private equity, venture capital and...

Private Equity,

Venture Capital and

LBOs

© 2014 by Deborah L. Paul and Donald E. Rocap

Deborah L. Paul

Wachtell, Lipton, Rosen & Katz

Donald E. Rocap

Kirkland & Ellis LLP

Life Cycle of an LBO Transaction

Event

• Acquisition of Target

• Holding and Partial Exit

• Complete Exit

Principal Tax Goals

• Obtain stepped-up basis in Target assets

where feasible

• Avoid double tax to Target shareholders

• Achieve tax deferral for rollover shareholders

• Structure equity-based compensation for

management

• Avoid phantom income from debt and

preferred stock OID

• Avoid phantom income from subpart F

inclusions

• Maximize deductibility of LBO interest

• For partial withdrawals of cash: • Maximize basis recovery

• Maximize eligibility for 20% LTGG/QDI rate

• Minimize withholding taxes

• Deliver stepped up basis to buyer where

feasible

• Maximize eligibility for 20% LTGG/QDI rate

• Minimize withholding taxes

• Capture tax benefits triggered by transaction

2

3

Life Cycle of a Leveraged Buyout in an

Economic Downturn

Event Principal Tax Concerns

Acquisition of Target Amortizable stepped-up basis in Target assets Tax-free rollover for Target shareholders who retain equity Equity-based compensation for management Tax-efficient financing

Repurchase of Debt by the Company Cancellation of debt income to Issuer

Purchase of Debt by the Fund Cancellation of debt income to Issuer Original issue discount/market discount on resulting debt AHYDO limitations on resulting debt

Debt-for-Debt Exchange or Modification of Debt Cancellation of debt Income to Issuer AHYDO limitations on resulting debt Gain or loss recognition to Holders

Debt-for-Equity Exchange Cancellation of debt income to Issuer §382 ownership change for Issuer Gain or loss recognition to Holders Rollover of market discount to Holders

Acquisition Structure

Whether to Structure for Stepped-Up Basis (“SUB”) or Carryover Basis

(“COB”)

• Benefit of SUB

• Present value of incremental depreciation and amortization

deductions; approximately 20% of SUB, assuming:

• 15 years straight-line amortization

• Buyer taxable at 40% rate

• 10% discount rate

• Buyers are typically willing to increase purchase price by some

amount less than 20% of the potential SUB to obtain SUB, due to:

• Possible lack of post-acquisition taxable income may defer

use of depreciation/amortization deductions

• Buyer may use a discount rate higher than 10%, particularly if

paying the incremental purchase price requires additional

equity investment

• Buyer typically anticipates an exit from the investment in, e.g.,

5 years, and may doubt that a future buyer will fully pay for the

remaining unused tax benefits

4

• As rule of thumb, often assume that, to obtain SUB, buyers will be willing to

pay an incremental purchase price of roughly 10% of the potential SUB

• If transaction is structured to produce SUB, important to ensure that the

§197(f) anti-churning rules do not prevent amortization of SUB in goodwill and

other intangible assets that do not have a reasonably ascertainable useful life.

The anti-churning rules apply where:

• Some amount of the goodwill or similar intangible assets were held by

the Target on or before August 10, 1993 and

• There is a greater than 20% overlapping ownership between the Target

and the buyer (applying a number of alternative 20%-or-greater related

party tests containing broad ownership attribution rules) immediately

before or after the transaction

• Where some pre-August 11, 1993 goodwill or similar intangibles exist, all

amortization of the SUB in such intangibles is subject to disallowance --

not limited to the August 10, 1993 value of the intangibles

• Where the Target or the buyer is a partnership/LLC, the determination of

whether, and to what extent, a SUB-producing transaction is treated as a §197

related party differs significantly depending on the transaction form (e.g.,

acquisition of assets vs. acquisition of equity interests) and the particular

Code section that produces the SUB (e.g., §707 disguised sale vs. §734(b)

cash distribution in excess of basis vs. §743(b) sale of partnership interest)

5

Acquisition Structure

6

Acquisition of Target:

Stepped Up Basis in Assets

• If (domestic) target is publicly traded or is a standalone C corp, a step up

in target’s asset basis is not likely to be viable (unless target has an NOL

sufficient to absorb the asset sale gain).

• If (domestic) target is a subsidiary of a corporate parent or is an S corp,

then a step up in target’s asset basis can be achieved by: • buying the assets of target

• converting target to an LLC treated as a disregarded entity or partnership and

buying the LLC interests

• merging target into purchasing corporation or LLC

• buying the stock of target and making a §338(h)(10) or §336(c) election

• Acquisition of stock of Target S Corp or Target Bigco Sub with a

§338(h)(10) or §336(e) election achieves stepped up tax basis in Target

assets without requiring an actual transfer of Target assets, which may

be undesirable for commercial law, regulatory or transfer tax purposes

• If target is a partnership for tax purposes, then a step up in target’s asset

basis can be achieved by buying target assets or by buying all the

partnership’s equity interests or by buying some equity interests and

making a §754 election.

