodrich & RosatiPillsbury Winthrop Shaw Pittman LLP Wilson Sonsini Goodrich & Rosati
John Lorito John Simon John Lorito John Simon Stikeman Elliott LLP Stikeman Elliott LLP KPMG LLP KPMG LLP
Introduction to VC/PE Introduction to VC/PE Fund StructuresFund Structures
plusplusUpdate on Proposed Update on Proposed
Changes to Taxation of Changes to Taxation of Carried InterestCarried Interest
3
IntroductionIntroduction
Venture Capital and Private Equity (VC/PE) firms traditionally have used partnership structures for the “Funds” that they use to raise capital and make investments
These structures vary significantly and have evolved over time
Key considerations are tax, securities law, alignment of interests, difficulty of valuing private securities, and liability compartmentalization
This presentation briefly provides an overview of certain “typical” fund structures, primarily from a VC perspective
Special Bonus! A brief update on proposed changes to the taxation of carried interest
4
Traditional Fund StructureTraditional Fund Structure
Portfolio Securities
ROIManagement FeeCarry
Investors (LP)
$99%
ROI
VCs
MM/MD
$1%
Key:L.L.C. = Limited Liability CompanyLP = Limited PartnerL.P. = Limited PartnershipMM/MD = Managing Member or Managing DirectorROI = Return on Invested CapitalAll entities are organized under Delaware law.
Fund, L.P.
General Partner, L.L.C.
5
Traditional with Back-Office/Management Co.Traditional with Back-Office/Management Co.
VCs
Portfolio Securities
$99%ROIManagement FeeCarry
ROI
MM/MD
$1%
Key:L.L.C. = Limited Liability CompanyLP = Limited PartnerL.P. = Limited PartnershipMM/MD = Managing Member or Managing DirectorROI = Return on Invested Capital
All entities are organized under Delaware law.Management Co. has perpetual life and may provide services to multiple General Partner entities. All other entities are single-purpose and limited-term.
ManagementCo., L.L.C.
Venture Firm NameOffice Equipment/Lease
Payroll SystemStaff Relationships
Assign Management Fee
Back-Office Services
General Partner, L.L.C.
MM/MD
Fund, L.P.
Investors (LP)
6
Structure Often Includes Many Parallel EntitiesStructure Often Includes Many Parallel Entities
Notes:
1. Qualified Purchaser funds admit only investors that are “qualified purchasers” under the Investment Company Act of 1940 typically, individuals holding >$5 million, and entities holding >$25 million, in investment assets).
2. Affiliates funds have reduced/zero fees/carry.3. Non-MFO fund does not have an offset against management fees for directors fees, etc. received by
VCs from portfolio companies.4. Principals fund allows VCs and their family/estate planning vehicles to co-invest on a tax-efficient,
pro rata basis. It actually holds title as a mere nominee on behalf of its partners.
VCs
Portfolio Securities
QualifiedPurchaser Fund, L.P.
Investors Investors
Non-QualifiedPurchaser Fund, L.P.
Investors
Qualified PurchaserAffiliates Fund, L.P.
Investors
Non-Qual. Purchaser Affiliates Fund, L.P.
Non-MFO Fund, L.P.
General Partner, L.L.C.
Principals Fund, L.P.
ManagementCo., L.L.C.
Investors (Non-U.S.)
7
Alternative Structure For Principals FundAlternative Structure For Principals Fund
Portfolio Securities
Investors
General Partner, L.L.C.
Principals Fund, L.L.C.
Series 1 Series 2
Main Fund, L.P.
AC = Additional Capital
ACAC
Fund Manager 2Fund Manager 1
8
Sample Alternative For International Investing -- IndiaSample Alternative For International Investing -- India
FVCI Sub Mauritius Co.
FII Sub Mauritius Co.
Private Indian Investments Public Indian Investments
AdvisoryAgreement
Limited Partners
Fund Cayman Islands LP
Advisory Co Indian Co.
General Partner
9
Proposed Changes to Taxation of Carried InterestProposed Changes to Taxation of Carried Interest
S. 1624S. 1624
Would amend IRC Sec. 7704(c) to eliminate corporate Would amend IRC Sec. 7704(c) to eliminate corporate tax exemption for publicly traded partnerships with 90% tax exemption for publicly traded partnerships with 90% passive incomepassive incomeCovers partnerships “providing certain investment Covers partnerships “providing certain investment adviser and related asset management services”adviser and related asset management services”Often called the “Blackstone Bill” because thought to Often called the “Blackstone Bill” because thought to have been triggered by recent/proposed IPOs of large have been triggered by recent/proposed IPOs of large PE firmsPE firmsNot expected to have a huge impact on VC/PE industry Not expected to have a huge impact on VC/PE industry because so few firms in a position to go publicbecause so few firms in a position to go public
10
Proposed Changes to Taxation of Carried InterestProposed Changes to Taxation of Carried Interest
H.R. 2834H.R. 2834
Would add new IRC Sec. 710 to treat carried interest “distributive share” as Would add new IRC Sec. 710 to treat carried interest “distributive share” as ordinary income for the performance of services, regardless of character of ordinary income for the performance of services, regardless of character of partnership’s underlying incomepartnership’s underlying incomeEssentially based on a profit share that is disproportionately large relative Essentially based on a profit share that is disproportionately large relative to capital contributionto capital contributionApplies if there is provision of investment services in the active conduct of Applies if there is provision of investment services in the active conduct of a trade or businessa trade or business
Not clear how this would apply to a traditional fund structure, under Not clear how this would apply to a traditional fund structure, under which neither Fund nor General Partner typically would be engaged in which neither Fund nor General Partner typically would be engaged in a “trade or business”a “trade or business”
Per statements from Congress, intended to cover nearly all private Per statements from Congress, intended to cover nearly all private investment partnerships, including VC/PE, real estate, oil and gas, etc.investment partnerships, including VC/PE, real estate, oil and gas, etc.This bill is really just a first draft This bill is really just a first draft
Many technical issues/glitchesMany technical issues/glitchesHearings in processHearings in process
11
Proposed Changes to Taxation of Carried InterestProposed Changes to Taxation of Carried Interest
H.R. 2834 (cont)H.R. 2834 (cont)
Extremely controversialExtremely controversialApparent loophole closer – rich fund managers paying capital Apparent loophole closer – rich fund managers paying capital gains taxes on income from their advisory servicesgains taxes on income from their advisory servicesLeading Democrats voicing support (Clinton, Obama, Edwards)Leading Democrats voicing support (Clinton, Obama, Edwards)Republicans generally oppose (Treasury Dept., etc.)Republicans generally oppose (Treasury Dept., etc.)Lobbyists heavily engaged, with focus on Lobbyists heavily engaged, with focus on
International competitiveness (fund managers moving International competitiveness (fund managers moving offshore; foreign investors outbidding for US investments)offshore; foreign investors outbidding for US investments)Impairment of innovation and capital formationImpairment of innovation and capital formationComparison with “founders stock” (if entrepreneurs can get Comparison with “founders stock” (if entrepreneurs can get capital gains treatment when their companies appreciate, capital gains treatment when their companies appreciate, why not VC/PE managers who also work hard for the why not VC/PE managers who also work hard for the companies’ success?)companies’ success?)
