tax challenges with u.s.-based private equity fund...
TRANSCRIPT
Tax Challenges With U.S.-Based
Private Equity Fund Formation Maximizing Benefits for Clients Given Diverse Investor Tax Objectives
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THURSDAY, AUGUST 15, 2013
Presenting a live 110-minute teleconference with interactive Q&A
Elizabeth Norman, Attorney, Goulston & Storrs, Boston
Joshua V. Azran, Owner, Azran Financial, Century City, Calif.
David Benz, Principal, Rothstein Kass, Beverly Hills, Calif.
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Tax Challenges With U.S.-Based Private Equity Fund Formation
Aug. 15, 2013
Joshua V. Azran, Azran Financial David H. Benz, Rothstein Kass
[email protected] [email protected]
Elizabeth M. Norman, Goulston & Storrs
Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY
THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY
OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons,
without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to,
any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
7
Fund Characteristics
• Types of funds
— Private equity
— Venture capital
— Hedge
— Distressed debt
— Real estate
— LBO
— Fund of funds
8
Fund Characteristics (Cont.)
• Other important fund characteristics
— U.S.-based or based outside U.S.?
— Focus investing in U.S. or outside U.S., or both?
— Is fund an investor or conducting a trade or business?
› Investor: Possible disallowance of fund manager fees
for U.S. investors under Sect. 212
› Trade or business: Fees deductible under Sect. 162, but
UBTI, ECI and CAI concerns
9
Type Of Fund Investors
• U.S. taxable individual or corporation
• U.S. state and local government
— Pension funds
• U.S. tax-exempt investors
— Corporate pension plans
— University and college endowment funds
— Private foundations
— Charity endowment funds
— Individual retirement accounts (IRAs)
10
Type Of Fund Investors (Cont.)
• Non-U.S. investors
— Individuals
— Non-U.S. entities treated as corporations, for U.S. income
tax purposes
— Pension funds (not taxed in home country)
• Non-U.S. government investors (Sect. 892)
— Sovereign wealth funds
— Pension funds
11
U.S.
taxable
C Corp.
35% c.g. and o.i.
Fund L.P.
Portfolio
Corp.
Portfolio
LLC
- Gain on interest sale
- Gain on asset sale
- Interest
- Gain on debt sale
U.S. taxable
individual
- 20% c.g.
- 39.6% o.i.
- 3.8% nii
- Gain on stock sale
- Dividends
- Interest
- Gain on debt sale
No fund-blocker desired
Unblocked investor can also claim tax credits and treaty benefits.
U. S. Taxable Individuals And Corporations
12
U. S. State and
Local Government
0% U.S. tax rate
Fund L.P.
Portfolio
Corp.
Portfolio
LLC
Gain/income
No fund-blocker desired
Unblocked can also claim treaty benefits.
Gain/income
U. S. State And Local Government
13
U.S. Tax-Exempt
0% U.S. tax rate
Fund L.P.
Portfolio
Corp.
Portfolio
LLC
- Gain on interest sale (c.g.)
- Interest
- Gain on debt sale (c.g.)
- Gain on stock sale
- Dividends
- Interest
- Gain on debt sale
No fund-blocker desired
Unblocked investor can also claim treaty benefits.
- Gain on sale of
non-inventory property
U. S. Tax-Exempt Investors
14
U.S. Tax-Exempt
35% U.S. tax rate
Fund L.P.
Portfolio
LLC
Fees earned by L.P.
Fund-blocker often desired
Unrelated business taxable income (UBTI)
- Operating income
- Gain on sale of inventory
U. S. Tax-Exempt Investors (Cont.)
15
U.S. Tax-Exempt
35% U.S. tax rate
Fund L.P.
Portfolio
Corp.
Portfolio
LLC
Debt-Financed:
- Gain on interest sale
- Interest
- Gain on debt sale
Debt-Financed:
- Gain on stock sale
- Dividends
- Interest
- Gain on debt sale
Debt-financed income is UBTI.
Fund-blocker often desired
Debt-Financed:
- Gain on sale
of any property
- Operating Income
U. S. Tax-Exempt Investors (Cont.)
16
U.S. Tax-Exempt
Non-U.S. or U.S.
Feeder Fund
Non-U.S.
Investments
(No UBTI)
U.S.
Investments
(No UBTI)
U.S.
