advanced tax strategies in structuring private investment...

Advanced Tax Strategies in Structuring Private Investment Funds Balancing the Competing Interests of Fund Investors When Structuring Investment Funds

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1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, MAY 1, 2014

Presenting a live 110-minute teleconference with interactive Q&A

Christian M. McBurney, Partner, Nixon Peabody, Washington, D.C.

Jeremy Naylor, Partner, Cooley, New York

Elizabeth Norman, Attorney, Goulston & Storrs, Boston

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5

Advanced Tax Strategies in Structuring Private Investment Funds Christian McBurney, Nixon Peabody LLP, Washington, D.C. office Jeremy Naylor, Cooley LLP, New York office Elizabeth Norman, Goulston & Storrs, Boston office

May 1, 2014

6

Fund Characteristics

• Types of Funds

— Private Equity

— Venture Capital

— Hedge

— Distressed Debt

— Real Estate

— LBO

— Fund of funds

7

Fund Characteristics (cont’d)

• Other important fund characteristics

— U.S.-based or based outside U.S.?

— Focus investing in U.S. or outside U.S., or both?

— Is fund an investor or conducting a trade or business?

› Investor: possible disallowance of fund manager fees for U.S. investors under Section 212

› Trade or business: fees deductible under Section 162; but UBTI, ECI and CAI concerns

8

Type of Fund Investors

• U.S. Taxable Individual or Corporation

• U.S. State and Local Government

— Pension Funds

• U.S. Tax-Exempt Investors

— Corporate Pension Plans

— University and College Endowment Funds

— Private Foundations

— Charity Endowment Funds

— Individual Retirement Accounts (IRAs)

9

Type of Fund Investors (cont’d)

• Non-U.S. Investors

— Individuals

— Non-U.S. entities treated as corporations for U.S. income tax purposes

— Pension Funds (not taxed in home country)

• Non-U.S. Government Investors (Section 892)

— Sovereign Wealth Funds

— Pension Funds

10

U.S. Taxable C Corp.

35% c.g. and o.i.

Fund L.P.

Portfolio Corp.

Portfolio LLC

- Gain on interest sale - Gain on asset sale - Interest - Gain on debt sale

U.S. Taxable Individual

- 20% c.g. - 39.6% o.i. - 3.8% nii

- Gain on stock sale - Dividends - Interest - Gain on debt sale

No Fund Blocker desired Unblocked investor can also claim tax credits and treaty benefits

U. S. Taxable Individuals and Corporations

11

U. S. State and Local Government

0% U.S. tax rate

Fund L.P.

Portfolio Corp.

Portfolio LLC

Gain/income

No Fund Blocker desired Unblocked can also claim treaty benefits

Gain/income

U. S. State and Local Government

12

U.S. Tax-Exempt

0% U.S. tax rate

Fund L.P.

Portfolio Corp.

Portfolio LLC

- Gain on interest sale (c.g.) - Interest - Gain on debt sale (c.g.)


No Fund Blocker desired Unblocked investor can also claim treaty benefits

- Gain on sale of noninventory property

U. S. Tax-Exempt Investors

13

U.S. Tax-Exempt

35% U.S. tax rate

Fund L.P.

Portfolio LLC

Fees earned by L.P.

Fund Blocker often desired Unrelated business taxable income (UBTI)

- Operating income - Gain on sale of inventory

U. S. Tax-Exempt Investors (cont’d)

14

U.S. Tax-Exempt

35% U.S. tax rate

Fund L.P.

Portfolio Corp.

Portfolio LLC

Debt-Financed: - Gain on interest sale - Interest - Gain on debt sale

Debt-Financed: - Gain on stock sale - Dividends - Interest - Gain on debt sale

Debt-financed income is UBTI Fund Blocker often desired

Debt-Financed: - Gain on sale of any property - Operating Income

U. S. Tax-Exempt Investors (cont’d)

15

U.S. Tax-Exempt

Non-U.S. or U.S. Feeder Fund

Non-U.S. Investments (No UBTI)

U.S. Investments (No UBTI)

U.S. Corp. Blocker

Investments (UBTI)

U. S. Tax-Exempt Investors (cont’d) Parallel Fund Structure

16

Non-U.S. Investors

• U.S. tax goals

— Avoid having to file a U.S. income tax return

— Limit U.S. tax on “Effectively Connected Income” (ECI).