12
Proposed Changes to Taxation of Carried InterestProposed Changes to Taxation of Carried Interest
H.R. 2834 (cont)H.R. 2834 (cont)
It will be difficult for Congress to craft a statute that It will be difficult for Congress to craft a statute that can’t be structured aroundcan’t be structured around
At least without vast changes to the IRCAt least without vast changes to the IRCSee lack of success in shutting down See lack of success in shutting down swap/exchange funds, despite several targeted swap/exchange funds, despite several targeted IRC amendments IRC amendments
Lack of definitive statutory text (assuming current Lack of definitive statutory text (assuming current bill really is just a first draft) makes it difficult to bill really is just a first draft) makes it difficult to estimate what structures will be helpfulestimate what structures will be helpful
Nevertheless . . .Nevertheless . . .
13
Proposed Changes to Taxation of Carried InterestProposed Changes to Taxation of Carried Interest
H.R. 2834 (cont)H.R. 2834 (cont)
Potential gold mine for tax lawyersPotential gold mine for tax lawyersThe stakes are high enough to pay for almost any The stakes are high enough to pay for almost any degree of complex structuringdegree of complex structuringExample: Assume $1 billion fund, which yields a 3x Example: Assume $1 billion fund, which yields a 3x returnreturn
20% carry to GP: $400 million20% carry to GP: $400 millionOrdinary income vs. LTCG tax differential: $80 Ordinary income vs. LTCG tax differential: $80 millionmillion» Employment taxes and timing differences would Employment taxes and timing differences would
make spread even largermake spread even largerIf the bill (or anything like it) passes . . .If the bill (or anything like it) passes . . .
14
Expect This: Expect This:
VCs
Portfolio Securities
QualifiedPurchaser Fund, L.P.
Investors Investors
Non-QualifiedPurchaser Fund, L.P.
Investors
Qualified PurchaserAffiliates Fund, L.P.
Investors
Non-Qual. Purchaser Affiliates Fund, L.P.
Non-MFO Fund, L.P.
General Partner, L.L.C.
Principals Fund, L.P.
ManagementCo., L.L.C.
Investors (Non-U.S.)
15
To Be Replaced By This:To Be Replaced By This:
Tax Issues in Private Tax Issues in Private Equity and Venture Equity and Venture Capital: Capital:
Blocker CorporationsBlocker Corporations
Taxation of Pass-Through Taxation of Pass-Through Entities vs. CorporationsEntities vs. CorporationsTaxation of Pass-Through Taxation of Pass-Through Entities vs. CorporationsEntities vs. Corporations
18
Pass-Through EntitiesPass-Through Entities
What is a Pass-Through Entity?What is a Pass-Through Entity?An entity in which, for Federal income tax purposes, all An entity in which, for Federal income tax purposes, all of the income and losses of the entity flow through and of the income and losses of the entity flow through and are taxed to the owners of the entityare taxed to the owners of the entityOwners are taxed directly on the entity-level income, Owners are taxed directly on the entity-level income, regardless of whether cash is distributedregardless of whether cash is distributedIncome maintains same character (e.g. capital gain)Income maintains same character (e.g. capital gain)
Examples of Pass-Through Entities:Examples of Pass-Through Entities:
PartnershipsPartnershipsS CorporationsS CorporationsLimited Liability CompaniesLimited Liability Companies
19
CorporationsCorporations
C corporations are subject to “double taxation”C corporations are subject to “double taxation”
Income of a corporation is taxed first at the corporate level Income of a corporation is taxed first at the corporate level Shareholders of a corporation are not directly taxable on this Shareholders of a corporation are not directly taxable on this income income
Second level of tax is at the shareholder level - when a Second level of tax is at the shareholder level - when a corporation distributes the income in the form of dividends, the corporation distributes the income in the form of dividends, the shareholders pay tax shareholders pay tax
Not a direct share of entity incomeNot a direct share of entity income
Dividends, return of capital, capital gainDividends, return of capital, capital gain
Private Equity FundsPrivate Equity FundsPrivate Equity FundsPrivate Equity Funds
21
Private Equity FundsPrivate Equity Funds
Private equity funds (“Funds”) are organized frequently as Private equity funds (“Funds”) are organized frequently as entities classified as partnerships (pass-through entities) entities classified as partnerships (pass-through entities) for Federal tax purposes for Federal tax purposes
LLCsLLCsLimited PartnershipsLimited Partnerships
Typical Fund investors include:Typical Fund investors include:State pension plansState pension plansOther tax-exempt organizations Other tax-exempt organizations Corporate sponsored retirement plans Corporate sponsored retirement plans Foreign investors Foreign investors Other U.S. investors Other U.S. investors
22
Significance of Types of Fund InvestorsSignificance of Types of Fund Investors
Tax-exempt and foreign investors generally qualify for Tax-exempt and foreign investors generally qualify for certain exemptions from U.S. federal income taxcertain exemptions from U.S. federal income tax
However:However:Tax-exempt investors are taxed on Tax-exempt investors are taxed on Unrelated Unrelated Business Taxable IncomeBusiness Taxable Income (“UBTI”) (“UBTI”)Foreign investors are taxed on Foreign investors are taxed on Effectively Connected Effectively Connected IncomeIncome (“ECI”) (“ECI”)
23
Significance of Types of Fund InvestorsSignificance of Types of Fund Investors
If a Fund that is classified as a pass-through entity has UBTI or ECI, its tax-exempt or foreign owners may be required to pay U.S federal income tax on such income because the income flows through to them
Requires filing US tax return
What is UBTI?What is UBTI?What is UBTI?What is UBTI?
25
Unrelated Business Income TaxUnrelated Business Income Tax
Overview and General RulesOverview and General Rules
Internal Revenue Code (“IRC”) Section 501 grants tax Internal Revenue Code (“IRC”) Section 501 grants tax exempt status to a variety of tax-exempt and mutually exempt status to a variety of tax-exempt and mutually beneficial organizationsbeneficial organizations
IRC Section 511 may tax otherwise tax-exempt IRC Section 511 may tax otherwise tax-exempt organizations on their unrelated business income (the organizations on their unrelated business income (the “Unrelated Business Income Tax,” or “UBIT”) “Unrelated Business Income Tax,” or “UBIT”)
Unrelated Business Taxable Income (“UBTI”) is income Unrelated Business Taxable Income (“UBTI”) is income from a trade or business regularly carried on by an exempt from a trade or business regularly carried on by an exempt organization that is not substantially related to the organization that is not substantially related to the organization’s exempt purposeorganization’s exempt purpose
26
Unrelated Business Taxable Income Unrelated Business Taxable Income
The following are excluded from UBTI unless The following are excluded from UBTI unless they are derived from debt-financed property, they are derived from debt-financed property, or, in the case of interest, from controlled or, in the case of interest, from controlled organizations:organizations:
Gains from the sale of stockGains from the sale of stockInterest Interest DividendsDividends
27
Sources of UBTISources of UBTI
For private investment funds the principal For private investment funds the principal areas of concern are:areas of concern are:
Fund investments in portfolio pass-Fund investments in portfolio pass-through entitiesthrough entitiesUnrelated debt-financed incomeUnrelated debt-financed incomeFees earned by the FundFees earned by the Fund
28
Sources of UBTI – Operating PartnershipsSources of UBTI – Operating Partnerships
Unrelated trade or business of a partnership is Unrelated trade or business of a partnership is imputed to the tax-exempt partnersimputed to the tax-exempt partners
The tax-exempt partner’s share of the income The tax-exempt partner’s share of the income for the trade or business is UBTI for the trade or business is UBTI
Trade or business can be attributed up through Trade or business can be attributed up through partnershipspartnerships
If a Fund invests in a pass-through entity that If a Fund invests in a pass-through entity that is engaged in a trade or business, a tax-is engaged in a trade or business, a tax-exempt partner’s share of the entity’s income exempt partner’s share of the entity’s income would be UBTI would be UBTI
29
Portfolio Investments in Partnerships?Portfolio Investments in Partnerships?