Corp. Blocker
Investments
(UBTI)
U. S. Tax-Exempt Investors: Parallel Fund Structure
17
Non-U.S. Investors
• U.S. tax goals
— Avoid having to file a U.S. income tax return
— Limit U.S. tax on ―effectively connected income‖ (ECI)
— If ECI:
› Must file U.S. federal, state and local returns
› Must pay income tax at regular, federal, state and
local rates
• Non-U.S. corp. must also pay U.S. 30% ―branch
profits‖ tax.
— Limit U.S. tax on FDAP income
› 30% U.S. withholding tax rate, unless U.S. tax treaty
applies
› Claim U.S. treaty benefits where possible
18
Non-U.S. Investors (Cont.)
• Effectively connected income (ECI) is income recognized by a
non-U.S. person that is effectively connected with a business
carried on in the U.S.
— Does fund have a loan origination business?
— ―Securities trading safe harbor‖ protects offshore funds.
• ECI includes share of operating income from a pass-through
entity conducting business in the U.S.
— Non-U.S. partners are deemed engaged in a U.S. business.
— Sale of partnership interest in partnership that generates
ECI; IRS takes the position that gain is ECI.
• FIRPTA income treated like ECI
19
Non-U.S. Investor
0% U.S. tax rate
Fund L.P.
Portfolio
Corp.
Portfolio
LLC
U.S. Source:
- Portfolio interest
- Gain on debt sale
No fund-blocker desired
Portfolio
Corp.
Non-U.S.
Source:
- Gain/income
U.S. Source:
- Gain on stock sale
Non-U.S. Investors (Cont.)
20
Non-U.S. Investor
30% U.S. tax rate (unless treaty applies)
Fund L.P.
Treaty benefits can be claimed.
Non-U.S. pension fund from a treaty country – 0% U.S. tax rate
No fund-blocker desired
Portfolio
Corp.
U.S. Source:
- Dividends
- Non-portfolio interest
Non-U.S. Investors (Cont.)
21
Non-U.S. Investor
35%/39.6% U.S. tax rate
Fund L.P.
Fund-blocker usually desired
Gain on interest sale (ECI)
Portfolio
LLC
U.S. Source:
- Gain on sale of operating assets (ECI)
- Operating income (ECI)
Non-U.S. Investors (Cont.)
22
Non-U.S. Investor
Non-U.S. or U.S.
Feeder Fund
Non-U.S.
Investments
(No ECI)
U.S.
Investments
(No ECI)
U.S.
Corp. Blocker
U. S.
Investments
(ECI)
Non-U.S. Investors: Parallel Fund Structure
23
U.S. Tax-Exempt Investor: Parallel Fund Structure (Cont.)
• Why use non-U.S. feeder?
— Not have to report non-U.S. investments
— Can avoid "controlled foreign corporation" (CFC) treatment
in which substantial investors are non-U.S. investors and
fund owns 50% or more of the non-U.S. portfolio company
• Why use U.S. feeder?
— Easier to claim U.S. treaty benefits; only need to issue
W-8BEN to U.S. feeder
— Will relevant non-U.S. tax treaties "flow-through" a non-
U.S. feeder? See also Sect. 894(c)
24
UBTI And ECI: Not Exactly The Same
• Some investments may generate UBTI but not ECI.
— Debt-financed income (including stock sales, dividends,
and interest)
• Some investments may generate ECI but not UBTI.
— Sale of partnership interests when partnership conducts a
U.S. trade or business
— Investments in U.S. real property holding corporations
(holding 50% or more of gross assets in U.S. real property)
— Loan commitment fees are not UBTI but may be ECI.
• Accordingly, a blocker that avoids all ECI may be too broad for
a U.S. tax-exempt investor, and a blocker that avoids all UBTI
may be too broad for a non-U.S. Investor.
26
Non-U.S. Governmental Investors
• Non-U.S. governments (including their controlled entities) are
generally exempt from U.S. tax under IRC Sect. 892 on income
from investments from securities, except income from the
conduct of a "commercial activity" (CAI).
• If a controlled entity has CAI (either U.S. or non-U.S.), it could
lose its Sect. 892 exemption (but recent relief in proposed
regulations —―inadvertent‖ and ―de minimis‖ standards;
interest in non-controlled LP)
• Investments in operating partnerships generate CAI/
• Non-U.S. government owning U.S. real property or 50% or
more of the stock of a U.S. real property holding corporation
(USRPHC) can generate CAI.
27
Non-U.S. Government
0% U.S. tax rate
Fund L.P.