— If ECI:

› Must file U.S. federal, state, and local returns

› Must pay income tax at regular, federal, state and local rates

• Non-U.S. corp must also pay U.S. 30% “branch profits” tax

— Limit U.S. tax on FDAP income

› 30% U.S. withholding tax rate unless U.S. tax treaty applies

› Claim U.S. treaty benefits where possible

17

Non-U.S. Investors (cont’d)

• Effectively Connected Income (ECI) is income recognized by a non-U.S. person that is effectively connected with a business carried on in the U.S.

— Does fund have a loan origination business?

— “Securities trading safe harbor” protects offshore funds

• ECI includes share of operating income from a pass-through entity conducting business in the U.S.

— Non-U.S. partners are deemed engaged in a U.S. business

— Sale of partnership interest in partnership that generates ECI: IRS takes the position that gain is ECI

• FIRPTA income treated like ECI

18

Non-U.S. Investor

0% U.S. tax rate

Fund L.P.

Portfolio Corp.

Portfolio LLC

U.S. Source: - Portfolio interest - Gain on debt sale

No Fund Blocker desired

Portfolio Corp.

Non-U.S. Source: - Gain/income

U.S. Source: - Gain on stock sale

Non-U. S. Investors (cont’d)

19

Non-U.S. Investor

30% U.S. tax rate (unless treaty applies)

Fund L.P.

Treaty benefits can be claimed Non-U.S. pension fund from a treaty country – 0% U.S. tax rate


Portfolio Corp.

U.S. Source: - Dividends - Non-portfolio interest


20

Non-U.S. Investor

35%/39.6% U.S. tax rate

Fund L.P.

Fund Blocker usually desired

Gain on interest sale (ECI)

Portfolio LLC

U.S. Source: - Gain on sale of operating assests (ECI)

- Operating income (ECI)


21

Non-U.S. Investor


Non-U.S. Investments

(No ECI)

U.S. Investments

(No ECI)

U.S. Corp. Blocker

U. S. Investments

(ECI)

Non-U. S. Investors (cont’d) Parallel Fund Structure

22

U.S. Tax-Exempt Investor (cont’d) Parallel Fund Structure

• Why use non-U.S. Feeder?

— Not have to report non-U.S. investments

— Can avoid "controlled foreign corporation" (CFC) treatment where substantial investors are non-U.S. investors and fund owns 50% or more of the non-U.S. portfolio company

— Minimize risk that Fund interest will be treated as part of non-U.S. individual investor’s estate for U.S. estate tax purposes

23

U.S. Tax-Exempt Investor (cont’d) Parallel Fund Structure

• Why use U.S. Feeder?

— Easier to claim U.S. treaty benefits—only need to issue W-8BEN to U.S. Feeder

— Will treaty benefits "flow-through" a non-U.S. Feeder to a non-U.S. investor? Generally, non-U.S. entity must be fiscally transparent for non-U.S. as well as U.S. purposes

› See also Section 894(c).

Slide Intentionally Left Blank

25

UBTI and ECI—Not Exactly the Same

• Some investments may generate UBTI, but not ECI

— Debt-financed income (including stock sales, dividends, and interest)

• Some investments may generate ECI, but not UBTI

— Sale of partnership interests where partnership conducts a U.S. trade or business

— Investments in U.S. real property holding corporations (holding 50% or more of gross assets in U.S. real property)

— Loan commitment fees not UBTI, but may be ECI

• Accordingly, a blocker that avoids all ECI may be too broad for a U.S. tax-exempt investor; and a blocker that avoids all UBTI may be too broad for a non-U.S. Investor

26

Non-U.S. Governmental Investors

• Non-U.S. Governments (including their controlled entities) are generally exempt from U.S. tax under IRC Section 892 on income from investments from securities, except income from the conduct of a "commercial activity" (CAI)

• If a controlled entity has CAI (either US or non-US), it could lose its Section 892 exemption (but recent relief in proposed regulations—“inadvertent” and “de minimis” standards; interest in non-controlled LP)

• Investments in operating partnerships generate CAI

• Non-US Government owning U.S. real property or 50% or more of the stock of a United States Real Property Holding Corporation (USRPHC) can generate CAI

27

Non-U.S. Government

0% U.S. tax rate

Fund L.P.