§338(h)(10) and §336(e) Compared

7

§338(h)(10) §336(e)

§338(h)(10) requires that: §336(e) requires that:

• a corporation • one or more persons (corporate, partnership, LLC or individual)

• acquires within a 12-month period • acquires within a 12-month period

• from a single U.S. corporate seller or consolidated group (Bigco)

or a group of S corporation shareholders

• from a single U.S. corporate seller or consolidated group (Bigco)

or a group of S corporation shareholders

• stock of a U.S. corporation (Target Bigco Sub or Target S Corp) • stock of a U.S. corporation (Target Bigco Sub or Target S Corp)

• representing at least 80% of Target stock (by vote and value,

disregarding §1504(a)(4) preferred stock)

• representing at least 80% of Target stock (by vote and value,

disregarding §1504(a)(4) preferred stock)

• by “purchase,” which does not include

• any acquisition of Target stock in a carryover basis exchange or

other exchange to which §§351, 354, 355 or 356 applies, and

• any acquisition of Target stock from a person the ownership of

whose stock would be attributed to the purchasing corporation

under the §318 ownership attribution rules

• by “disposition,” which does not include

• any acquisition of Target stock in a carryover basis exchange or

other exchange to which §§351, 354, 355 or 356 applies, except for

a §355 distribution that is taxable at the corporate level under

§335(d) or (e), and

• any acquisition of Target stock from a related person. Two

persons are related if stock owned by one of them would be

attributed to the other under the §318 ownership attribution rules

(with attribution between a partner and a partnership limited to 5%

or greater (by value) partners)

• Purchasing corporation and Bigco or all of Target S Corp

shareholders (including non-selling shareholders) make joint

§338(h)(10) election

• Target and Bigco or all of Target S Corp shareholders (including

non-selling shareholders) make joint §336(e) election

• in case of overlap, a §338 QSP trumps a §336(e) QSD

8

Cash

100% of Target

Stock

Investors

Purchasing

Corporation

Target

Shareholders

Target

S Corp

Basic §338(h)(10) Fact Pattern

Target

Bigco Sub

Bigco

or

9

Basic §336(e) Fact Pattern

Cash

100% of Target

Stock

Investors

Purchasing

Partnership/LLC Target

Shareholders

Target

S Corp

Target

Bigco Sub

Bigco

or

10

• Receipt of any equity in the Purchasing Corporation by historic Target Shareholders who own more than 20% of Target, in direct (or possibly recharacterized) exchange for their Target stock, raises the risk that the acquisition from these shareholders is a §351 transaction ineligible for a §338 (or §336(e)) election.

Code §338(h)(10) Trap - §351 Recharacterization

Step 1

Cash

100% of Target Stock

Investors

Purchasing

Corporation

Target

S Corp or

Bigco Sub

Step 2

Cash

> 50% of Purchasing Corp stock

Target

Shareholder(s)

11

Avoiding §351 Recharacterization Trap

• In order to bolster eligibility for a §338 election, Purchasing Corp could provide cash and Newco shares to the historic Target Shareholders. Consider impact, if any, of Rev. Rul. 2003-51.

• Target shareholders recognize gain on cash and Newco shares received.

• Even if a basis step-up is obtained, the anti-churning rules under §197 generally will prevent amortization of goodwill and certain other intangibles if there is greater than 20% overlap in ownership before or after the transaction (after attribution) and the target’s goodwill or other intangibles existed on August 10, 1993, the date that §197 was enacted.

Investors

Newco Corp Target

Shareholder(s)

Target

S Corp or

Bigco Sub Purchasing Corp

Cash and

Newco Shares

Target

shares

12

§338(h)(10) Trap – §318 Attribution

Holdco LLC

Purchasing Corp

Target S Corp

or

Bigco Sub

Investors

100%

cash

90% LLC

equity

Target

Shareholder(s)

• §338 “purchase”

definition excludes

acquisition from

person whose stock

would be attributed to

Purchasing Corp

• But §336(e) election

permitted if no single

historic Target

Shareholder owns 5%

or more (by value) of

Holdco LLC

13

Purchasing Corp

Target

§318(a)(3)(A) attribution

(no threshold under §338,

5% threshold under §336)

§318(a)(3)(C) attribution (> 50%)

Target

Shareholder(s)

Investors

Holdco LLC

14

Bifurcated Purchase –

Consistency Rules for Consolidated Group

Target

Sub

Step 3

Bigco $50 cash

Step 1

$50 cash

Step 2

$50 dividend

TB = 50

FV = 100

Division 1 Division 2

TB = 0

FV = 50

TB = 0

FV = 50

Purchaser

Entity

Investors

• Bigco has higher outside basis in Target Sub stock than Target

Sub has in its assets

• One-step sale of Target Sub stock without §338(h)(10) or

§336(e) election would trigger $50 Bigco gain, but produce no

basis step-up for Purchaser

• Sale of Target Sub’s assets or sale of Target Sub’s stock with

§338(h)(10) or §336(e) election would produce $100 basis step-

up for Purchaser, but trigger $100 Bigco group gain

• Bifurcated purchase of Division 1 assets (triggering $50 gain to

Bigco group but producing $50 increase in tax basis of Target

Sub stock) triggers only $50 Bigco group gain and allows

Purchaser to obtain $50 basis step-up

• If Purchaser is a corporation, Reg. §1.338-8 “consistency rules”

disallow basis step-up in Division 1 assets if a §338 election is

not made with respect to Target Sub stock

15

Bifurcated Purchase

• If Purchaser is a partnership/LLC, PLR 201214012 held that the §338

consistency rules do not apply because purchase by a partnership/LLC is

not a QSP

• Reg. §1.336-1(b) extends the principles of the §338 consistency rules to

“qualified stock dispositions”

• Purchase of all of Target Sub’s stock by a partnership/LLC is a “qualified

stock disposition” and basis step-up in Division 1 assets would be denied

if a §336(e) election is not made with respect to Target Sub’s stock

• If Bigco acquires 5% or more (by value) of the equity of Purchaser

partnership/LLC, the purchase should not be a QSD and the §336(e)

consistency rules should not apply

• Bifurcated asset/stock purchase may be advantageous outside of the

consolidated group context

• E.g., where Target S Corp owns 2 divisions or QSubs, one with potential

Code §1374 liability and the other without

• §338/336 consistency rules do not apply outside the consolidated group

context

16

Bifurcated Purchase

17

• S Corp shareholders may seek indemnification or higher purchase price to reflect:

• Higher federal tax if SUB transaction causes portion of the shareholders’ gain to be taxed as OI (e.g., depreciation recapture or gain on inventory) rather than LTCG

• Higher shareholder state tax if SUB transaction causes portion of the shareholders’ gain to be taxed in a state that imposes a higher tax rate than the state of the shareholders’ residence

• Accelerated federal and state gain recognition

• §338(h)(10) or 336(e) election triggers gain on any stock retained by the shareholders

• S corp gain allocated proportionately even if rollover is disproportionate

• Possible §1374 tax

• Possible state entity-level taxes

Acquisition of Target S Corp:

Stepped Up Basis in Assets

18

Drop-Down LLC as §338(h)(10)/336(e) Alternative

Target

SCorp

Newco

LLC

Investors

Assets LLC Equity Step 1

Target

Shareholder(s)

19

Drop-Down LLC as §338(h)(10) Alternative

Target

SCorp

Newco

LLC

Step 2

Cash

Investors

Target

Shareholder(s)

20

Target

SCorp

Newco

LLC

Drop-Down LLC as §338(h)(10) Alternative

Rollover

equity

• Target Shareholders defer gain recognition on retained Newco LLC equity held through Target S

Corp

• Newco LLC obtains partial SUB

• Potential application of §197 anti-churning rules and allocation of benefits of SUB between

Target Shareholders and Investors depends on details of transaction mechanics and 704(c)

elections

Investors

Purchased

equity

Target

Shareholder(s)

21

Deemed Asset Drop Down

New

SCorp

Step 1

New SCorp stock

Target

SCorp

Step 2

State law conversion to LLC

Target

LLC

Target

SCorp

stock

Target

Shareholders

22

New

SCorp

Step 3

Cash

Investors

all or part of

Target LLC equity

• Target Shareholders’ contribution of Target S Corp stock to New S Corp and Target SCorp’s

conversion to LLC (or Q sub election) qualifies as “F” reorganization

• Investors obtain basis step-up on Target LLC assets

• Target Shareholders (through New SCorp) defer gain recognition on retained Target LLC equity

• Often desirable to cause Target LLC to be treated as a partnership for tax purposes (by admitting a

second non-transitory equity owner) before the sale to Buyerco so that Buyerco obtains SUB under

Code §743(b)

Basis Step-Up Upon Acquisition

Target

LLC

Target

Shareholders

23

Special Issues Involving

LBOs of Foreign Targets: Subpart F

• §951(a) requires any “United States shareholder” (generally, a U.S. person who owns, within the meaning of §958(a) or (b), at least 10 percent of the voting power) of a CFC to include the shareholder’s pro rata share of Subpart F income if the shareholder “owns (within the meaning of §958(a))” stock in the CFC on the last day of the year.

Principals

Foreign

Targets

Foreign

General

Partner

Domestic

General

Partner

Domestic

Targets

Limited

Partners Domestic

Fund

Foreign

Fund

24

Special Issues Involving

LBOs of Foreign Targets: Subpart F

• If either the Domestic Fund invests or the Foreign Fund invests, Foreign Target will often be a CFC and the Domestic Fund will often be a “United States shareholder.” If Foreign Fund invests, for purposes of determining CFC status, Foreign Fund’s ownership in Foreign Target is attributed to Domestic Fund under §958(b).

• If Domestic Fund invests, Domestic Fund would be a “United States shareholder” and would own stock within the meaning of §958(a). As a result, Subpart F inclusions would be required under §951(a).

• If Foreign Fund instead invests, then §951(a) inclusions should be analyzed at the level of the Principals and Limited Partners, all of whom may avoid “united States shareholder” status. Additional planning at the general partner level is often required.

• A key issue is whether the Foreign Fund and the Domestic Fund will be respected as separate partnerships. If viewed as one partnership, is it domestic or foreign? Some funds are now organized solely as foreign funds.

25

Special Issues Involving LBOs of Foreign Targets:

Basis Step Up Techniques

• §338 elections are almost never made on a domestic target, unless

the transaction is eligible for a §338(h)(10) election. For example,

§338 elections are rarely made on publicly-traded domestic targets

or on domestic targets that are privately-held by private equity

funds.

• In the case of a foreign target, it is often desirable to have the

transaction treated as an asset sale for U.S. tax purposes in order to

eliminate historic E&P and Subpart F income and minimize future

E&P and Subpart F income. Therefore,

• make a §338(g) election OR

• “Check and sell”: have the seller check the box on the entities that are

being acquired so that those entities are treated as disregarded entities

for U.S. tax purposes. See Dover v. Commissioner, 122 TC 324 (2004).

• §901(m) limits foreign tax credits after a §338(g) election, “check and

sell” or similar transaction to the amount of foreign tax credits that

would have been available absent the U.S. tax basis step-up.

26

Special Issues Involving LBOs of Foreign Targets:

Investing through an Intermediate Holding Company to

Address Foreign Withholding and Capital Gains Taxes

• Eligibility for 20% rate on dividends from Luxco (if Luxco is a corporation) versus Foreign Target

• Potential PFIC status of Luxco if Luxco is a corporation and ownership by Luxco of Foreign Target drops below 25%

• Publicly traded partnership status of Luxco if Luxco is a partnership

• Avoid trade or business at Luxco and debt at Luxco if Luxco is a partnership, because of UBTI rules

• Tax consequences of exit via a sale of Foreign Target (sale or exchange treatment flows through if Luxco is a partnership)

• Tax consequences of exit via a sale of Luxco

• Phantom income on non pro rata redemption of Luxco shares if Luxco is a partnership, because income at Luxco is not necessarily allocated to redeemed Luxco shareholders

• Tax treatment of preferred stock if Luxco is a partnership (is yield an allocation of income or a guaranteed payment?)