Portfolio
Corp.
Portfolio
LLC
U.S. Source:
- Interest
- Gain on debt sale
No fund-blocker desired
Portfolio
Corp.
Non-U.S.
Source:
- Gain/income
U.S. Source:
- Gain on stock sale
- Interest
- Dividends
Non-U.S. Governmental Investors (Cont.)
28
Non-U.S. Government
35% U.S. tax rate
Fund L.P.
Fund-blocker desired
Gain on interest sale (CAI)
Portfolio
LLC
U.S. Source:
- Operating income (CAI)
- Gain on sale of operating assets (CAI)
Non-U.S. Governmental Investors (Cont.)
29
Non-U.S. Government
Non-U.S. or U.S.
Feeder Fund
Non-U.S.
Investments
(No CAI)
U.S.
Investments
(No CAI)
U.S.
Corp. Blocker
U. S.
Investments
(CAI)
Non-U.S. Governmental Investors (Cont.)
30
ECI, FDAP And CAI: Not Exactly The Same
• Some investments may generate ECI but not CAI.
— Investments in U.S. real property holding corporations
(USRPHC) (holding 50% or more of gross assets in U.S.
real property)
› Only CAI if non-U.S. government holds 50% of more
of USRPHC
• Some investments may generate CAI but not ECI.
— Sale at gain of non-U.S. corporate entity controlled by
non-U.S. government, which would be a USRPHC if formed
in the U.S., is taxable CAI but would not be ECI.
• Some investments may generate FDAP withholding
for non-U.S. investors but not for non-U.S. governmental
investors.
31
Parallel Fund Structure
• Most tax-efficient fund structure generally is to use separate
parallel funds for each type of investor.
— Administrative costs
• Should each investment have a newly formed, separate
blocker?
— This can avoid U.S. dividend withholding tax on exit
— But, if a single blocker is used for multiple investments,
then income and gain from one investment can be offset by
losses from another.
• Risk of aggregation of different fund entities used in
parallel/AIV structure, due to applying carried interest across
all funds
32
Main Fund
Other Investors
Parallel Fund
Portfolio
LLC
Intermediate
Partnership
GP
Electing U.S. Tax-Exempt, Non-U.S. and Non-U.S.
Governmental Investors
Blocker Corp.
Portfolio Corp.
Carry Carry
Simplified Parallel Fund
33
AIF “A”
Other Investors
AIF “B”
Portfolio
LLC
Intermediate
Partnership
GP
Main Fund
All Investors
Blocker Corp.
Portfolio Corp.
Carry
Carry
Electing U.S. Tax-Exempt, Non-U.S. and Non-U.S.
Governmental Investors
Alternative Investment Fund
34
Other Investors
Portfolio
LLC
GP
Electing U.S. Tax-Exempt, Non-U.S. and Non-U.S. Governmental Investors
Main Fund L.P.
Feeder Fund
(Offshore)
Portfolio Corp.
Feeder Fund: No Flexibility
35
Non-U.S./U.S. Tax-Exempt
Investors
Fund
U.S.
Corp. Blocker
Taxable Investors
Portfolio
LLC
Taxable investor capital
Sensitive investor capital
Subsidiary Blocker Structures
36
Subsidiary Blocker Structures (Cont.)
• Some funds use subsidiary ―blocker‖ corporations for ECI and
UBTI investments.
— Capital of tax-sensitive investors channeled through blockers
› Special allocations at the fund level – substantiality
concerns?
› Risk to non-U.S. investors of U.S. tax return filing
obligation
— GP carry pre- or post-tax? Take out GP carry below the
blocker
• Exit from investment
— Sale of assets and liquidation of blocker
— Sale of blocker shares?
› Allocation of discount?
37
Foreign Investment In Real Property Tax Act (FIRPTA)
• In general, non-U.S. persons generally do not pay U.S. tax on
disposals of stock or securities of U.S. issuers.
• FIRPTA is an exception to this general treatment.
• FIRPTA imposes a tax on gains realized from the disposition of
a U.S. real property interest, which includes direct real estate
holdings and:
— Partnership/flow-throughs that hold U.S. real estate
— Interests in a ―U.S. real property holding corporation‖
(USRPHC)
— Direct or indirect rights to share in proceeds, appreciation
or profit of U.S. real estate
38
FIRPTA (Cont.)
• USRPHCs
— FIRPTA also applies to companies in which at least half of
the fair market value of the company’s trade or business
assets is attributable to U.S. real property assets.