Why would a Fund invest in a partnership?Why would a Fund invest in a partnership?
Existing target is a partnership (e.g. an LLC)Existing target is a partnership (e.g. an LLC)
Single level of tax on target earningsSingle level of tax on target earningsStepped up basis from earned incomeStepped up basis from earned income
Exit strategy: sale of partnership can give buyer stepped-Exit strategy: sale of partnership can give buyer stepped-up basis in target assetsup basis in target assets
May result in higher sale priceMay result in higher sale price
Tax DistributionsTax Distributions
30
Partnership acquisition structurePartnership acquisition structure
Fund can get basis step up through 754 election
Maintains single level of tax
May avoid potential anti-churning problem
Next buyer can get basis step up on sale of New Portfolio LLC
Target
NewPortfolio
Sellers
Fund
Investors
Target Assets
31
Unrelated debt-financed incomeUnrelated debt-financed income
Capital gain, interest and dividends normally Capital gain, interest and dividends normally excluded from UBTI are treated as UBTI to the excluded from UBTI are treated as UBTI to the extent the property generating the income is extent the property generating the income is financed by debtfinanced by debt
Includes both direct debt of the investor and Includes both direct debt of the investor and investor’s allocable share of Fund or portfolio investor’s allocable share of Fund or portfolio company (if a pass-through) debtcompany (if a pass-through) debt
32
Sources of UBTI – FeesSources of UBTI – Fees
Fees may constitute UBTIFees may constitute UBTI
May result from dealings with a portfolio companyMay result from dealings with a portfolio company
Examples include:Examples include:
Management and monitoring feesManagement and monitoring fees
Origination and commitment feesOrigination and commitment fees
Break-up and finder’s feesBreak-up and finder’s fees
Underwriting commissions Underwriting commissions
Other transaction-related paymentsOther transaction-related payments
What is ECI?What is ECI?What is ECI?What is ECI?
34
Effectively Connected IncomeEffectively Connected Income
Overview and General RulesOverview and General Rules
Section 871(b) subjects foreign persons to U.S. federal Section 871(b) subjects foreign persons to U.S. federal income tax on income effectively connected with the income tax on income effectively connected with the conduct of a trade or business within the U.S. conduct of a trade or business within the U.S.
Section 875 treats a foreign person that is a partner in a Section 875 treats a foreign person that is a partner in a partnership as being engaged in any trade or business in partnership as being engaged in any trade or business in which the partnership is engaged which the partnership is engaged
Both the Fund and the foreign investors are deemed to be Both the Fund and the foreign investors are deemed to be engaged in the U.S. trade or business in which any of the engaged in the U.S. trade or business in which any of the portfolio companies taxed as pass-through entities are portfolio companies taxed as pass-through entities are engaged engaged
35
Consequences of ECIConsequences of ECI
ECI generated by the portfolio company is taxed ECI generated by the portfolio company is taxed on a net basis in the same manner and at the on a net basis in the same manner and at the same rates as income of a U.S. personsame rates as income of a U.S. person
The foreign investor must file a U.S. tax return, The foreign investor must file a U.S. tax return, regardless of whether it actually recognizes regardless of whether it actually recognizes income in any given yearincome in any given year
36
Sources of ECISources of ECI
In private investment funds, the principal In private investment funds, the principal areas of concern are:areas of concern are:
Fund investments in portfolio pass-through Fund investments in portfolio pass-through entitiesentities
Investments in U.S. real property interestsInvestments in U.S. real property interests
Fees earned by the FundFees earned by the Fund
37
Sources of ECI – Fund Investments in Portfolio Pass-Through EntitiesSources of ECI – Fund Investments in Portfolio Pass-Through Entities
If a Fund invests in a pass-through entity that is engaged in a trade or business, a foreign partner’s share of the entity’s income would be ECI
A portion of any gain realized by the foreign investor upon the sale of its interest in a Fund that directly or indirectly conducts a US trade or business would be ECI to the extent of the foreign investor’s share of gain or loss on sale of Fund assets would be ECI.
Sale by Fund of investment in pass through entity can create ECI if assets used in US trade or business
38
Sources of ECI – U.S. Real Property InterestsSources of ECI – U.S. Real Property Interests Investments in U.S. Real Property Interests are always Investments in U.S. Real Property Interests are always
treated as ECItreated as ECI
U.S. Real Property Interests include:U.S. Real Property Interests include:Real property located in the U.S.Real property located in the U.S.Fixtures on such real propertyFixtures on such real propertyStock in a U.S. Real Property Holding Company Stock in a U.S. Real Property Holding Company (“USRPHC”)(“USRPHC”)
A USRPHC is any domestic corporation if more than A USRPHC is any domestic corporation if more than 50% of the fair market value of such corporation’s 50% of the fair market value of such corporation’s assets is attributable to U.S. real property interestsassets is attributable to U.S. real property interests
A blocker corporation structure is NOT effective to avoid A blocker corporation structure is NOT effective to avoid the recognition of ECI from U.S. real property intereststhe recognition of ECI from U.S. real property interests
39
Sources of ECI – Income from FeesSources of ECI – Income from Fees
Fees may be considered ECI, including:Fees may be considered ECI, including:Management, consulting and monitoring feesManagement, consulting and monitoring feesOrigination and commitment feesOrigination and commitment feesBreak-up and finder’s feesBreak-up and finder’s feesClosing feesClosing feesEquity commitment feesEquity commitment feesGuarantee feesGuarantee fees
More inclusive then UBTIMore inclusive then UBTI
40
Branch Profits TaxesBranch Profits Taxes
Foreign investors that are corporations, or that invest Foreign investors that are corporations, or that invest through a foreign corporation, may be subject to an through a foreign corporation, may be subject to an additional tax (the “branch profits tax”)additional tax (the “branch profits tax”)
Branch profits tax is equal to 30% of the “dividend Branch profits tax is equal to 30% of the “dividend equivalent amount,” which is the earnings and profits of a equivalent amount,” which is the earnings and profits of a U.S. branch of a foreign corporation attributable to its ECI U.S. branch of a foreign corporation attributable to its ECI
Triggered by changes in US net equityTriggered by changes in US net equity
Avoided by complete termination of US trade or businessAvoided by complete termination of US trade or business
May be modified by treatyMay be modified by treaty
What is a Blocker What is a Blocker Corporation?Corporation?
What is a Blocker What is a Blocker Corporation?Corporation?
42
What is a Blocker Corporation?What is a Blocker Corporation?