Investors

Foreign

Target

Luxco

The country in which Foreign Target is organized may

impose withholding tax on distributions out of Foreign

Target and may impose capital gains tax on sales by

large holders of stock in Foreign Target. Often, in order

to address those issues, it is desirable to invest in

Foreign Target through a holding company organized in

a jurisdiction (such as Luxembourg) with a favorable

treaty network or that is eligible for the EU

Parent/Subsidiary Directive. If such a holding company

is used, consider whether to treat Luxco as a

corporation or partnership for U.S. tax purposes:

27

Capital Structure of the Target Going Forward: All Common vs. Tranches of Common,

Preferred and Subordinated Debt

• Advantages of subordinated debt and preferred

• For debt, interest deduction, subject to limitations

• For debt, allows tax-free return of capital as principal is repaid

• Provides senior position over holders of common (or options/warrants to acquire common) in flat or downside scenario

• Provides a return hurdle (i.e., the interest or dividend rate) prior to participation in upside by holders of common/options/warrants

• Depresses value of common stock, allowing management to purchase “cheap” common stock which represents small interest in current value but larger interest in future appreciation

• For investor purchasing debt/preferred and common, allows most of tax basis to be concentrated in debt/preferred

• If exit is IPO, underwriters more likely to permit existing owners to take cash out in repayment of debt or preferred than in sale or redemption of common

28

Potential Disadvantages of Subordinated Debt

and Preferred Stock

• For debt, potential limits on interest deductibility, OID

accrual to holders, withholding tax on payments to

non-US holders

• For preferred, potential phantom income inclusions to

holders and withholding tax on payments to non-US

holders

29

Possible Capital Structure

Holdco

T

Rollover Investors VC

20% 80%

• $40m Holdco capital • $15m jr. subordinated debt

• $24m preferred stock

• $1m common stock

• warrants to mezzanine lender

• $100m T capital • $50m Sr. debt

• $10m Sr. subordinated debt

• $40m common stock

30

Subordinated Debt:

Limits on Interest Deductibility

• Common law debt-equity rules

• Code §163(e)(5) (AHYDO)

• Code §279 (Corporate acquisition indebtedness)

• Code §163(j) (Earnings stripping)

• Code §163(l) (Debt payable in stock)

• Code §163(e)(3) (related foreign holders of debt with

OID)

• Code §267(a)(3) (payments to related foreign holders)

31

Subordinated Debt Provided by VC and

Rollover Investors: Limits on Interest Deductibility

• Common law debt/equity rules

• High degree of overlap with equity ownership

• Because of subordination to senior debt, high debt-equity

ratio

32

• §163(e)(5) AHYDO: Deferral and/or Disallowance

• Senior lenders will require term to be more than 5 years

• Subordinated position typically will dictate an arms-length interest rate

greater than AFR + 5%

• Cash flow constraints and senior debt covenants typically will require

accrual of all or part of interest yield in early years

• Typically seek to avoid §163(e)(5) limits by providing for interest catch-

up in 6th year following issuance. Interest catch-up represents

unconditional obligation as between issuer and holder, with normal

default remedies, but holder often enters into subordination agreement

with senior lenders agreeing not to assert default without permission

of senior lenders if lenders have not been repaid.

Subordinated Debt:


33

Subordinated Debt:


• §163(j) Earnings Stripping: Deferral

• VC often owns more than 50% of borrower’s equity. If VC is a

partnership 10% or more of the capital or profits interests in

which are owned by TEOs or FPs, interest is “disqualified

interest” subject to §163(j)

• Under §163(j), interest deduction deferred to extent

borrower’s net interest expense exceeds 50% of tax EBITDA

• Frequently impossible to structure to avoid §163(j) where

subordinated loan made by majority owner VC; must rely on

EBITDA increases to “grow out” of the interest limitations

34

Subordinated Debt:

Phantom Income to Holders

• Holder taxed on accruing yield on current basis

• Typically seek to negotiate with senior lenders to permit

portion (e.g., 45%) of interest to be paid in cash to fund

holders’ tax payments, subject to cutoff if borrower’s

performance lags

• Accrual method precedent supports ending accrual of interest

income if substantial doubt as to ultimate collectibility

• Spring City Foundry, Rev. Rul. 80-361

• IRS takes position that OID rules override this precedent -- TAM

9538007

35

CERT Limits on NOL Carryback

• Corporate equity reduction ("CERT") rules limit carry back by C

corporation of NOLs attributable to interest expense following a

"major stock acquisition" ("MSA") or "excess distribution" ("ED") to

the extent aggregate annual interest expense exceeds average during

3 prior years

• Detailed proposed regulations issued 9/12

• MSA is acquisition of 50% or more of stock of another corporation

• Under proposed regulations:

• Would include tax-free stock acquisitions as well as taxable

• Where redemption occurs as part of MSA, tested as MSA

rather than as ED

36

• ED occurs where distributions during a taxable year exceed the

greater of (a) 150% of average distributions in 3 prior years or (b) 10%

of FMV of stock as of beginning of year

• Under proposed regulations, distributions would include tax-free

distributions -- e.g., tax-free distributions under Code sec. 355

• Consolidated group treated as a single entity for purposes of

determining and tracking a CERT

• Under proposed regulations, a corporation leaving a consolidated

group would take with it a proportionate share of the group's

CERT, interest and distribution history, unless election made to

permanently waive any carryback of losses to the consolidated

group

CERT Limits on NOL Carryback

37

• Cash and accrual method holders generally not taxed on accruing stated dividend yield until paid