› Five-year lookback
— Carve-out for investments in publicly traded stocks for
which the investor does not hold more than 5% of the class
of stock being traded
— FIRPTA traps
› Distressed companies
› Publicly traded stock de-listed
39
FIRPTA (Cont.)
• Tax imposed at U.S. tax rates
• Collected partially through withholding
• Gains treated as ECI
• Non-U.S. person with FIRPTA gain also incurs a U.S. federal
income tax filing obligation.
• Branch profits tax may also apply.
40
FIRPTA (Cont.)
• U.S. blockers frequently used to hold U.S. real estate assets,
which blocks application of FIRPTA tax and filing obligations
• Note, however, that the U.S. blocker itself may be a
―USRPHC,‖ which would trigger FIRPTA gain if sold (unlikely
exit).
• Trap for unwary: Sect. 1445(e) withholding on non-dividend
distributions from a USRPHC
41
FIRPTA (Cont.)
Non-U.S. Fund
Non-U.S.
Investments
(No FIRPTA)
U.S.
Non-Real
Estate
Investments
(No FIRPTA)
U.S.
Corp. Blocker
U. S. Real
Estate
Investments
42
FIRPTA (Cont.)
Non-U.S. Fund
Non-U.S.
Investments
(No FIRPTA)
U.S.
Non-Real
Estate
Investments
(No FIRPTA)
U.S.
Corp. Blocker
U. S. Real
Estate
Investments
Offshore Blocker
Loan
Financing the U.S. blocker: Potential
complications (withholding tax,
earnings-stripping, AHYDO, Sect. 267)
Interest
44
U.S. Tax-Exempt Investors: 514(c)(9)
• Certain tax-exempt investors (―qualified organizations‖ or
QOs) are eligible for an exception to debt-financed UBTI in
certain circumstances.
— Most common QOs are pension funds and educational
organizations
• Provided certain requirements are met, Sect. 514(c)(9)
provides that debt incurred to acquire or improve ―real
property‖ won’t give rise to UBTI for QOs.
— Definition of ―real property‖ unclear
• Compliance with 514(c)(9) poses challenges, particularly for
funds.
45
U.S. Tax-Exempt Investors: 514(c)(9), Cont.
• Sect. 514(c)(9): General requirements for debt-financed
acquisition of real estate
— Purchase agreements
— Borrowing agreements
› General rule
› Eligible lenders
› Multi-property loans
— Leasing agreements
46
U.S. Tax-Exempt Investors: 514(c)(9), Cont.
• Requirements for a 514(c)(9)-compliant fund
— Fund must comply with general requirements,
— AND
› All of the partners must be QOs; or
› Each allocation to a QO partner must be a ―qualified
allocation‖, or
› The partnership’s allocation provisions for tax
purposes:
• Satisfy the ―fractions rule,‖ and
• Have ―substantial economic effect.‖
• Potential legal and economic consequences of complying with
the fractions rule and the substantial economic effect rules
47
Non-U.S. Funds With U.S. Investments
• Same general structural considerations as above
— Non-U.S. Investors will be focused on ECI.
— If fund holds real estate assets, FIRPTA may also apply.
— Special structuring requirements for non-U.S. investors
— Treaty planning and additional documentation
requirements
— Non-U.S. corporation in structure (including offshore
blocker entity)? Potential branch profits tax
• U.S. source income = FATCA implications for fund and
its investors
48
Non-U.S. Funds With U.S. Investors: Investing Overseas
• Some considerations:
— PFIC/CFC issues (want non-U.S. fund to be pass-through)
— Tax filing obligations in non-U.S. jurisdictions
— Non-U.S. withholding tax
— Treaty analysis
— U.S. tax-exempt investors will still be concerned about
UBTI, and may wish to invest through a blocker if there
will be debt-financing or investments in operating
pass-throughs.
— Certain countries (India, China) have begun imposing tax
on indirect gains, which has led to an increase in the use
of ―filing blockers.‖
49
U.S. Funds Investing Overseas
• Same general structural considerations as have been
illustrated, with some additions
— UBTI on debt-financed investments/pass-through income
— Treaty benefits
— PFIC/CFC
— Foreign tax credit flow-through
— Commercial activities income still a concern for controlled
commercial entities (but, 892 benefits generally
irrelevant)
• Some of these are incompatible
— E.g., flow-through structures for taxable investors, but
UBTI issues for tax-exempts
50
U.S. Taxable/U.S.