A “blocker corporation” is a corporation that is A “blocker corporation” is a corporation that is placed between the tax-exempt or foreign investors placed between the tax-exempt or foreign investors and the source of UBTI and ECIand the source of UBTI and ECI
The blocker corporation incurs and pays tax on the The blocker corporation incurs and pays tax on the operating income that is allocated to it from the operating income that is allocated to it from the pass-through entity, and thus “blocks” such income pass-through entity, and thus “blocks” such income from reaching the tax-exempt and foreign investors from reaching the tax-exempt and foreign investors
Any net after-tax proceeds distributed by the blocker Any net after-tax proceeds distributed by the blocker corporation to the tax-exempt and foreign investors corporation to the tax-exempt and foreign investors should be non-UBTI, non-ECI distributionsshould be non-UBTI, non-ECI distributions
43
Structures Using Blocker CorporationsStructures Using Blocker Corporations
There are generally three types of blocker structures:There are generally three types of blocker structures:
Parent BlockerParent Blocker, in which the blocker is positioned , in which the blocker is positioned “above the Fund” as a direct investor in the Fund“above the Fund” as a direct investor in the Fund
Subsidiary BlockerSubsidiary Blocker, in which the blocker is positioned , in which the blocker is positioned “below the Fund” as a wholly-owned subsidiary of the “below the Fund” as a wholly-owned subsidiary of the FundFund
Parallel BlockerParallel Blocker, in which the blocker is positioned , in which the blocker is positioned below a parallel Fund that is formed to invest side-by-below a parallel Fund that is formed to invest side-by-side with the main Fundside with the main Fund
44
Tax Consequences of Using a Blocker CorporationTax Consequences of Using a Blocker Corporation
The U.S. tax consequences of holding a pass-through The U.S. tax consequences of holding a pass-through investment through a blocker corporation depends on investment through a blocker corporation depends on the chosen structure the chosen structure
Specifically, the tax consequences depend on:Specifically, the tax consequences depend on:Whether the blocker is domestic or foreignWhether the blocker is domestic or foreignWhether the blocker holds all or only a subset of the Whether the blocker holds all or only a subset of the fund investments fund investments Whether the blocker resides above, below, or parallel Whether the blocker resides above, below, or parallel to the Fundto the Fund
Threshold question is whether the blocker will be Threshold question is whether the blocker will be respected as the tax owner of the investmentrespected as the tax owner of the investment
Blocker Structuring ExamplesBlocker Structuring ExamplesBlocker Structuring ExamplesBlocker Structuring Examples
46
Fund Invests in CorporationFund Invests in Corporation
Investors contribute capital to FundInvestors contribute capital to Fund
Fund invests in portfolio corporationFund invests in portfolio corporation
GP
Fund
ForeignInvestor
Exempt Investor
Corp
OtherInvestors
47
Fund Invests in LLC Fund Invests in LLC
Investors contribute capital to FundInvestors contribute capital to Fund
Fund invests in portfolio LLCFund invests in portfolio LLC
GP
Fund
ForeignInvestor
Exempt Investor
LLC
OtherInvestors
48
No BlockerNo Blocker
ProsProsStructural simplicityStructural simplicityNot all gain on sale of LLC interest will necessarily be Not all gain on sale of LLC interest will necessarily be UBTI or ECIUBTI or ECI
ConsConsExempt Investor and Foreign Investor probably have Exempt Investor and Foreign Investor probably have UBTI and ECIUBTI and ECI
Foreign Investor is required to file US tax returnForeign Investor is required to file US tax returnExempt Investor may have to file tax returnExempt Investor may have to file tax return
Sale of one (of multiple) LLC by Fund could trigger Sale of one (of multiple) LLC by Fund could trigger branch profits tax on Foreign Investorbranch profits tax on Foreign Investor
49
Parent BlockerParent Blocker
Mechanics:Mechanics:
Exempt Investor and Foreign Investor contribute Exempt Investor and Foreign Investor contribute capital for investment in LLC to a corporation capital for investment in LLC to a corporation (“Blocker Corp”) in exchange for 100% of the stock(“Blocker Corp”) in exchange for 100% of the stock
Blocker Corp contributes capital to Fund and Blocker Corp contributes capital to Fund and participates in investment in same manner as all participates in investment in same manner as all Other InvestorsOther Investors
New Blocker Corp for each investmentNew Blocker Corp for each investment
Blocker Corp will generally be a foreign corporationBlocker Corp will generally be a foreign corporation
50
Parent BlockerParent Blocker
GP
Fund
LLC
ForeignInvestor
Blocker Corp
Exempt Investor
OtherInvestors
51
Parent BlockerParent Blocker
ProsProsExempt Investor and Foreign Investor will not Exempt Investor and Foreign Investor will not have to report UBTI or ECI have to report UBTI or ECI Foreign and Exempt Investors will not have to Foreign and Exempt Investors will not have to file US tax returnfile US tax returnGP’s carried interest is not affected by Blocker GP’s carried interest is not affected by Blocker CorpCorp
ConsConsDifficult to avoid Blocker Corp level tax on Difficult to avoid Blocker Corp level tax on dispositiondispositionPotential Branch Profits Tax issuePotential Branch Profits Tax issueTax rate to Foreign InvestorTax rate to Foreign Investor
52
Subsidiary BlockerSubsidiary Blocker
Mechanics:Mechanics:
Fund forms Blocker Corp as wholly-owned subsidiaryFund forms Blocker Corp as wholly-owned subsidiaryFund agreement provides:Fund agreement provides:
Fund contributes capital contributions of Exempt Fund contributes capital contributions of Exempt Investor and Foreign Investor to Blocker Corp, which Investor and Foreign Investor to Blocker Corp, which uses them to acquire pro rata share of portfolio LLCuses them to acquire pro rata share of portfolio LLCExempt Investor and Foreign Investor share in Exempt Investor and Foreign Investor share in distributions and allocations to extent they are derived distributions and allocations to extent they are derived from distributions or sales proceeds attributable to from distributions or sales proceeds attributable to Blocker CorpBlocker CorpDistributable cash of Fund attributable to Blocker Corp Distributable cash of Fund attributable to Blocker Corp is divided between Exempt Investor, Foreign Investor is divided between Exempt Investor, Foreign Investor and GPand GPAll other distributable cash and allocations of income All other distributable cash and allocations of income and losses attributable to LLC are allocated among and losses attributable to LLC are allocated among Other Investors and GP Other Investors and GP