• If preferred sold to third party or redeemed (e.g., in connection with IPO) and redemption not recharacterized as a dividend under §302, redemption proceeds in respect of accrued dividends taxed as capital gain, provided that the accrued dividends not “declared” prior to redemption

• Capital gain treatment generaly avoids withholding tax on dividends to non-US holders

• Accrued yield on non-participating preferred is taxed (to the extent of E&P) if paid in kind (including conversion into common, e.g., in connection with IPO)

Preferred Stock:

Taxation of Stated Yield

38

• OID on non-participating preferred taxed as accrues (to

the extent of e&p)

• Where preferred is issued in unit with common or

warrants, risk that more than stated value may be

attributed to common or warrants and less than stated

value attributed to preferred, creating preferred OID

• Relevant factors bearing on valuation of preferred include

whether stated yield is lower than an arms-length rate and

whether common equity is too “thin”

• Risk that stated yield may be treated as “disguised

redemption premium” (creating OID) if “no intention to

pay currently”

Preferred Stock:

Taxation of Yield

39

• Taxation of preferred OID and dividends paid in kind generally

applies only if stock is “preferred” stock under §305, i.e., stock that

does not participate in corporate growth to a significant extent

• Ignore participation through right to convert into different class of stock

• Can add a participation feature to preferred stock, avoiding §305 preferred stock

characterization, by creating a class of stock that combines some or all of the

holder’s common stock and preferred stock rights

• Assume Investors invest $100 in Target at the time of the acquisition. They

could invest, e.g., $9 in nine shares of common stock and $91 in

participating preferred with a liquidation preference of $90, a fixed annual

yield and a right to 10% of the value of Target in excess of the liquidation

preference on the preferred.

• Unfavorable dividend or recapitalization basis recovery rules may apply if

the preferred element of the participating preferred is paid off (e.g., in

connection with IPO) while the common element remains outstanding.

Preferred Stock:

Taxation of Yield

40

Cheap Common Issues

• If yield on preferred or subordinated debt is too low or

common is too thin (resulting in “option value” for common), FMV of common stock may be greater than purchase price

• Resulting Risks • Executives purchasing common stock may have ordinary

income under §83

• Company may have GAAP compensation charges under FASB 123R

• Employee options on common stock may be in-the-money at grant, triggering §409A penalties

• Holder of preferred or subordinated debt may have OID

• Might alleviate §83 cheap common concerns by creating partnership/LLC holding company and issuing to management profits interests rather than common corporate shares. But: • Some accountants are concerned that Rev. Proc. 93-27

(allowing use of §83 liquidation value methodology for partnership/LLC interests) may not apply to this fact pattern

• May result in ordinary income on exit without compensation deduction if carried interest legislation enacted.

41

Cheap Common Issues

42

• Nonqualified preferred (“NQ Pfd”) stock is treated as

boot.

• Stock is NQ Pfd if it does not participate significantly in

corporate growth and is mandatorily redeemable within

20 years after issuance, puttable within 20 years after

issuance or callable within 20 years after issuance, with

it being more likely than not to be called.

• Although NQ Pfd is treated like debt for gain recognition

purposes, recognized gain cannot be deferred under the

installment sale rules.

Preferred Stock Issued to Rollover Investors

43


• Can avoid NQ Pfd treatment by issuing to rollover investors a

separate class of preferred stock that is neither mandatorily

redeemable nor puttable within 20 years

• Company may desire call right (e.g., in connection with IPO). Is right

more likely than not to be exercised? §305 regulations provide safe

harbor under similar rules if issuer and holder are not related, call is

not compelled and call would not reduce yield to maturity. This safe

harbor should apply by analogy but no definitive guidance exists.

• Holder right to convert (or issuer’s right to force conversion) into

common stock at IPO price should not be treated as a put right for

this purpose because conversion is not a “redemption” or

“purchase”

• If preferred stock received by rollover investor is not NQ Pfd and

receipt of cash would have been treated as a dividend, preferred

stock may be §306 stock

44

• Can avoid NQ Pfd treatment by issuing to rollover

investors a class of stock (treated as “common” stock)

that combines some or all of the holder’s common stock

and preferred rights

• Unfavorable dividend or recapitalization basis recovery rules

may apply if subsequently the preferred element of the stock

is paid (e.g., in connection with IPO) while the common

element remains outstanding. Not important issue for rollover

investors if tax basis in rollover shares is low.


45

Withdrawal of Cash from Target:

“Leveraged Recap”

• If Target borrows funds and then distributes the funds to the Investors, the first

dollars paid to the Investors could qualify as §301(c)(2) basis recovery if Target

has no current or accumulated earnings and profits.

(1) Dividend to the

extent of earnings

and profits

(2) Basis recovery

(3) Capital gain

§301(c)

Target Lenders Cash

Investors

Cash

46

Withdrawal of Cash from Target:

“Leveraged Recap”

• If a §338 or §336(e) election was made on the acquisition, the pre-acquisition E&P of Target was eliminated.

• If a §338 or §336(e) election was not made on the acquisition, the pre-acquisition E&P of Target would generally not flow up to Purchasing Corp.

• Whether or not a §338 or §336(e) election is made, post-acquisition E&P, if any, of Target would generally flow up to Purchasing Corp (unless Purchasing Corp and Target do not file consolidated returns).

Purchasing

Corp Lenders

Investors

Target

Cash

Cash

Cash

Lenders

or

Cash

47

Withdrawal of Cash from Target

Funded by Sale of a Business

• The distribution of cash could qualify as a “partial liquidation” under §302(b)(4).

• If so, certain Investors would recover a portion of their basis and be taxed at capital gains rates.