Portfolio Corp.

Portfolio LLC

U.S. Source: - Interest - Gain on debt sale


Portfolio Corp.

Non-U.S. Source: - Gain/income

U.S. Source: - Gain on stock sale - Interest - Dividends

Non-U. S. Governmental Investors (cont’d)

28

Non-U.S. Government

35% U.S. tax rate

Fund L.P.

Fund Blocker desired

Gain on interest sale (CAI)

Portfolio LLC

U.S. Source: - Operating income (CAI) - Gain on sale of operating assets (CAI)


29

Non-U.S. Government



(No CAI)

U.S. Investments

(No CAI)

U.S. Corp. Blocker

U. S. Investments

(CAI)


30

ECI, FDAP and CAI—Not Exactly the Same

• Some investments may generate ECI but not CAI

— Investments in U.S. real property holding corporations (USRPHC) (holding 50% or more of gross assets in U.S. real property)

› Only CAI if Non-U.S. Government holds 50% of more of USRPHC

• Some investments may generate CAI but not ECI

— Sale at gain of non-U.S. corporate entity controlled by Non-U.S. Government, which would be a USRPHC if formed in the U.S., is taxable CAI, but would not be ECI

• Some investments may generate FDAP withholding for non-U.S. Investors, but not for Non-U.S. Governmental Investors

31

Parallel Fund Structure

• Most tax efficient fund structure generally is to use separate parallel funds for each type of investor

— Administrative costs

• Should each investment have a newly-formed separate blocker?

— This can avoid U.S. dividend withholding tax on exit

— But if a single blocker is used for multiple investments, income and gain from one investment can be offset by losses from another

• Risk of aggregation of different fund entities used in parallel/AIV structure due to applying carried interest across all funds

32

Main Fund

Other Investors

Parallel Fund

Portfolio LLC

Intermediate Partnership

GP

Electing U.S. Tax-Exempt, Non-U.S. and Non-U.S.

Governmental Investors

Blocker Corp.

Portfolio Corp.

Carry Carry

Simplified Parallel Fund

33

AIF “A”

Other Investors

AIF “B”

Portfolio LLC

Intermediate Partnership

GP

Main Fund

All Investors

Blocker Corp.

Portfolio Corp.

Carry

Carry

Electing U.S. Tax-Exempt, Non-U.S. and Non-U.S.

Governmental Investors

Alternative Investment Fund

34

Other Investors

Portfolio LLC

GP

Electing U.S. Tax-Exempt, Non-U.S. and Non-U.S. Governmental Investors

Main Fund L.P.

Feeder Fund (Offshore)

Portfolio Corp.

Feeder Fund – No Flexibility

35

Non-U.S./U.S. Tax-Exempt Investors

Fund

U.S. Corp. Blocker

Taxable Investors

Portfolio LLC

Taxable investor capital

Sensitive investor capital

Subsidiary Blocker Structures

36

Subsidiary Blocker Structures

• Some funds use subsidiary “blocker” corporations for ECI and UBTI investments

— Capital of tax sensitive investors channeled through blockers

› Special allocations at the Fund level – substantiality concerns?

› Risk to Non-U.S. Investors of U.S. tax return filing obligation

— GP Carry pre- or post-tax? Take out GP carry below the blocker

• Exit from investment

— Sale of assets and liquidation of blocker

— Sale of blocker shares?

› Allocation of discount?

37

Other Types of US Funds

• Hedge Funds

• Distressed Debt

• Real Estate (including oil and gas)

38

Other Types of US Funds – Hedge Funds

• Onshore/offshore structure

— Typically Cayman “master fund” – taxed as a partnership

— Onshore feeder – Delaware LP or LLC

› Taxable investors invest here

› Simplifies reporting for U.S. taxable investors

— Offshore feeder – Cayman company (or LP that box checks to be treated as a corp)

› Tax-Exempts and Non-U.S. investors invest here

› Offshore feeder may make sense for taxable investors given Section 212 limitations on deductibility of management and other fees and NII Medicare tax

39

Other Types of US Funds – Hedge Funds (cont’d)

• Issues for taxable investors

— Is the fund a “trader” for tax purposes?