53
Subsidiary BlockerSubsidiary Blocker
GP
Fund
LLC
OtherInvestors
ForeignInvestor
Blocker Corp
Exempt Investor
54
Subsidiary BlockerSubsidiary Blocker
ProsProsFund can sell Blocker Corp as part of sale of portfolio Fund can sell Blocker Corp as part of sale of portfolio LLCLLCExempt Investor and Foreign Investor not taxable on Exempt Investor and Foreign Investor not taxable on disposition of stockdisposition of stock
ConsConsSubstantial economic effect issuesSubstantial economic effect issuesBuyer will not get a step up on sale of Blocker CorpBuyer will not get a step up on sale of Blocker CorpOther ECI or UBTI at Fund?Other ECI or UBTI at Fund?Effect on GP’s carryEffect on GP’s carry
55
Subsidiary Blocker (alternative)Subsidiary Blocker (alternative)
GP
Fund
LLC
ForeignInvestor
Blocker Corp
Exempt Investor
LLC
OtherInvestors
56
Parallel BlockerParallel Blocker
Mechanics:Mechanics:
Parallel investment vehicle (“Parallel Parallel investment vehicle (“Parallel Fund”) is established for Exempt and Fund”) is established for Exempt and Foreign InvestorsForeign InvestorsParallel Fund will incorporate wholly-Parallel Fund will incorporate wholly-owned subsidiary for each pass-through owned subsidiary for each pass-through investmentinvestment
57
Parallel Fund Parallel Fund
OtherInvestors
ParallelFund
LLC
GPForeignInvestor
Blocker Corp
Exempt Investor
Fund
CorporateInvestments
58
Blocker Corp DebtBlocker Corp Debt
Use capital contribution of Exempt Investor and Use capital contribution of Exempt Investor and Foreign Investor to loan capital to Blocker CorpForeign Investor to loan capital to Blocker Corp
Creates deductions at Blocker Corp that offset gain in Creates deductions at Blocker Corp that offset gain in sale of portfolio LLCsale of portfolio LLC
Reduces corp level tax at Blocker CorpReduces corp level tax at Blocker CorpInterest non-taxable to Exempt Investor and maybe Interest non-taxable to Exempt Investor and maybe Foreign InvestorForeign Investor
Earnings stripping (Section 163(j))Earnings stripping (Section 163(j))Portfolio interest limitationsPortfolio interest limitations
59
Blocker Corp DebtBlocker Corp Debt
GP
Fund
LLC
OtherInvestors
ForeignInvestor
Blocker Corp
Exempt Investor
Debt
60
Debt and Warrant StructureDebt and Warrant Structure
Structure portfolio investment as straight debt Structure portfolio investment as straight debt coupled with warrants coupled with warrants
Debt/equity issues Debt/equity issues
Basic tax objective is to avoid status as a "partner" Basic tax objective is to avoid status as a "partner" for tax purposesfor tax purposes
If the investor is not a partner of the portfolio If the investor is not a partner of the portfolio company, it will not be deemed to be engaged company, it will not be deemed to be engaged in the trade or business of the portfolio in the trade or business of the portfolio companycompany
61
Debt and Warrant StructureDebt and Warrant Structure
Fund
LLC
DebtOther
Investors
Warrant
ForeignInvestor
Exempt Investor
GP
62
Debt and Warrant StructureDebt and Warrant Structure
UBTI/ECI Risks UBTI/ECI Risks
Debt could be treated as equityDebt could be treated as equity
Warrant could be treated as profits interest in Warrant could be treated as profits interest in operating company, resulting in UBTI and ECIoperating company, resulting in UBTI and ECI
particularly if warrant holders have rights particularly if warrant holders have rights typically held by equity holders (such as typically held by equity holders (such as voting rights)voting rights)
Structuring Investments in or Structuring Investments in or Acquisitions of Portfolio Acquisitions of Portfolio
CompaniesCompanies
Structuring Investments in or Structuring Investments in or Acquisitions of Portfolio Acquisitions of Portfolio
CompaniesCompanies
64
Portfolio InvestmentsPortfolio Investments
Providing for dividend vs. capital gain in a Providing for dividend vs. capital gain in a “partial exit”“partial exit”
Acquisitions utilizing Section 338(h)(10) in Acquisitions utilizing Section 338(h)(10) in transactions involving management rolloverstransactions involving management rollovers
Minimizing taxes on ‘PIK’ preferred stockMinimizing taxes on ‘PIK’ preferred stock
Dividend vs. Capital Gain in a Dividend vs. Capital Gain in a “Partial Exit”“Partial Exit”
Dividend vs. Capital Gain in a Dividend vs. Capital Gain in a “Partial Exit”“Partial Exit”
66
Dividend vs. Capital GainDividend vs. Capital Gain
InvestorCharacter of Income Individual US Corporate Foreign Tax-Exempt
Dividend 15% if QDI/10.5% (after
DRD)Withholding at
30% or Exempt
No Basis Offset Reduced Treaty
Rate
STCG35% + Basis
Offset35% + Basis
Offset Exempt Exempt
LTCG15% + Basis
Offset35% + Basis
Offset Exempt Exempt
67
Leveraged Recap in < One Year(assumes e&p > total distribution)Leveraged Recap in < One Year(assumes e&p > total distribution)
Investor
Individual*
US Corporate*
Foreign
Tax-Exempt
Prefer Dividend or Capital Gain?
Dividend if (15% x (Distribution)) < (35% x (Distribution - Basis))
Dividend if (35% x (Distribution x (1 - 70%)) < (35% x (Distribution - Basis))
Capital Gain
Indifferent
* Assumes full use of "lost basis" to reduce future capital gain
68
Leveraged Recap in > One Year(assumes e&p > total distribution)Leveraged Recap in > One Year(assumes e&p > total distribution)
Investor
Individual*
US Corporate*
Foreign
Tax-Exempt
Prefer Dividend or Capital Gain?
Capital Gain
Dividend if (35% x (Distribution x (1 - 70%)) < (35% x (Distribution - Basis))
Capital Gain
Indifferent
* Assumes full use of "lost basis" to reduce future capital gain
69
Parial Exit: Leveraged RecapParial Exit: Leveraged Recap
TargetTarget
HoldcoHoldco
MidcoMidco
Holdco incurs debt to finance distribution of investors. Newco designed to minimize E&P. (It has no other debt so need for distributions to Newco is eliminated.)
Distributions are taxed: First, as dividends to the extent of earnings and profits; Second, as tax-free return of capital; and Third, as capital gain (once basis is offset).
Query whether result can be changed to “boot dividend” treatment if existing shares are exchanged for new shares. Boot dividend is taxed as a dividend, but only to the extent of any built-in gain.
LoanLoan
Fund Fund Fund
70
Partial ExitPartial Exit
TargetTarget
HoldcoHoldco
MidcoMidco
Alternatively, structure could have Holdco owning all Midco common but with each Fund owning Midco nonvoting preferred in proportion to their common interests in Holdco.
Midco uses loan proceeds to redeem preferred shares. Redemption should be entitled to capital gain treatment under section 302(a). See Trea. regs. § 1.302-2(a) and Rev. Rul. 77-426.
Another alternative in some cases: Convert Midco to an LLC, treatd as a deemed liquidation. Sale or exchange treatment under section 331 should be available as long as preferred stock is not “plain vanilla” preferred under section 1504(a).