• Partial liquidation treatment is desirable if the Investors have held Target stock for more than one year, but undesirable if they have held for one year or less (and qualified dividend income treatment would otherwise be available).

• Qualification as a partial liquidation is highly formal. For example, a sale of stock of a subsidiary (without a §338 (h)(10) (or §336(e)) election) followed by a distribution of the proceeds is not a partial liquidation, but an actual or deemed sale of assets by Target (or a sale of assets by a subsidiary of Target followed by a liquidation of the subsidiary) and a subsequent distribution of the proceeds could qualify. Rev. Ruls. 75-223, 79-184.

Cash

Target Cash

Investors

Business

48

Partial Exit through an

Initial Public Offering

• If structured as a secondary sale, Investors would have sale or exchange treatment on the shares sold.

• If structured as a primary sale of shares by Target to the public followed by a payment of cash by Target to the Investors, the transaction raises a number of issues, such as (1) whether it will be recast as a secondary sale under the step transaction doctrine, see Waterman Steamship v. Commissioner, 430 F.2d 1185 (5th Cir. 1970); Rev. Ruls. 71-336, 75-447, and 75-493, and (2) if not recast as a secondary sale, whether the transaction between Target and the Investors will be analyzed as a §301 distribution, a §302 redemption, a §356/368(a)(1)(E) recapitalization with boot or, if a holding company is used, a §304 transaction.

Cash

Target

shares

Secondary Sale Primary Sale and

Distribution/Redemption/Recapitalization

Target

Public Investors

Target

Target

shares

Cash

Target

shares

Cash

Investors Public

49

Partial Exit Through an Initial Public Offering

• If §302 or §356 applies, the reduction in percentage interest

experienced by the Investors as a result of the public obtaining

shares in Target should be taken into account in determining

whether the Investors’ percentage interest has gone down

sufficiently to result in sale or exchange treatment under §302 or

§356. See Zenz v. Quinlivan, 213 F.2d 914 (1954), Rev. Ruls. 54-

458, 55-745, 84-114. Cf. Bazley v. Commissioner, 331 U.S. 737

(1947); Treas. Reg. Sec. 1.301-1(l).

• If §301(c)(1) applies and the Target is U.S., then withholding would

be required with respect to non-U.S. investors.

50

Partial Exit Through an Initial Public Offering:

Tax Receivables Agreements

• Market is thought not to value tax attributes (e.g., basis, net

operating losses) of IPO company since not reflected in GAAP

earnings.

• Tax Receivables Agreement causes IPO company to pay historic

owners a portion (e.g., 85%) of IPO company’s tax savings as tax

attributes are used.

• May cover basis step-up arising from exchange of

partnership interests for IPO company stock in connection

with or after IPO

• May cover historic stepped-up tax basis or NOLs

• Treatment of TRA to historic investors depends on structure. In

basis step-up case, TRA payments are often viewed as

installment payments.

51

Partial Exit through an Initial Public Offering:

Basis Concentration Using Participating Preferred Stock

• Suppose Investors invested $100 in Target at the time of the acquisition. They would invest, e.g., $9 in nine shares of common stock and $91 in participating preferred.

• The participating preferred has a liquidation preference of $90, a fixed annual yield and a right to 10% of the value of Target in excess of the liquidation preference on the preferred. At the time of an IPO, the preferred converts into a number of common shares having a value equal to the liquidation preference plus common shares representing 10% of the remaining value of Target.

• For example, suppose an IPO is going to occur at $10 per common share at a time when the value of the Target is $200 (and assume the preferred liquidation preference has grown to $100). The preferred would convert into 11 shares (equal to $100 liquidation preference/$10 per share plus one additional common share representing 10% of the value of the company in excess of $100) with a basis of $8.27 per share. A portion of these high-basis common shares would be sold to New Investors in the IPO resulting in only a small amount of gain recognized.

Cash

Investors

New

Investors

Target

low basis common

high basis participating

preferred

converts

to common

at IPO

52

Partial Exit through an Initial Public Offering:

Basis Concentration Using Participating Preferred Stock

• Treasury Regulation §1.1012-1(c) permits specific

identification of shares sold.

• Valuation of the preferred at the time of original

investment is a key issue as it determines the Investors’

basis in the preferred.

• Preferred is intended not to be preferred stock for §305

and 306 purposes as a result of the participation feature.

53

Restructurings/Workouts

• Cancellation of Indebtedness Income (“CODI”) and related

tax issues can arise in three principal situations:

• Debtor repurchases its own debt at a discount to par, either

for cash, stock or a new debt instrument;

• A party “related” to the debtor acquires the debtor’s debt at a

discount; or

• The debtor and creditor agree to modify the terms of a debt

instrument, and the debt instrument has been traded at a

discount on an “established securities market” (broadly

defined) during the 31-day period ending 15 days after the

modification

54


Mitigation of CODI Income

• Use of Net Operating Losses against CODI Income. Note

that NOL carryovers will not completely eliminate tax,

because of AMT.

• Bankruptcy Exception

• Insolvency Exception

• State tax consequences also must be considered as

State results do not always conform to federal.

