private equity, venture capital and...

© 2016 by Kevin Keyes, Deborah L. Paul and Donald E. Rocap

Private Equity,

Venture Capital

and LBOs Kevin Keyes

KPMG

Deborah L. Paul

Wachtell, Lipton, Rosen & Katz

Donald E. Rocap

Kirkland & Ellis LLP

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

Life Cycle of an LBO Transaction

2

Event

Repurchase of Debt by the Company

Purchase of Debt by the Fund

Debt-for-Debt Exchange or Modification of

Debt

Debt-for-Equity Exchange

Principal Tax Concerns

Cancellation of debt income to Issuer


Original issue discount/market discount on

resulting debt

AHYDO limitations on resulting debt

Cancellation of debt Income to Issuer

AHYDO limitations on resulting debt

Gain or loss recognition to Holders


§382 ownership change for Issuer

Gain or loss recognition to Holders

Rollover of market discount to Holders

Post-Acquisition Life Cycle of a Leveraged Buyout in an Economic Downturn

3

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

5


• 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)

• If (domestic) target is a C corp (and not a subsidiary of another 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).

6

Acquisition of Target:

Stepped Up Basis in Assets

• 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.

7

§338(h)(10)

§338(h)(10) requires that:

a corporation

acquires within a 12-month period

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)

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

Purchasing corporation and Bigco or all of Target S

Corp shareholders (including non-selling

shareholders) make joint §338(h)(10) election

§336(e)

§336(e) requires that:

one or more persons (corporate, partnership, LLC or

individual)

acquires within a 12-month period

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)

representing at least 80% of Target stock (by vote

and value, disregarding §1504(a)(4) preferred stock)

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)

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

§338(h)(10) and §336(e) Compared

8

Basic §338(h)(10) Fact Pattern

Cash

100% of Target

Stock

Investors

Purchasing

Corporation

Target

Shareholders

Target

S Corp

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

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

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.

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)

13

§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

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

15

Bifurcated Purchase

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

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

16

Bifurcated Purchase

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

17

Acquisition of Target S Corp:

Stepped Up Basis in Assets

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

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

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

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

Target

SCorp

Newco

LLC Rollover

equity

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

Basis Step-Up Upon Acquisition

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 (Reg. §1.368-2(m))

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)

New

SCorp

Step 3

Cash

Investors

all or part of

Target LLC equity

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? Many funds that expect to make non-U.S.

control investments 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

(absent portfolio interest qualification or treaty or §892

exemption)

For preferred, potential phantom income inclusions to holders

and withholding tax on payments to non-US holders (absent

treaty or §892 exemption)

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

Proposed §385 regulations

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


Common law debt/equity recharacterization factors:

• High debt-equity ratio

• High overlap between debt and c/s

• Questionable projected ability to service debt

• Not reasonable arms-length debt terms

• Debt holder doesn't act like creditor

E.g., S/H-creditor ignores Newco defaults bec owns 70% of c/s

Where subordinated debt provided by VC and rollover

investors:

• High degree of overlap with equity ownership

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

32


4/16 proposed §385 regulations contain 2 recharacterization

rules for debt between 80% or more related corps (including

such relationship through a common partnership):

• Where any member's stock publicly traded or group financial

statement shows assets greater than $100m or annual total

revenue greater than $50m, such debt automatically treated as

equity unless prompt and ongoing documentation and creditor

exercises appropriate creditor remedies

• Where aggregated intercompany debt $50m or more, portion of

such debt which finances certain types of transactions between

the related entities (e.g., dividend or stock redemption paid by debt

or purchase price for another group member's stock or purchase

price for another group member's property in certain asset reorgs)

automatically treated as equity

33


§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.

34


§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

35

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

36

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

37

CERT Limits on NOL Carryback

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

38

Preferred Stock: Taxation of Stated Yield

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 generally 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)

39

Preferred Stock: Taxation of Yield

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”

40

Preferred Stock: Taxation of Yield

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.

41

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

42

Cheap Common Issues

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.

43

Preferred Stock Issued to Rollover Investors

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.

44


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

45


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.

46

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

47

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

48

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

49

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

50

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.

51

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.

52


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

53


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.

54

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 where more

than $100m principal amount is outstanding) during the 31-day

period ending 15 days after the modification

55


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.

56

Situation 1: PC Purchases Debt at Discount

Equity Fund

PC $2B Notes

Partners

60%

Other

Shareholders

40%

Lenders

$350m cash

$500m face Notes

57

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

58

Situation 2: Related Party Purchases Debt

Equity Fund

PC $2B Notes

Lenders

60%

Other

Shareholders

40% $350m $500m face Notes

Partners

59

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

60

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

61

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%

62

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

63

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

64



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

Due to attribution to fund of trade or business activities of GP or affiliated

management company, particularly if fund receives economic benefit through

management fee offset arrangement

65



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

66



$2B Notes Lenders

Partners

60%

Other

Shareholders

40%

$350m

$500m face Notes

$350m

Equity Fund

PC

Cayman

Corp

67



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

68

Situation 3: Debt Restructuring

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

SHs

Other Holders

$1.5B Notes

$1.5B face New Notes

PC

Distressed

Debt Fund

69

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

70

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

71

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

72

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

73

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

74

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

75

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

76


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.

77


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

78


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

79

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

80


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)

81



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

82

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