› deductibility of management fees and expenses

— GP’s performance compensation structured as a partnership allocation of profits

› If paid as fee and fund is not trader – Section 212 deductibility limitations

— Management fees and other expenses should be paid at the master fund level

› Risk that under logic of Rev. Rul. 2008-39, if paid at the feeder level may not be deductible.

— Investment in offshore feeder may offer tax advantages

› Deferral of 3.8% Medicare tax on NII until distribution

› Effective deduction of management fees in non-trader fund

40


• Issues for Non-U.S./U.S. Tax-Exempt investors

— Trading in stocks and securities safe harbor for feeder

— Offshore feeder is effective “blocker” for UBTI and ECI

› But corporate income tax and branch profits tax on any ECI

— Non-U.S. government investors cannot access 892 benefits through offshore feeder

— Allocation of FATCA risk

41


• Issues for Investment Manager

— Treatment of incentive compensation

› Allocation allows for potential for capital gains

› Generally not a large portion of hedge fund’s revenues

› Not available for funds that mark-to-market

— Incentive fees

› Section 457A/409A issues if paid by offshore feeder

› Potentially avoid self-employment tax and new 3.8% Medicare tax on NII

42

Other Types of US Funds – Distressed Debt

• Typically structured similar to hedge funds with same general issues

• Distressed debt-specific issues

— Portfolio Interest

— Market Discount; OID

— Recovery of basis treatment for deeply discounted debt?

— Loan origination activities

› Workouts/loan modifications resulting in reissuances/deemed new originations

› “Season and Sell” – other strategies to avoid being considered in loan origination/active financing business

› Impact of 2009 GLAM (Chief Counsel Mem. AM2009010)

43

Foreign Investment in Real Property Tax Act (FIRPTA)

• In general, non-US persons generally do not pay U.S. tax on disposals of stock or securities of U.S. issuers

• FIRPTA is an exception to this general treatment

• FIRPTA imposes a tax on gains realized from the disposition of a U.S. real property interest, which includes direct real estate holdings and:

— Partnership/flow-throughs that hold U.S. real estate

— Interests in a “U.S. real property holding corporation” (USRPHCs)

— Direct or indirect rights to share in proceeds, appreciation or profit of U.S. real estate

44

FIRPTA (cont’d)

• USRPHCs

— FIRPTA also applies to companies where at least half of the fair market value of the company’s trade or business assets is attributable to U.S. real property assets

› Five-year lookback

— Carve-out for investments in publicly traded stocks where the investor does not hold more than 5% of the class of stock being traded

— FIRPTA Traps

› Distressed companies

› Publicly traded stock de-listed

45

FIRPTA (cont’d)

• Tax imposed at U.S. tax rates

• Collected partially through withholding

• Gains treated as ECI

• Non-U.S. person with FIRPTA gain also incurs a U.S. federal income tax filing obligation

• Branch profits tax may also apply

46

FIRPTA (cont’d)

• U.S. blockers frequently used to hold U.S. real estate assets, which blocks application of FIRPTA tax and filing obligations

• Note, however, that the U.S. blocker itself may be a “USRPHC” which would trigger FIRPTA gain if sold (unlikely exit)

• Trap for unwary: Section 1445(e) withholding on non-dividend distributions from a USRPHC

47

FIRPTA (cont’d)

Non-U.S. Fund

Non-U.S. Investments (No FIRPTA)

U.S. Non-Real Estate

Investments

(No FIRPTA)

U.S. Corp. Blocker

U. S. Real Estate

Investments

48

FIRPTA (cont’d)

Non-U.S. Fund

Non-U.S. Investments (No FIRPTA)

U.S. Non-Real Estate

Investments

(No FIRPTA)

U.S. Corp. Blocker

U. S. Real Estate

Investments

Offshore Blocker

Loan

Financing the U.S. Blocker: Potential Complications (Withholding Tax, Earnings Stripping, AHYDO, Section 267)