55

Situation 1: PC Purchases Debt at Discount

Equity Fund

PC $2B Notes

Partners

60%

Other

Shareholders

40%

Lenders

$350m cash

$500m face Notes

56

Debt Purchase Tax Issues

• PC’s purchase of $500m debt for $350m triggers $150m

CODI

• CODI excluded from PC’s taxable income

• If purchase occurs in PC’s bankruptcy proceeding, or

• To extent PC was insolvent prior to the purchase

• CODI excluded under bankruptcy or insolvency exception

applied to reduce PC’s NOLs and other tax attributes

• If PC is a partnership or LLC, bankruptcy and insolvency

exceptions applied at the partner/member level and hence

are generally unavailable

57

Situation 2: Related Party Purchases Debt

Equity Fund

PC $2B Notes

Lenders

60%

Other

Shareholders

40% $350m $500m face Notes

Partners

58

Purchase of Debt by Related Party

• Code §108(e)(4) and Reg. §1.108-2 -- Where debt acquired by

person related to issuer from an unrelated person at

discount:

• Acquisition discount = CODI to issuer

• New debt deemed to be issued with issue price = purchase price

of debt

• Whether person acquiring debt treated as related to issuer

tested under §267(b) and §414(b) and (c)

• Partnership and corporation treated as related if same persons

own > 50% of value of corporation’s stock and capital or profits

interest in partnership (§267(b)(10))

• Stock owned by partnership or corporation treated as

constructively owned by the entity’s owners (§267(c)(1))

• Result: Partners of Equity Fund own 100% of Equity Fund

and treated as constructively owning 60% of PC

59

Purchase of Debt by Related Party

• Hence Equity Fund’s purchase of PC debt triggers

§108(e)(4):

• $150m taxable CODI to PC

• For 2009 and 2010 transactions, PC may elect to defer CODI

recognition under Code § 108(i)

• $150m OID income (rather than market discount) to Equity Fund

accrued over remaining term of debt

• $150m OID deductions to PC, but may be limited by §163(e)(5)

(AHYDO rules) or §163(j) (interest stripping rules)

• Upon resale of debt by Equity Fund, debt has same CUSIP as

other PC notes but is not fungible because of OID taint

60

Determining Related Party Status -- Partnership

with Overlapping Ownership Purchases Debt

Equity Fund Distressed

Debt Fund

PC $2B Notes

Lenders

Non-Overlapping

Partners

60%

Other

Shareholders

40% $350m $500 face Notes

Non-Overlapping

Partners

Overlapping

Partners

30% 55% 45% 70%

61

Determining Related Party Status -- Partnership with

Overlapping Ownership Purchases Debt

• Actual common ownership of PC and Distressed Debt Fund

<50%

• But assume that one or more of Overlapping Partners is an

individual

• An individual who owns stock (directly or constructively

through an entity) in a corporation treated as owning stock

owned by his partner (§267(c)(3))

• Individual Overlapping Partner treated as constructively

owing 100% of PC stock owned by Equity Fund

• Therefore Overlapping Partners own 55% of Distressed Debt

Fund and treated as constructively owning 60% of PC

62

Determining Related Party Status -- Corporation

Owned by Equity Fund Purchases Debt

Equity Fund

PC $2B Notes

Lenders

Partners

60%

Other

Shareholders

40%

$350m

$500m face Notes

Cayman

Corp

$350m

63



• Whether PC and Cayman Corp treated as related persons is

tested under §267(f) and §414(b) and (c)

• PC and Cayman Corp treated as related if:

• 5 or fewer individuals, trusts or estates own > 50% of both PC and

Cayman Corp,

• Under applicable constructive ownership rules, individual not treated as

owning stock owned by partner

• Equity Fund is treated as the parent of a chain of “trades or

businesses” under common control that includes PC and Cayman

Corp

• Equity Fund should not be treated as engaged in a trade or business and

hence this test should not apply (see, e.g., Rev. Rul. 2008-39)

• 1st Circuit has held (in Sun Capital case) that a private equity fund may be

the parent of a chain of trades or businesses under common control for

purposes of ERISA controlled group tests

64



• Cayman Corp subject to 30% withholding tax on interest

income if treated as a 10% shareholder of PC under Code

§871(h)(3)

• Applying §871(h)(3)(C) constructive ownership rules,

Cayman Corp would own > 10% of PC

• Therefore, portfolio interest exemption apparently not

available

• Tax leakage may be reduced if corporation purchasing PC

debt is formed in jurisdiction that may make available tax

treaty reductions in withholding tax

• May make QEF election for Cayman Corp, which is likely a

PFIC, to preserve capital gain treatment on eventual sale

of debt

65

Determining Related Party Status -- Corporation with

Overlapping Ownership Purchases Debt

$2B Notes Lenders

Partners

60%

Other

Shareholders

40%

$350m

$500m face Notes

$350m

Equity Fund

PC

Cayman

Corp

66


with Overlapping Ownership Purchases Debt

• PC and Cayman Corp should not be treated as related for

purpose of §108(e)(4)

• Applying §871(h)(3)(C) constructive ownership rules,

Cayman Corp apparently treated as owning < 10% of PC

• Therefore, portfolio interest exemption apparently available

67

Situation 3: Debt Restructuring

SHs

Other Holders

$1.5B Notes

$1.5B face New Notes

PC

Distressed

Debt Fund

In debt restructuring transaction:

• Other Holders exchange $1.5B face old Notes for $1.5B face New Notes

with revised terms (e.g., extended maturity, higher or lower interest

rate, revised covenants)

• Distressed Debt Fund exchanges

• $200m face old Notes for $200 face New Notes

• $300m face old Notes for 60% of PC’s post-restructuring equity

• FMV of old Notes and New Notes = 70% of face

68

Debt Restructuring Tax Issues

• Exchange of new debt for old debt held by Distressed Debt

Fund and other holders may trigger CODI

• Upon exchange of old Notes for New Notes with “significantly

modified” terms (or upon “significant modification” of old Note

terms by amendment), old Notes treated as satisfied for amount

equal to “issue price” of New (or amended) Notes

• Whether change in terms represents a “significant modification” is

determined under Treas. Reg. § 1.1001-3(b)