33%33%CommonCommon
Fund Fund Fund
LoanLoan
33%33%CommonCommon
33%33%CommonCommon
33%33% PfdPfd
33%33% PfdPfd
33%33% PfdPfd
Section 338(h)(10) Section 338(h)(10) Transactions Involving Transactions Involving Management RolloversManagement Rollovers
Section 338(h)(10) Section 338(h)(10) Transactions Involving Transactions Involving Management RolloversManagement Rollovers
72
Section 338(h)(10) ElectionSection 338(h)(10) Election
Election to Treat a Stock Sale as an Asset Sale
Can Apply to a Subsidiary in a Consolidated/Affiliated Group or to an S Corporation
Purchaser must be a corporation
Qualified Stock Purchase (QSP)— Acquiring must purchase amount of stock described in section 1504(a)(2) in one or more transactions within a 12-month period. See section 338(d)(3)
73
Section 338(h)(10) ElectionSection 338(h)(10) Election
Section 1504(a)(2): Generally 80% voting power and 80% value (excluding certain plain vanilla preferred)
Purchase under section 338(h)(3) means:The stock basis is not determined, in whole or part, by reference to its basis in the hands of the sellerThe stock is not acquired in an exchange that is subject to section 351 or section 354The stock is not a acquired from a person whose stock would be attributed to the acquiring person under section 318(a) (ignoring option attribution)
74
Section 338(h)(10) Election: Example 1Section 338(h)(10) Election: Example 1
TargetTarget
TargetTargetStockStock(20%) (20%)
NewcoNewco
MgmtMgmt
NewcoNewcoStockStock
MergerMergerSubSub
$150$150
PPX forms Newco to acquire TargetX forms Newco to acquire Target
Target’s FMV is $200.Target’s FMV is $200.
P corp. owns 80% of Target; Mgt. P corp. owns 80% of Target; Mgt. owns 20% of Targetowns 20% of Target
Mgmt. will “rollover” their 20% Mgmt. will “rollover” their 20% interest by contributing their interest by contributing their Target stock to NewcoTarget stock to Newco
X contributes $150 to NewcoX contributes $150 to Newco
Newco forms Merger Sub and Newco forms Merger Sub and contributes the $150 received contributes the $150 received from Xfrom X
Merger Sub borrows $10Merger Sub borrows $10
Merger Sub merges into Target Merger Sub merges into Target with Target surviving; P receives with Target surviving; P receives $160 in the merger$160 in the merger
XX
$150$150
$10$10
LoanLoan
20%20% 80%80%
ReverseReverseMergerMerger
NewcoNewcoStockStock
75
Section 338(h)(10) Election: Example 1Section 338(h)(10) Election: Example 1
TargetTarget
TargetTargetStockStock(20%) (20%)
NewcoNewco
MgmtMgmt
NewcoNewcoStockStock
$150$150
PP
Are the QSP requirements satisfied?
Newco is treated as acquiring Target stock. Rev Rul. 73-427, Rev. Rul. 78-250 and Rev. Rul. 79-273.
Transfer of P shares is treated as part-sale and part-redemption.
Mgmt. shares acquired tax-free under section 351. Rev. Rul. 84-71.
However, Mgmt. shares represent 21% of total Target shares. P only acquires 79% of Target shares by “purchase.” (Where Section 338(h)(10) election is respected Target recognizes 100% of the gain on the deemed sale of its assets.)
What if the loan is to Newco?
XX
$150$150
$10$10
LoanLoan
$160$160
NewcoNewcoStockStock
76
Section 338(h)(10) Election: Example 2Section 338(h)(10) Election: Example 2
TargetTarget
TargetTargetStockStock(100%) (100%)
NewcoNewco
5% 5% NewcoNewcoStockStock& $190& $190
PP
X forms Newco to acquire Target
Target’s FMV is $200.
P receives $190 plus 5% of the Newco stock
Are the QSP requirements satisfied?
P’s shares of Target were acquired in a section 351 transaction with boot
Any difference if all of P’s gain is recognized? See section 338(h)(3)(A)(ii).
XX
$190$190NewcoNewcoStockStock
77
Section 338(h)(10) Election: Example 3Section 338(h)(10) Election: Example 3
TargetTarget
(S Corp.)(S Corp.)
TargetTargetStockStock(30%) (30%)
NewcoNewco
AA
NewcoNewcoStockStock& $40& $40
MergerMerger
SubSub
$140$140
X forms Newco to acquire Target
Target is an S corporation with a FMV of $200.
P owns 70% of Target; A owns 30% of Target
X contributes $180 to Newco
A will “rollover” a third of her shares. A receives 10% of the stock of Newco and $40
Newco forms Merger Sub and contributes $140
Merger Sub merges into Target with Target surviving; P receives $140 in the merger
XX
$180$180
30%30% 70%70%
MergerMerger
PP
NewcoNewcoStockStock
78
Section 338(h)(10) Election: Example 3Section 338(h)(10) Election: Example 3
TargetTarget
(S Corp.)(S Corp.)
TargetTargetStockStock(30%) (30%)
NewcoNewco
AA
NewcoNewcoStockStock& $40& $40
$140$140
XX
$180$180
$140$140
PPAre the QSP requirements satisfied?
A’s shares (equal to 30% of Target) were acquired in a section 351 transaction
NewcoNewcoStockStock
79
Section 338(h)(10) Election: Example 4Section 338(h)(10) Election: Example 4
TargetTarget
TargetTargetStockStock(20%) (20%)
NewcoNewco
NewcoNewcoStockStock
XX$160$160
AA
P and A (Target P and A (Target shareholders) contribute shareholders) contribute Target stock to Newco in Target stock to Newco in exchange for Newco shares exchange for Newco shares in a section 351 transactionin a section 351 transaction
At the same time, P sells its At the same time, P sells its Newco shares to X pursuant Newco shares to X pursuant to a binding written to a binding written agreementagreement
Transaction fails section 351 Transaction fails section 351 “control immediately after” “control immediately after” test. See Rev. Rul. 70-140.test. See Rev. Rul. 70-140.
Can Newco and P make the Can Newco and P make the section 338(h)(10) election?section 338(h)(10) election?
What if A receives a note What if A receives a note convertible into Newco convertible into Newco shares?shares?
TargetTargetStockStock(80%) (80%)
PP
(1)(1) (2)(2)
NewcoNewcoStockStock
NewcoNewcoStockStock
80
Section 338(h)(10) Election: Example 5Section 338(h)(10) Election: Example 5
TargetTarget
TargetTargetStockStock(20%) (20%)
NewcoNewco
AA
NewcoNewcoStockStock
$160$160
PP
Facts are the same as in Example 1 Facts are the same as in Example 1 except:except:
Pursuant to a binding written Pursuant to a binding written agreement, X sells Newco agreement, X sells Newco shares to friendly bank.shares to friendly bank.
What if the Newco shares sold What if the Newco shares sold by X are a special class of by X are a special class of nonvoting preferred stock? nonvoting preferred stock? What if there is only one share of What if there is only one share of the special class of preferred?the special class of preferred?
See PLR 8817079 (2/4/88), See PLR 8817079 (2/4/88), supplemented by PLR 8822062 supplemented by PLR 8822062 (3/7/88) (single share of non-(3/7/88) (single share of non-voting preferred stock sold to voting preferred stock sold to affiliate is sufficient to disqualify affiliate is sufficient to disqualify transaction under section 368(a)transaction under section 368(a)(2)(E)).(2)(E)).
XX
$160$160
$160$160
NewcoNewcoStockStock(common(common&&preferred)preferred)
FBFB $$$$
Newco Newco preferred preferred stockstock
(1)(1)(2)(2)
81
Section 338(h)(10) Election:Example 6Section 338(h)(10) Election:Example 6
TargetTarget
TargetTargetPref. Stk. Pref. Stk. & Com. & Com. Stk. Stk. (20%) (20%)
NewcoNewco
AA
NewcoNewcoStockStock
$150$150
PP
Facts are the same as in Example 1 Facts are the same as in Example 1 except:except:
A’s interest in Target is A’s interest in Target is recapitalized immediately recapitalized immediately before the incorporation of before the incorporation of Newco. A receives “plain Newco. A receives “plain vanilla” preferred stock.vanilla” preferred stock.