Interest

49

U. S. Tax-Exempt Investors: 514(c)(9)

• Certain tax-exempt investors (“Qualified Organizations”, or QOs) are eligible for an exception to debt-financed UBTI in certain circumstances

— Most common QOs are pension funds and educational organizations

• Provided certain requirements are met, Section 514(c)(9) provides that debt incurred to acquire or improve “real property” won’t give rise to UBTI for QOs

— Definition of “real property” unclear

• Compliance with 514(c)(9) poses challenges, particularly for funds

50

U. S. Tax-Exempt Investors (cont’d) : 514(c)(9)

• Requirements for a 514(c)(9)-Compliant Fund

— Fund must comply with general requirements

— AND

› All of the partners must be QOs, or

› Each allocation to a QO Partner must be a “Qualified Allocation”, or

› The partnership’s allocation provisions for tax purposes: • Satisfy the “Fractions Rule”, and

• Have “Substantial Economic Effect”

• Potential Legal and Economic Consequences of complying with the Fractions Rule and the Substantial Economic Effect Rules

52

Non-U.S. Funds with U.S. Investments

• Same general structural considerations as above

— Non-U.S. Investors will be focused on ECI

— If fund holds real estate assets, FIRPTA may also apply

— Special structuring requirements for non-U.S. investors

— Treaty planning and additional documentation requirements

— Non-U.S. corporation in structure (including offshore blocker entity)? Potential branch profits tax

• U.S. source income = FATCA implications for fund and its investors

53

Non-U.S. Funds with U.S. Investors: Investing Overseas

• Some considerations:

— PFIC/CFC issues (want non-U.S. fund to be pass-through)

— Tax filing obligations in non-U.S. jurisdictions

— Non-U.S. withholding tax

— Treaty analysis

— U.S. tax-exempt investors will still be concerned about UBTI, and may wish to invest through a blocker if there will be debt-financing or investments in operating pass-throughs

— Certain countries (India, China) have begun imposing tax on indirect gains, which has led to an increase in the use of “filing blockers”

54

US Funds Investing Overseas

• Same general structural considerations as have been illustrated, with some additions

— UBTI on debt-financed investments/pass-through income

— Treaty benefits

— PFIC/CFC

— Foreign tax credit flow-through

— Commercial activities income still a concern for controlled commercial entities (but 892 benefits generally irrelevant)

• Some of these are incompatible

— E.g., flow-through structures for taxable investors, but UBTI issues for tax-exempts

55

U.S. Taxable/U.S. Government Investors

Fund (taxed as

partnership)



US Funds Investing Overseas – Parallel Funds

Fund (taxed as corporation)

56

U.S. Taxable/U.S. Government Investors

Master Fund (taxed as

partnership)



US Funds Investing Overseas – Master/Feeder

Feeder Fund (taxed as corporation)

57

US Funds Investing Overseas (cont’d)

• PFIC/CFC issues for US taxable investors

— Anti-deferral regimes

• PFIC - ≥ 50% passive assets or ≥ 75% passive income

— Look-through 25% owned subsidiaries

• Recharacterization of distributions, gain as ordinary income + penalty interest charge

— No chance for qualified dividend income

58


• Make “check the box election” to treat as a pass-through

— Can be difficult to persuade local owners to make US tax election

• QEF Election – modified look-through

— Losses and FTCs generally don’t flow through

— Often covenants to make election and obtain information to make US tax filings

— Can be burdensome for funds to gather required information, including from 25% owned subsidiaries

59


• CFC – more than 50% of a foreign corporation owned by “U.S. Shareholders”

— U.S. persons with 10% or more voting power

› U.S. partnership = 1 U.S. person

— Structure Fund and management entities as Cayman vehicles to apply 10% voting power test on look-through basis

— Or elect to treat foreign portfolio corporation as a pass-through

60

Luxembourg Investment Structure into Europe

• Luxco set up with minimal capital

• PECs yield 8% per year

• CPECs can be redeemed for FMV of shares into which CPECs are convertible

• PECs and CPECs

• Debt for Luxemburg tax purposes

• Equity for U.S. tax purposes (99/1 debt -equity ratio)