• Increase in interest rate is a significant modification if greater than a de

minimis safe harbor

• Payment of a fee to a lender to cure a covenant default or obtain a waiver or

consent is treated as an increase in the interest rate

• Extension of the term of a debt instrument beyond safe harbor levels

can be a significant modification

69

Determining “Issue Price” of New Notes:

• If neither old Notes nor New Notes are treated as “market

traded,” “issue price” equals the principal amount of the

New Notes, unless interest rate less than applicable

federal rate (“AFR”)

• If either old Notes or New Notes are treated as “market

traded,” issue price of New Notes generally equals the

FMV of the New Notes at the time of the exchange

70

Debt-for-Debt Exchange Tax Consequences --

Notes Not Market Traded

If Notes not treated as market traded:

• PC treated as satisfying $1.7B old Notes with New

Notes having issue price of $1.7B

• No CODI for PC

• Holders realize gain or loss on exchange based on

$1.7B face amount, generally deferred under

“recapitalization” tax rules if the old Notes and New

Notes are “securities” for tax purposes

• No OID for holders

71

Debt-for-Debt Exchange Tax Consequences --

Notes Market Traded

If Notes are treated as market traded:

• PC treated as satisfying $1.7B old Notes with New Notes

having issue price of $1.19B (FMV = 70% of face)

• PC realizes $510m CODI

• Holders realize gain or loss on exchange based on $1.19B

FMV, generally deferred under “recapitalization” tax rules

if the old Notes and New Notes qualify as “securities” for

tax purposes

• New Notes have $510m OID

• OID deductions for debtor, potentially limited under

AHYDO rules

• OID income for holders

72

Broad Definition of Market Traded

• Under Treas. Reg. § 1.1273-2(f), old Notes or New Notes are

“traded on an established market” if at any time during the 31-day

period ending 15 days after the exchange date:

• An actual sales price for the old Notes or New Notes is reasonably

available to market participants;

• One or more firm quotes for the old Notes or New Notes is available

from a broker or dealer, or

• One or more indicative quotes for the old Notes or New Notes is

available from a broker or dealer.

• Value is presumed to be sales price or quotes price.

• If indicative price materially misrepresents value, taxpayer can use

any method that provides reasonable basis to determine value.

• Small issuance exception: outstanding stated principal amount of

$100 million or less

• Issuer’s determination binding unless holder discloses on tax

return for year that includes acquisition date

73

Anti-Abuse Rule

• If a temporary restriction on trading is implemented, a

purpose of which is to avoid characterization of a debt as

market traded, then the debt instrument or property is

treated as market traded under Treas. Reg. 1.1273-2(f)(7)

• This anti-abuse rule applies even if a third party (and not

the issuer) has imposed the restriction, e.g., the holders

themselves or a federal bankruptcy court

74

AHYDO

• In a debt-for-debt exchange or modification where the face

amount of the debt is unchanged, but CODI is triggered because

the new debt is treated as having an “issue price” less than

face, the new debt will generally have an equivalent amount of

OID, the debtor’s deduction of which may offset the tax cost of

the CODI

• However, for applicable high-yield debt obligations (those with

terms >5 years and YTM > AFR + 5% and OID accruals in excess

of cash payments plus one year’s worth of interest)

(“AHYDOs”):

• No deduction is available for OID to the extent that it exceeds AFR +

6%, and

• the remaining OID is only deductible when paid in cash or property

75


• CODI on equity-for-debt exchange

• Distressed Debt Fund's exchange of PC debt for PC equity

triggers CODI equal to excess of issue price of exchanged PC

debt over FMV of PC equity received in exchange

• § 382 ownership change

• Distressed Debt Fund's acquisition of > 50% of PC's equity

triggers ownership change of PC under § 382, resulting in limits

on use of PC's NOLs and built-in losses

• If debt issuer is a subsidiary of equity issuer, consider

application of Treas. Reg. §1.1032-3, §351 and Revenue

Ruling 59-222.

76


• Potential additional CODI as result of Distressed Debt

Fund becoming related to PC

• Distressed Debt Fund's original acquisition of PC debt at a

discount did not trigger CODI because Distressed Debt Fund

was unrelated to PC

• But CODI also triggered under Treas. Reg. §1.108-2 if

Distressed Debt Fund treated as acquiring PC debt "in

anticipation of becoming related” to PC

77


• If Distressed Debt Fund acquires > 50% of PC's stock within 6

months of purchasing PC's debt at a discount:

• Purchase deemed to be in anticipation of becoming related

• PC has CODI on restructuring date equal to excess of face of debt

purchased by Distressed Debt Fund over Distressed Debt Fund's

purchase price

• PC deemed to issue new debt instrument to Distressed Debt Fund

with issue price equal to Distressed Debt Fund's purchase price,

resulting in OID equal to discount

78


• If Distressed Debt Fund acquires > 50% of PC's stock more

than 6 months after purchasing PC's debt at a discount,

whether Distressed Debt Fund purchased the PC debt "in

anticipation of becoming related" to PC determined based on

all relevant facts, including:

• Distressed Debt Fund's intent at time of debt purchase

• Any pre-purchase discussions with PC

• Period of time between purchase of debt and acquisition of stock

and

• Significance of PC debt as a proportion of Distressed Debt Fund's

total assets

79


• If Distressed Debt Fund becomes related to PC more than

6 months after purchase of PC debt at a discount and

purchase treated as "in anticipation of becoming related"

to PC:

• CODI measured by reference to FMV of PC debt on date

Distressed Debt Fund becomes related to PC (rather than

Distressed Debt Fund's purchase price)

80


• Holders’ treatment

• Recapitalization treatment of debt-for-debt

(“securities”) or debt-for-stock exchange

• Determination of “issue price” of new debt is key (e.g.,

OID on new debt if traded at a discount)

• Worthless stock deduction

private equity, venture capital and...

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