Government Investors
Fund
(taxed as
partnership)
Non-U.S./U.S.
Tax-Exempt Investors
Non-U.S.
Investments
U.S. Funds Investing Overseas: Parallel Funds
Fund
(taxed as corporation)
51
U.S. Taxable/U.S.
Government Investors
Master Fund
(taxed as
partnership)
Non-U.S./U.S.
Tax-Exempt Investors
Non-U.S.
Investments
U.S. Funds Investing Overseas: Master/Feeder
Feeder Fund
(taxed as corporation)
52
U.S. Funds Investing Overseas (Cont.)
• PFIC/CFC issues for U.S. taxable investors
— Anti-deferral regimes
• PFIC - ≥ 50% passive assets or ≥ 75% passive income
— Look-through 25% owned subsidiaries
• Recharacterization of distributions, gain as ordinary income +
penalty interest charge
— No chance for qualified dividend income
53
U.S. Funds Investing Overseas (Cont.)
• Make ―check the box election‖ to treat as a pass-through
— Can be difficult to persuade local owners to make U.S. tax
election
• QEF election – modified look-through
— Losses and FTCs generally don’t flow through.
— Often, covenants to make election and obtain information
to make U.S. tax filings
— Can be burdensome for funds to gather required
information, including from 25%-owned subsidiaries
54
U.S. Funds Investing Overseas (Cont.)
• CFC – more than 50% of a foreign corporation owned by ―U.S.
shareholders‖
— U.S. persons with 10% or more voting power
› U.S. partnership = 1 U.S. person
— Structure fund and management entities as
Cayman vehicles, to apply 10% voting power test on
look-through basis
— Or, elect to treat foreign portfolio corporation as a pass-
through
55
Luxembourg Investment: Structure Into Europe
• Luxco set up with
minimal capital.
• PECs yield 8% per year.
• CPECs can be redeemed for
FMV of shares into which
CPECs are convertible.
• PECs and CPECs
• Debt, for Luxemburg
tax purposes
• Equity for U.S. tax
purposes (99/1 debt
-equity ratio)
German Portfolio Company
U.S. Main Fund LP
Luxco
Cash
CTB to be Taxed as a Disregarded Entity
U.S. Investors
Cash
PECs CPECs
German Portfolio Company
56
Luxembourg Investment: Structure Into Europe (Cont.)
• Little or no Lux
withholding tax
• Luxco benefits from EU
tax treaties.
• Luxco disregarded, for
U.S. tax purposes
• Some U.S. tax issues: Debt-
equity (including debt
maturity); Sect. 305 German Portfolio Company
U.S. Fund LP
Luxco
Dividends Capital Gains
CTB to be Taxed as a Disregarded Entity
U.S. Investors
Dividends Capital Gains
57
Structuring Fund Manager Entities
• Funds generally have separate general partners and
investment managers
— GP (or special LP owned by principals) receives carried
interest
› Generally special purpose entity for each fund
— Investment manager receives management fees
› Generally single management company across all funds
› Employees, contracts
› Franchise value
58
Structuring Fund Manager Entities (Cont.)
• Reasons for separation?
— Ensure proper tax treatment of separate income streams
› Carried interest – capital gains
› Management fees – ordinary income
— State/local tax reasons
› NYC unincorporated business tax
— Often separate ownership stakes
› Carried interest more widely distributed than
ownership of management company
› Deal-by-deal; fund-by-fund
59
Limited Partners
Fund
General
Partner
Investments
Management
Company
Principals
Carried
interest
Management Fees
Structuring Fund Manager Entities (Cont.)
60
Structuring Fund Manager Entities (Cont.)
• Considerations?
— Management company – choice of entity
› S corp.: Limited flexibility; state tax issues; perhaps
avoid self-employment taxes on dividends
› LLC: Flexibility; self-employment taxes on distributive
share of fee income?
› LP: Flexibility; requires separate GP entity; avoid self-
employment taxes on distributive share of fee income
• Statutory exception from SECA for distributive
share of a limited partner
• Impact of Renkemeyer?
61
Structuring Fund Manager Entities (Cont.)
• Considerations?
— General partner – choice of entity
› Less of an issue than management company as all
distributions should avoid self-employment taxes
› Use of LP arguably avoids new Medicare tax on NII
— General partner – issuances of interests; vesting
› Issuance of profits interest; no interest in current value
› 83(b) election
› Catch-up allocations
› Vesting/forfeiture/allocations to other partners
62
Foreign Account Tax Compliance Act (FATCA)
• Foreign Account Tax Compliance Act, or FATCA, is generally
effective as of Jan. 28, 2013.