German Portfolio Company

U.S. Main Fund LP

Luxco

Cash

CTB to be Taxed as a Disregarded Entity

U.S. Investors

Cash

PECs CPECs


61

Luxembourg Investment Structure into Europe (cont’d)

• Little or no Lux withholding tax

• Luxco benefits from EU tax treaties

• Luxco disregarded for U.S. tax purposes

• Some US tax issues: debt-equity (including debt maturity); Section 305


U.S. Fund LP

Luxco

Dividends Capital Gains

CTB to be Taxed as a Disregarded Entity

U.S. Investors

Dividends Capital Gains

62

Issue for Canadian Investors in U.S. Fund

• Canada treats U.S. Blocker LP as a partnership

• Under U.S.-Canada tax treaty, U.S. 30% withholding tax applies (hybrid entity)

• Avoided if U.S. Blocker is instead an LLC

Distribution

US Investors

Canadian Corporation

(Taxable)

Canadian Pension Fund (Non-Taxable)

U.S. Fund Main LP

U.S. Blocker LP

U.S. Portfolio L.P.

Distribution

CTB to be Taxed as a Corporation

63

Another Issue for Canadian Investors

• Canada treats LLC as a corporation

• Under U.S.-Canada tax treaty, U.S. 30% withholding tax applies (hybrid entity)

• Avoided if U.S. Portfolio LLC is instead U.S. Portfolio LP

US Investors

Canadian Corporation

(Taxable)

Canadian Pension Fund (Non-Taxable)

U.S. Main Fund LP

U.S. Portfolio LLC

Dividends

U.S. Corporation

64

Structuring Fund Manager Entities

• Funds generally have separate General Partners and Investment Managers

— GP (or special LP owned by principals) receives carried interest

› Generally special purpose entity for each fund

— Investment Manager receives management fees

› Generally single Management Company across all funds

› Employees, contracts

› Franchise value

65

Structuring Fund Manager Entities (cont’d)

• Reasons for separation?

— Ensure proper tax treatment of separate income streams

› Carried interest – capital gains

› Management fees – ordinary income

— State/local tax reasons

› NYC unincorporated business tax

— Often separate ownership stakes

› Carried interest more widely distributed than ownership of Management Company

› Deal-by-deal; fund-by-fund

66

Limited Partners

Fund

General Partner

Investments

Management Company

Principals

Carried

interest

Management Fees

Structuring Fund Management Entities (cont’d)

67


• Considerations?

— Management Company – Choice of Entity

› S corp – limited flexibility; state tax issues; perhaps avoid self-employment taxes on dividends

› LLC – flexibility; self-employment taxes on distributive share of fee income?

› LP – flexibility; requires separate GP entity; avoid self-employment taxes on distributive share of fee income

• Statutory exception from SECA for distributive share of a limited partner

• Impact of recent case law?

68


• Considerations?

— General Partner – Choice of Entity

› Less of an issue than Management Company as distributions are generally not subject to self-employment taxes

› Use of LP may avoid new Medicare tax on NII

— General Partner – Issuances of Interests; Vesting

› Issuance of profits interest; no interest in current value

› 83(b) election

› Catch-up allocations

› Vesting/forfeiture/allocations to other partners

70

Foreign Account Tax Compliance Act (FATCA)

• “Foreign Account Tax Compliance Act” or FATCA

• Intended to ensure that U.S. persons holding assets through offshore entities and accounts pay U.S. taxes on related income

• Compels non-U.S. financial entities to either (1) document and report information about their U.S. accountholders/investors or (2) face a withholding tax of 30% on most U.S. source gross income or gross proceeds

71

FATCA (cont’d)

• FATCA does not replace the current withholding and reporting regime for non-U.S. persons

— FATCA is intended to be coordinated with the current regime in order to prevent double withholding

72

FATCA (cont’d)

• Categories Under Regulations

• U.S. Withholding Agents

— U.S. hedge and private equity funds may be required to act as withholding agents under FATCA

• Foreign Financial Institutions (FFIs)

— Non-U.S. funds likely FFIs

— Multiple categories: Participating FFI, Deemed Compliant FFI, and Non-Participating FFI

• Non-Financial Foreign Entities (NFFEs)