Can A get section 351 Can A get section 351 treatment this way without treatment this way without impacting the section 338(h)impacting the section 338(h)(10) election? See Rev. Rul. (10) election? See Rev. Rul. 57-114 (transitory ownership 57-114 (transitory ownership not respected).not respected).
Does it help if A gets plain Does it help if A gets plain vanilla preferred stock of vanilla preferred stock of Newco?Newco?
XX
$150$150
$10$10
LoanLoan
$160$160
NewcoNewcoStockStock
Alternatives to Section 338(h)Alternatives to Section 338(h)(10)(10)
Alternatives to Section 338(h)Alternatives to Section 338(h)(10)(10)
83
Asset Sale through Forward Merger Asset Sale through Forward Merger
TargetTarget
NewcoNewco
AANewcoNewcoStockStock
MergerMergerSubSub
$150$150
PP
Same as Example 1 except:
Target merges into Merger Sub in a forward subsidiary merger.
P receives cash and A receives Newco stock.
A does not achieve rollover treatment
XX
$150$150
$10$10
LoanLoan
20%20% 80%80%
MergerMerger
NewcoNewcoStockStock
$160$160
84
Asset Sale through LLC ConversionAsset Sale through LLC Conversion
TargetTargetLLCLLC
NewcoNewco
MgmtMgmtNewcoNewcoStockStock
PP
Same as Example 1 except:
Target is converted into an LLC immediately before the transaction. Mgmt. is taxed in connection with the deemed liquidation of Target.
No merger. Instead Mgmt. receives Newco stock and P receives cash in exchange for Target LLC interests.
Target is a disregarded entity in Newco hands; Newco is treated as owning assets for tax purposes.
XX
$150$150
20%20% 80%80%
NewcoNewcoStockStock
$160$160Target Target LLC LLC interestsinterests
Target Target LLC LLC interestsinterests
$10$10
LoanLoan
85
Asset Sale through LLC ConversionAsset Sale through LLC Conversion
TargetTargetLLCLLC
MgmtMgmtNewcoNewcoLLC LLC interestsinterests
PP
LLC conversion allows asset sale treatment without the requirement that assets continue to be held by a corporate buyer:
Target is converted into an LLC immediately before the transaction.
Mgmt. and P are taxed on the deemed liquidation of Target, but liquidation is tax-free to P under section 332.
Mgmt. receives Newco LLC interests and P receives cash in exchange for Target LLC interests.
Section 754 election for Target LLC provides stepped-up basis in assets
XX
$150$150
20%20% 80%80%
NewcoNewcoLLC LLC interestsinterests
$160$160Target Target LLC LLC interestsinterests
Target Target LLC LLC interestsinterests$10$10
LoanLoanNewcoNewco
LLCLLC
86
Asset Sale through LLC Conversion (S Corp. Target)Asset Sale through LLC Conversion (S Corp. Target)
TargetTargetLLCLLC
MgmtMgmt
NewcoNewcoLLC LLC interestsinterests& $160& $160
XX
$150$150 20%*20%*80%80%NewNewTargetTargetSharesShares
NewcoNewcoLLC LLC interestsinterests
$160$160
Target Target LLC LLC interestsinterests
$10$10
LoanLoanNewcoNewco
LLCLLC
PP
NewNew TargetTarget
(S Corp.)(S Corp.)
Same facts as prior example except that Target is an S corp.
Target is converted to an LLC as part of an “F reorganization. New Target (holding company) is formed. Old Target is contributed to New Target. Old Target is converted into an LLC.
New Target is treated as the alter ego of Old Target for tax purposes. Target LLC is disregarded.
New Target sells Target LLC (deemed asset sale) for cash and Newco LLC interests. Cash is distributed to P in exchange for P’s shares.
S corporation mechanics mean that only 20% of Mgmt’s gain will be deferred.
Minimizing Dividend Taxes Minimizing Dividend Taxes on ‘PIK’ Preferred Stockon ‘PIK’ Preferred Stock
Minimizing Dividend Taxes Minimizing Dividend Taxes on ‘PIK’ Preferred Stockon ‘PIK’ Preferred Stock
88
Significance to ParticipantsSignificance to Participants
Foreign InvestorsAvoid U.S. withholding taxesAvoid accelerated liability for taxPotential tax exemption
U.S. InvestorsAvoid accelerated liability for taxCapital gain conversion
89
“Pre-Money” Valuation Disputes“Pre-Money” Valuation Disputes
Conversion Price = LP / # of Common SharesConversion Price = LP / # of Common Shares
Conversion Price usually ‘at-the-money’Conversion Price usually ‘at-the-money’
PIK Preferred to bridgePIK Preferred to bridge
90
A Common Valuation DisputeA Common Valuation Dispute
The founders of XYZ Corp need to raise $20 The founders of XYZ Corp need to raise $20 million. They value the business at $30 million. million. They value the business at $30 million. VentureCo proposes to invest $20 million in VentureCo proposes to invest $20 million in exchange for newly-issued convertible preferred exchange for newly-issued convertible preferred stock, but values the business at only $20 million. stock, but values the business at only $20 million. So the founders propose that the preferred be So the founders propose that the preferred be convertible into 40% of the common stock (i.e., convertible into 40% of the common stock (i.e., $20/($20 + $30)), VentureCo proposes that the $20/($20 + $30)), VentureCo proposes that the preferred be convertible into 50% of the common preferred be convertible into 50% of the common stock (i.e., $20/($20 + $20)).stock (i.e., $20/($20 + $20)).
91
The ‘PIK’ SolutionThe ‘PIK’ Solution
XYZ Co issues PIK preferred stock, initially convertible into XYZ Co issues PIK preferred stock, initially convertible into 40% of the underlying common. The PIK dividend rate is 40% of the underlying common. The PIK dividend rate is 8.5%.8.5%.
After 5 years, the preferred stock is now convertible into After 5 years, the preferred stock is now convertible into 50% of the common stock (i.e., ($20M x 1.085)^5 = $30M).50% of the common stock (i.e., ($20M x 1.085)^5 = $30M).
By “PIKing” the dividends, VentureCo receives its desired By “PIKing” the dividends, VentureCo receives its desired conversion price after 5 years, even though it invested at a conversion price after 5 years, even though it invested at a pre-money valuation of $30 million.pre-money valuation of $30 million.
92
§ 305 Issues with PIK Preferred§ 305 Issues with PIK Preferred
PIK dividend is taxed to the extent of E&P:
§ 305 (b)(4): distributions ‘on’ preferred stock.
§ 305 (b)(5): distributions ‘of’ convertible preferred stock
§ 305 (b)(2): cash to some, increase in proportionate interest to others
93
Tax Considerations in Capitalizing Holdcos: Debt vs. Preferred StockTax Considerations in Capitalizing Holdcos: Debt vs. Preferred Stock
Debt provides an immediate deduction for portfolio companies operating as C corporations (and reduce income subject to double taxation)
Funds will be immediately taxable on interest income.