• Intended to ensure that U.S. persons holding assets through
offshore entities and accounts pay U.S. taxes on related
income
• Compels non-U.S. financial entities to either (1) document and
report information about their U.S. accountholders/investors
or (2) face a withholding tax of 30% on most U.S. source gross
income or gross proceeds
63
FATCA (Cont.)
• FATCA does not replace the current withholding and reporting
regime for non-U.S. persons.
— FATCA is intended to be coordinated with the current
regime in order to prevent double-withholding,
• While FATCA is generally effective as of Jan. 28, 2013, a
phased implementation timeline applies.
• FATCA has a global reach.
— It imposes new documentation, withholding and reporting
requirements not only on non-U.S. entities, but also on
certain U.S. financial entities.
64
FATCA (Cont.)
• Categories under regulations
• U.S. withholding agents
— U.S. hedge and private equity funds may be required to
act as withholding agents under FATCA.
• Foreign financial institutions (FFIs)
— Non-U.S. funds likely FFIs
— Multiple categories: Participating FFI, deemed compliant
FFI and non-participating FFI
• Non-financial foreign entities (NFFEs)
• Exempt beneficial owners
— Generally not subject to FATCA withholding as long as
necessary documentation is provided to withholding agent
65
FATCA (Cont.)
• Withholding under FATCA
• FFIs: 30% of any ―withholdable payment‖ paid to non-
participating FFIs and recalcitrant account holders
— Tiered implementation of withholdable payments
› 2014: U.S.-source FDAP income
› 2017: U.S.-source gross proceeds on sale of stock or
securities
› 2017: ―Foreign pass-through payments‖
• Other withholding agents: Non-FFI withholding agents must
withhold 30% of any withholdable payment paid to non-
participating FFIs and passive NFFEs that fail to report on their
significant U.S. owners.
• ―Withholding agent‖ broadly construed under FATCA
66
FATCA (Cont.)
• Two-pronged approach to FATCA compliance
— IRS regulations
— Inter-governmental agreements (IGAs)
• Important guidance to come
• FFI model agreement, registration portal, tax certificates,
FATCA reporting form, withholding reports
• Coordinating guidance, plus guidance on ―foreign
pass-through payments‖
• IGAs
67
FATCA (Cont.)
U.S. funds: U.S. withholding agents
• Withholding by U.S. fund: If an investor fails to provide
necessary information to U.S. fund, then 30% FATCA
withholding may be deducted from investor’s share of
withholdable payments.
• Tax withheld under FATCA is paid by U.S. fund to IRS
68
FATCA (Cont.)
• Non-U.S. funds (and non-US blockers): Are they FFIs?
— Definition of FFI in the final regulations includes (among
others) foreign ―investment entities‖
› Broad definition of ―investment entities‖
— Most non-U.S. funds will be FFIs, with the exception of
certain real estate funds.
— No credit or refund of 30% withholding tax — if fund or
blocker is treated as corporation for U.S. tax purposes and
treaty does not change result
• Does every FFI need to comply with FATCA?
— Material U.S.-source income?
— Legal and practical considerations
— Various classifications for compliant FFIs
69
FATCA (Cont.)
• Special considerations for funds organized as partnerships for
U.S. tax purposes
— FATCA withholding applies not just to withholdable
payments, but also to allocations of income.
— Timing of FATCA withholding on a partnership’s receipt of
gross proceeds is unclear.
— Regulations don’t address how the sale of a partnership
interest will be treated under FATCA.
70
FATCA (Cont.)
• FATCA and fund documentation
— Fund organizational and operational documents
› Operating agreements
› Investor subscription documents and account
applications
› Fund offering documents
› Side letters
— Service provider agreements (transfer agent, custodian,
administrator, withholding agent, adviser, etc.)
— Credit agreements/ISDAs/repo & securities
lending agreements
72
New 3.8% Medicare Contribution Tax
• Imposed on U.S. individuals taxpayers, and estates
and trusts
• Not imposed on corporations or pass-through entities — but
―net investment income‖ passes through to U.S. individuals,
and estates and trusts
• Not imposed on non-resident individuals
• Effective date: Jan. 1, 2013
73
New 3.8% Medicare Contribution Tax (Cont.)