• Exempt Beneficial Owners

— Generally not subject to FATCA withholding as long as necessary documentation is provided to withholding agent

73

FATCA (cont’d)

• Withholding Under FATCA

• FFIs: 30% of any “withholdable payment” paid to non-participating FFIs and recalcitrant account holders

— Tiered implementation of withholdable payments

› July 1, 2014: U.S. source FDAP income

› 2017: U.S. source gross proceeds on sale of stock or securities

› 2017: “foreign pass-through payments”

• Other withholding agents: Non-FFI withholding agents must withhold 30% of any withholdable payment paid to non-participating FFIs and passive NFFEs that fail to report on their significant U.S. owners

• “Withholding agent” broadly construed under FATCA

74

FATCA (cont’d)

• Two-pronged approach to FATCA compliance

— IRS Regulations

— Intergovernmental Agreements (IGAs)

75

FATCA (cont’d)

U.S. Funds: U.S. Withholding Agents

• Withholding by U.S. Fund: If an investor fails to provide necessary information to U.S. Fund, 30% FATCA withholding may be deducted from investor’s share of withholdable payments

• Tax withheld under FATCA is paid by U.S. Fund to IRS

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FATCA (cont’d)

• Non-U.S. Funds (and non-US blockers): Are they FFIs?

— Definition of FFI in the final regulations includes (among others) foreign “investment entities”

› Broad definition of “investment entities”

— Most non-U.S. funds will be FFIs, with the exception of certain real estate funds

— No credit or refund of 30% withholding tax—if fund or blocker is treated as corporation for U.S. tax purposes and treaty does not change result

• Does every FFI need to comply with FATCA?

— Material U.S. source income?

— Legal and practical considerations

— Various classifications for compliant FFIs

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FATCA (cont’d)

• Special Considerations for Funds Organized as Partnerships for U.S. Tax Purposes

— FATCA withholding applies not just to withholdable payments, but also to allocations of income

— Timing of FATCA withholding on a partnership’s receipt of gross proceeds is unclear

— Regulations don’t address how the sale of a partnership interest will be treated under FATCA

78

FATCA (cont’d)

• FATCA and Fund Documentation

— Fund organizational and operational documents

› Operating agreements

› Investor subscription documents and account applications

› Fund offering documents

› Side letters

— Service provider agreements (transfer agent, custodian, administrator, withholding agent, adviser, etc)

— Credit agreements/ISDAs/repo & securities lending agreements

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FATCA (cont’d)

• How to avoid 30% withholding after June 30, 2014?

• For an FFI not organized in a country with a Model 1 IGA in effect, FFI should provide withholding certificate or statement claiming status as a participating FFI or registered deemed-compliant FFI. Withholding agent then has 90 days to confirm that the FFI's GIIN appears on the IRS FFI List.

— For an FFI organized in a country with a Model 1 IGA, but with branches in a country without a Model 1 IGA—same

— For FFIs organized in a country with a Model 1 IGA, and with no branches in countries without a Model 1 IGA, deadline for GIIN registration is December 31, 2014

• But many are registering now by May 5, 2014 to get on first June 2, 2014 list

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New 3.8% Medicare Contribution Tax

• Imposed on U.S. individuals taxpayers, and estates and trusts

• Not imposed on corporations or pass-through entities—but “net investment income” passes through to U.S. individuals, and estates and trusts

• Not imposed on non-resident individuals

• Effective date: January 1, 2013

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New 3.8% Medicare Contribution Tax (cont’d)

• The Medicare contribution tax is 3.8% on the lesser of:

— “Net investment income” or

— The excess of modified adjusted gross income (MAGI) over the applicable “threshold amount”

• The threshold amounts are:

— Married individuals filing jointly - $250,000

— Married individuals filing separately - $125,000

— Qualifying widow(er) with dependent child - $250,000

— Trust and estates - $12,150 for 2014

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• Three Buckets of Net Investment Income:

— Gross income from interest, dividends, annuities, royalties, and rents

— Gross income derived from a business constituting a passive activity to the taxpayer under IRC Section 469 (and gross income derived from a trade or business comprised of trading in financial instruments or commodities)

— Net gains from the disposition of property, such as the sale of stocks, partnership interests, bonds, and real estate

• Under proposed regs, the first two buckets can be negative and offset other buckets, but the third bucket cannot

83


Other Investors

Fund L.P.