Excess deductions in C corporations are deferred and used only as net operating loss carryovers. In contrast, Funds may use interest deductions generated at the pass-through level.
Certain tax rules that eliminate, reduce or defer interest deductions must be considered:
Basic debt vs. equity rulesSection 163(e) (AHYDO Rules). Applies to debt instruments held more than 5 years, if interest rate is greater than AFR + 5% and there is significant OID.Section 279: Acquisition indebtedness that is convertible (or issued with options and warrants) and subordinated.Section 163(j): Interest paid to related party that is not subject to tax on the income (or where debt is guaranteed by tax-exempt party) if debt-equity ration is greater than 1.5 to 1.
94
Tax Considerations in Capitalizing Holdcos: Debt vs. Preferred StockTax Considerations in Capitalizing Holdcos: Debt vs. Preferred Stock
Dividends on preferred stock generally are not taxed until actual or constructive receipt. See Treas. reg. § 1.301-1(b).
Preferred “original issue discount” may be created if preferred stock is issued at a discount (i.e., redemption price exceeds issue price).
Arises where preferred stock is issued as part of an investment unit (with common stock or warrants) unless the value of the preferred stock is equal to its face amount.
Only applies if stock is preferred for tax purposes (i.e., stock that does not participate in corporate growth to a significant extent).
Dividend arrearages are generally taxed at capital gain rates upon a sale or redemption of preferred (unless dividends have been previously declared).
Dividend arrearages may be taxes as dividends (to the extent of E&P) if preferred stock is converted to common stock in a recapitalization. See Treas. Reg. § 1.305-7(c).
Tax ConsiderationsTax Considerations in Making Private Equity in Making Private Equity
InvestmentsInvestments in Canada in Canada
Tax ConsiderationsTax Considerations in Making Private Equity in Making Private Equity
InvestmentsInvestments in Canada in Canada
96
Tax Considerations in Making Private Equity Investments in CanadaTax Considerations in Making Private Equity Investments in Canada
General Canadian tax rules applicable to General Canadian tax rules applicable to non-resident investorsnon-resident investors
Treaty considerationsTreaty considerations
Using alternative investment vehiclesUsing alternative investment vehicles
Maximizing tax shelter in the targetMaximizing tax shelter in the target
97
General Canadian Tax Rules Applicable to Non-Resident InvestorsGeneral Canadian Tax Rules Applicable to Non-Resident Investors
Interest and dividends subject to 25% withholding tax
Gains on “taxable Canadian Property” subject to capital gains tax
Rollovers available for conversion of securities
Clearance certificate requirements
98
“Taxable Canadian Property”“Taxable Canadian Property”Shares of Canadian resident corporations not listed on a Shares of Canadian resident corporations not listed on a
prescribed stock exchangeprescribed stock exchange
Shares of non-resident corporations not listed on a Shares of non-resident corporations not listed on a prescribed stock exchange if more than 50% of property prescribed stock exchange if more than 50% of property is taxable Canadian property or Canadian resource is taxable Canadian property or Canadian resource property property andand more than 50% of property is Canadian real more than 50% of property is Canadian real property or resource propertyproperty or resource property
Listed shares of corporations described above if seller Listed shares of corporations described above if seller held 25% or more of shares of held 25% or more of shares of anyany class in 60 months class in 60 months preceding salepreceding sale
Also includes certain partnership and trust interestsAlso includes certain partnership and trust interests
Includes rights to acquire above property, therefore Includes rights to acquire above property, therefore includes debt convertible into any of the foregoingincludes debt convertible into any of the foregoing
99
Convertible SecuritiesConvertible Securities
Rollovers available for debt for share and share Rollovers available for debt for share and share for share exchangesfor share exchanges
Property acquired deemed to be taxable Canadian Property acquired deemed to be taxable Canadian property if converted property was taxable property if converted property was taxable Canadian propertyCanadian property
100
Clearance CertificatesClearance Certificates
Section 116 clearance certificate required when Section 116 clearance certificate required when non-resident sells taxable Canadian property that non-resident sells taxable Canadian property that is not “excluded property”is not “excluded property”
Excluded property includes shares listed on a Excluded property includes shares listed on a prescribed stock exchange, debt obligations and prescribed stock exchange, debt obligations and “deemed” taxable Canadian property“deemed” taxable Canadian property
Information required for all vendors including Information required for all vendors including partners of partnershipspartners of partnerships
Could be administratively burdensome procedureCould be administratively burdensome procedure
101
Treaty ConsiderationsTreaty Considerations
Treaties lower withholding rate on interest and dividendsTreaties lower withholding rate on interest and dividends
Generally exempt gains from Canadian tax unless value Generally exempt gains from Canadian tax unless value of property sold derived primarily from Canadian real of property sold derived primarily from Canadian real property or resource propertyproperty or resource property
Some treaties provide better protection on gains by Some treaties provide better protection on gains by excluding real property used in business from definition excluding real property used in business from definition of real propertyof real property
Additional exemptions available for tax-exemptsAdditional exemptions available for tax-exempts
LLC issues – resolved?LLC issues – resolved?
102
Alternative Investment VehiclesAlternative Investment Vehicles
Canadian investments may be made through Canadian investments may be made through intermediary entities in offshore jurisdictions such intermediary entities in offshore jurisdictions such as Barbados, Luxembourgas Barbados, Luxembourg
Advantages:Advantages:
added treaty protectionadded treaty protection
simplified clearance certificate proceduressimplified clearance certificate procedures
Disadvantages:Disadvantages:
maintenance costs, inconveniencemaintenance costs, inconvenience
assessment riskassessment risk
103
Maximizing Tax Shelter in the TargetMaximizing Tax Shelter in the Target
Maximize shelter for US tax purposes by structuring Maximize shelter for US tax purposes by structuring acquisition as asset acquisition for US tax purposesacquisition as asset acquisition for US tax purposes
Achieved by converting target to unlimited liability Achieved by converting target to unlimited liability company before or after acquisition or by making company before or after acquisition or by making s.338 elections.338 election
Generally no step-up in asset basis for Canadian Generally no step-up in asset basis for Canadian tax purposes on share acquisitiontax purposes on share acquisition
Shelter created for Canadian tax purposes through Shelter created for Canadian tax purposes through leverageleverage
104
Leveraged EquityLeveraged Equity
Equity to be used for acquisition can be structured Equity to be used for acquisition can be structured as two-thirds debt for Canadian tax purposesas two-thirds debt for Canadian tax purposes
2:1 debt to equity ratio required to comply with 2:1 debt to equity ratio required to comply with Canadian thin capitalization rulesCanadian thin capitalization rules
Possible to structure so no immediate income Possible to structure so no immediate income inclusion for interest on debt by using “blocker” inclusion for interest on debt by using “blocker” entityentity
35% tax savings achieved in exchange for 10% 35% tax savings achieved in exchange for 10% withholding taxwithholding tax
105
Leveraged Equity – Typical StructureLeveraged Equity – Typical Structure
Fund
Luxco
Acquisition Co
Finance LP
Target
Loan $200
$100 Equity
$200
QUESTIONS & ANSWERSQUESTIONS & ANSWERSQUESTIONS & ANSWERSQUESTIONS & ANSWERS
Recommended