• The Medicare contribution tax is 3.8% on the lesser of:
— ―Net investment income,‖ or
— The excess of modified adjusted gross income (MAGI) over
the applicable ―threshold amount.‖
• The threshold amounts are:
— Married individuals filing jointly - $250,000
— Married individuals filing separately - $125,000
— Qualifying widow(er) with dependent child - $250,000
— Trust and estates - $11,950 for 2013
74
New 3.8% Medicare Contribution Tax (Cont.)
• Three buckets of net investment income:
— Gross income from interest, dividends, annuities, royalties
and rents
— Gross income derived from a business constituting a
passive activity to the taxpayer under IRC Sect. 469 (and
gross income derived from a trade or business comprised
of trading in financial instruments or commodities)
— Net gains from the disposition of property, such as the sale
of stocks, partnership interests, bonds and real estate
• Under proposed regs, the first two buckets can be negative
and offset other buckets, but the third
bucket cannot.
75
New 3.8% Medicare Contribution Tax (Cont.)
Other
Investors
Fund L.P.
Portfolio
Corp.
Portfolio
LLC
- Gain on interest sale
- Gain on asset sale
- Interest
- Gain on debt sale
U.S. Taxable Individual
(and certain Trust and
Estate) Investors
3.8% nii
- Gain on stock sale
- Dividends
- Interest
- Gain on debt sale
76
New 3.8% Medicare Tax
• Impact on fund managers and planning
— Carried interest
› Passive investment income subject to new tax
› Additional 3.8% tax on top of 20% LTCG (or 39.6% for
interest, STCG and nonqualified dividend income)
— Incentive compensation in hedge fund?
› If paid as fee, may be subject to 3.8% self-employment
tax unless qualifying for LP exception or perhaps
flowing through as S Corp. dividends (but, see next
slide)
› If paid as allocation, subject to new Medicare tax
• Even if fund is a ―trader‖ hedge fund
77
New 3.8% Medicare Tax (Cont.)
• Impact on fund managers and planning (Cont.)
— Carried interest
› Passive investment income subject to new tax
› Additional 3.8% tax on top of 20% LTCG (or 39.6% for
interest, STCG and nonqualified dividend income)
— Incentive compensation in hedge fund?
› If paid as fee, may be subject to 3.8% self-employment
tax (but see next slide)
› If paid as allocation, subject to new Medicare tax
• Even if fund is a ―trader‖ hedge fund
78
New 3.8% Medicare Tax (Cont.)
• Planning opportunities
— More incentive for deferral transactions
— 1031s – gain not picked up under NII rules until recognized
— Restructure carried interests as incentive fees
› If majority of income is already ordinary (STCG,
interest, rent, royalties)
› If carried interest is taxed as OI, further incentive to
convert fees (even if self-employment taxes would
apply as the new Medicare tax is non-deductible
against recipient’s income)
› Potential bad result for taxable investors in fund, due
to 212 limitation on deductibility of incentive fee
79
New 3.8% Medicare Tax (Cont.)
• Planning opportunities
— Convert LLCs to S corps or LPs
› Trade or business income paid as dividends by an S corp
to its shareholders that ―materially participate‖ is not
subject to the tax
› Member in LLC on same facts arguably subject to self-
employment taxes on same income
› Meaning of ―materially participating‖ going to be
very important.
80
New 3.8% Medicare Tax (Cont.)
• Planning opportunities
— Using corporations
› Corporations pay low tax rates on income up to
$50,000.
› Incentive fees up to such amounts could be paid to a
corporation owned by fund manager.
› Dividend out of corporation subject to 20% top federal
tax + 3.8% NII tax
• Effective federal tax rate of 35.8% as compared
with 43.4%
› State and local taxes to be considered
• Potential double-state tax
82
What Is A Carried Interest?
• Private equity and hedge fund managers structure funds with a
2 and 20 compensation structure.
— Fixed percentage of gains over losses
› Typically 20%
— Often, most income/gain allocated to the 20% carry is
taxed at favorable capital gain rates.
— New legislation would apply to the 20% carry.
83
Carried Interest Tax Proposals
• In President Obama’s 2014 budget
• Proposed legislation to add new IRC Sect. 710
• Proposal would tax as ordinary income a fund manager’s share
of income from an ―investment services partnership interest‖
in an investment partnership.
• Or a portion, i.e, 50% if the investment is held for five
years or more
• Applies to old and new partnerships (no grandfathering)
84
Carried Interest Tax Proposals (Cont.)