Portfolio Corp.

Portfolio LLC

- Gain on interest sale - Gain on asset sale - Interest - Gain on debt sale

U.S. Taxable Individual (and certain Trust and

Estate) Investors

3.8% nii


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New 3.8% Medicare Tax

• Impact on Fund Managers and Planning

— Carried Interest in private equity fund

› Passive investment income subject to new tax

› Additional 3.8% tax on top of 20% LTCG and QDI (or 39.6% for interest, STCG and nonqualified dividend income)

— Incentive compensation in hedge fund?

› If paid as fee, may be subject to 3.8% self-employment tax unless qualifying for LP exception or perhaps flowing through as S corp dividends (but see next slide)

› If paid as allocation, subject to new Medicare tax • Even if fund is a “trader” hedge fund

85

New 3.8% Medicare Tax (cont’d)

• Planning Opportunities

— More incentive for deferral transactions

— 1031s – gain not picked up under NII rules until recognized

— Restructure carried interests as incentive fees?

› If majority of income is already ordinary (STCG, interest, rent, royalties)

› If carried interest is taxed as OI, further incentive to convert fees (even if self-employment taxes would apply as the new Medicare tax is nondeductible against recipient’s income)

› Potential bad result for taxable investors in fund due to 212 limitation on deductibility of incentive fee

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— Convert LLCs to S Corps or LPs

› Trade or business income paid as dividends by an S corp to its shareholders that “materially participate” is not subject to the tax

› Member in LLC on same facts arguably subject to self-employment taxes on same income

› Meaning of “Materially participating” going to be very important

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— Using corporations

› Corporations pay low tax rates on income up to $50,000.

› Incentive fees up to such amounts could be paid to a corporation owned by Fund manager

› Dividend out of corporation subject to 20% top federal tax + 3.8% NII tax

• Effective federal tax rate of 35.8% as compared with 43.4%

› State and local taxes to be considered • Potential double state tax

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What is a Carried Interest?

• Private equity and hedge fund managers structure funds with a 2 & 20 compensation structure

— Fixed percentage of gains over losses

› Typically 20%

— Often, most income/gain allocated to the 20% carry is taxed at favorable capital gain rates

— New legislation would apply to the 20% carry

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Some Partnerships Covered Include:

• Private equity funds

• Hedge funds

• Venture capital funds

• LBO funds

• Real estate funds and partnerships

• Marketable securities funds and partnerships

• Oil and gas funds and partnerships???

90

Fund Documents – Key Tax Provisions

• Offering Memorandum

• Limited Partnership Agreement

• Subscription Documents

• Side Letters

• Tax Opinions

91

Fund Documents – Key Tax Provisions

• Private Placement Memorandum

• Summary of key tax provisions

• General overview of tax treatment

• Limited Partnership Agreement (Operating Agreement)

Examples of key tax-related provisions: • ECI and UBTI Covenants • GP Clawback • Management fee waivers • Management fee offsets • Withholding • Allocations • Tax Distributions • Non-U.S. Taxes and Returns • Tax information reporting • Tax matters partner

92

Fund Documents – Key Tax Provisions (cont’d)

• Subscription Documents

• Investor tax representations

• PTP representations

• Transfer restrictions

• Electronic K-1 consent

• Side Letters

• PFIC/QEF election and CFCs

• Foundation issues

• ERISA issues

• Tax reporting, and much more

• Tax Opinions • Partnership Tax Opinion • 514(c)(9) Opinion

• Prohibited transactions • 892 Non-U.S. Governmental

Investors • Non-U.S. investor-specific

issues

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Today’s Speakers

• Christian McBurney, Partner, Nixon Peabody LLP, Washington, D.C. Office, (202) 585-8358, [email protected]

• Jeremy Naylor, Partner, Cooley, New York City Office, (212) 479-6580, [email protected]

• Elizabeth Norman, Associate, Goulston & Storrs, Boston Office, (617) 574-3568, [email protected]

mailto:[email protected]