• Applies to persons (or related persons) who:
— Directly or indirectly provide any of the following services
with respect to assets held (directly or indirectly) by the
partnership:
› Advising on investing in, purchasing or selling a
―specified asset‖
› Managing, acquiring or disposing of a specified asset
› Arranging financing with respect to a specified asset, or
› Any activity in support of any of the previously
described activities
85
Definition Of Specified Assets
• The term ―specified asset‖ means:
— Securities (Sect. 475(c)(2))
— Real estate held for rental or investment
— Partnership interests
— Commodities (Sect. 475(e)(2))
— Options or derivative contracts with respect to
these assets
86
Some Partnerships Covered Include:
• Private equity funds
• Hedge funds
• Venture capital funds
• LBO funds
• Real estate funds and partnerships
• Marketable securities funds and partnerships
• Oil and gas funds and partnerships ???
87
Some Partnerships Not Covered
• Partnership operates an active business.
— E.g., profits interests are issued to service providers by an
LLC that operates a manufacturing business.
• Obama budget: Proposal is not intended to affect qualification
of a REIT owning a carried interest in a real estate
partnership.
88
Tax Acceleration
• Tax on carried interest is accelerated if:
— Carried interest holder transfers carried interest (even
transfers to family partnerships or REIT operating
partnerships).
— Carried interest holder receives property distributions
from the partnership.
— Partnership merges into another partnership.
• In limited cases, the carried Interest holder can elect to avoid
the gain if the carried Interest taint is carried over to the new
partnership (e.g., a partnership merger, division or
termination under Sect. 708(b)(1)(B)).
89
Other Consequences
• When an individual is engaged in the trade or business of
providing specified services, income taken into account as
ordinary income would become subject to self-employment
tax .
— This applies regardless of whether the partner is a limited
partner and regardless of whether the underlying
partnership income would be exempt from self-
employment tax (e.g., dividends, interest, capital gain).
• Net income and net loss generally is treated as ordinary.
— The idea is that carried interest is compensation income
and should not receive tax losses like an investment.
90
Qualified Capital Exception
• Carried Interest holder can exclude ―qualified capital‖ that is
acquired for invested capital and is intended to be the ―side-
by-side‖ capital such holder puts in with the investors.
• To apply the rule, there must be an unrelated investor who
contributes cash in exchange for a capital interest on the
same basis as the carried interest holder.
• One exception: Carried interest rule does not apply if all
allocations, distributions and capital contributions have been
pro rata.
91
Qualified Capital Exception: Loans
• Carried interest holder will not be treated as having a
qualified capital interest, to the extent that contributed
capital is attributable to a loan made or guaranteed, directly
or indirectly, by any other partner or the partnership (or a
person related to such partner or the partnership).
• Other loans to carried interest holder are not disqualified.
91
92
Sale Of Interests In Fund Manager Entity
• Obama budget: ―Committed to working with Congress to
develop mechanisms to assure the proper amount of income
recharacterization where the business has goodwill or other
assets unrelated‖ to services
B A
GP
Goodwill
C
LLC
20%
GP 20%
Investors Investors LP LP
A, B and C Sell LLC Interests
XYZ Fund Managers
93
Fund Documents: Key Tax Provisions (Cont.)
• Offering memorandum
• Limited partnership agreement
• Subscription documents
• Side letters
• Tax opinions
94
Fund Documents: Key Tax Provisions (Cont.)
• Private placement memorandum
• Summary of key tax provisions
• General overview of tax treatment
95
Fund Documents: Key Tax Provisions (Cont.)
• Limited partnership agreement (operating agreement)
Examples of key tax-related provisions:
• ECI and UBTI covenants
• GP clawback
• Management fee waivers
• Management fee offsets
• Withholding
• Allocations
• Tax distributions
• Non-U.S. taxes and returns
• Tax information reporting
• Tax matters partner
96
Fund Documents: Key Tax Provisions (Cont.)
• Subscription documents
• Investor tax
representations
• PTP representations
• Transfer restrictions
• Electronic K-1 consent
• Side letters
• PFIC/QEF election and
CFCs
• Foundation issues
• ERISA issues
• Tax reporting, and
much more
• Tax opinions
• Partnership tax opinion
• 514(c)(9) opinion
• Prohibited transactions
• 892 non-U.S.
governmental investors
• Non-U.S. investor-specific
issues