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Presenting a live 110‐minute teleconference with interactive Q&A
Tax Considerations in StructuringPrivate Investment FundsBalancing the Competing Interests of Fund Investors When Structuring Investment Funds
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
THURSDAY, MAY 2, 2013
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
Christian M McBurney Partner Nixon Peabody Washington D CChristian M. McBurney, Partner, Nixon Peabody, Washington, D.C.
Jeremy Naylor, Partner, White & Case, New York
Elizabeth Norman, Attorney, Goulston & Storrs, Boston
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May 2, 2013
Tax Considerations in Structurinin StructuringPrivate Equity Fundsq y
Balancing the Competing Interests of Fund Investors Balancing the Competing Interests of Fund Investors When Structuring Investment Funds
Christian McBurney, Nixon Peabody LLP, Washington, D.C. officeJeremy Naylor, White & Case LLP, New York officeEli b th N G l t & St B t ffi
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Elizabeth Norman, Goulston & Storrs, Boston office
Fund Characteristics
• Types of Funds
P i E i— Private Equity
— Venture Capital
Hedge— Hedge
— Distressed Debt
— Real Estate
— LBO
— Fund of funds
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Fund Characteristics (cont’d)
• Other important fund characteristics
U S b d b d id U S ?— 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?— Is fund an investor or conducting a trade or business?
› Investor: possible disallowance of fund manager fees for U.S. investors under Section 212
› Trade or business: fees deductible under Section 162; but UBTI, ECI and CAI concerns
7
Type of Fund Investors
• U.S. Taxable Individual or Corporation
S S d l G• U.S. State and Local Government
— Pension Funds
U S Tax Exempt Investors• U.S. Tax-Exempt Investors
— Corporate Pension Plans
— University and College Endowment FundsUniversity and College Endowment Funds
— Private Foundations
— Charity Endowment Fundsy
— Individual Retirement Accounts (IRAs)
8
Type of Fund Investors (cont’d)
• Non-U.S. Investors
I di id l— Individuals
— Non-U.S. entities treated as corporations for U.S. income tax purposesp p
— Pension Funds (not taxed in home country)
• Non-U.S. Government Investors (Section 892)
— Sovereign Wealth Funds
— Pension Funds
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U. S. Taxable Individuals and Corporations
U.S.Taxable
U.S. Taxable Individual
C Corp.
35% c.g. and o.i.
- 20% c.g.- 39.6% o.i.- 3.8% nii
Fund L.P.- Gain on interest sale- Gain on asset sale- Interest
- Gain on stock sale- Dividends- Interest
PortfolioCorp
PortfolioLLC
- Gain on debt sale- Gain on debt sale
Corp.
N F d Bl k d i d
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No Fund Blocker desiredUnblocked investor can also claim tax credits and treaty benefits
U. S. State and Local Government
U. S. State and L l G tLocal Government
0% U.S. tax rate
Fund L.P.
Gain/income Gain/income
PortfolioCorp
PortfolioLLC
Gain/income Gain/income
Corp.
N F d Bl k d i d
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No Fund Blocker desiredUnblocked can also claim treaty benefits
U. S. Tax‐Exempt Investors
U.S. Tax-Exempt
0% U.S. tax rate
Fund L.P. - Gain on interest sale (c.g.)- Interest- Gain on debt sale (c.g.)
- Gain on stock sale- Dividends- Interest- Gain on debt sale
PortfolioCorp.
PortfolioLLC
- Gain on debt sale
p
N F d Bl k d i d
- Gain on sale of noninventory property
12
No Fund Blocker desiredUnblocked investor can also claim treaty benefits
U. S. Tax‐Exempt Investors (cont’d)
U.S. Tax-Exempt
35% U.S. tax rate
Fund L.P.Fund L.P.
Fees earned by L.P.
PortfolioLLC
- Operating income
F d Bl k ft d i d
p g- Gain on sale of inventory
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Fund Blocker often desiredUnrelated business taxable income (UBTI)
U. S. Tax‐Exempt Investors (cont’d)
U.S. Tax-Exempt
35% U.S. tax rate
Fund L.P. Debt-Financed:- Gain on interest sale- Interest- Gain on debt sale
Debt-Financed: - Gain on stock sale- Dividends- Interest
PortfolioCorp.
PortfolioLLC
- Gain on debt sale
Debt-Financed:- Gain on sale Corp.
D bt fi d i i UBTI
Gain on sale of any property
- Operating Income
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Debt-financed income is UBTIFund Blocker often desired
U. S. Tax‐Exempt Investors (cont’d)Parallel Fund Structure
U.S. Tax-Exempt
Parallel Fund Structure
p
Non-U.S. or U.S.Feeder Fund
Non-U.S.Investments(N UBTI)
U.S.Investments(N UBTI)
U.S.Corp. Blocker
(No UBTI) (No UBTI)
Investments(UBTI)
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(UBTI)
Non‐U.S. Investors
• U.S. tax goals
A id h i fil U S i — Avoid having to file a U.S. income tax return
— Limit U.S. tax on “Effectively Connected Income” (ECI).
If 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
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Non‐U.S. Investors (cont’d)
• Effectively Connected Income (ECI) is income recognized by a non U S person that is effectively connected with a 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?g
— “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
S l f hi i i hi h — Sale of partnership interest in partnership that generates ECI: IRS takes the position that gain is ECI
• FIRPTA income treated like ECI
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FIRPTA income treated like ECI
Non‐U. S. Investors (cont’d)
Non-U.S. Investor
0% U.S. tax rate
d U S SFund L.P. U.S. Source:- Portfolio interest- Gain on debt sale
Non-U.S.
U.S. Source:- Gain on stock sale
PortfolioCorp
PortfolioLLCPortfolio
Source:- Gain/income
Corp. PortfolioCorp.
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No Fund Blocker desired
Non‐U. S. Investors (cont’d)
Non-U.S. Investor
30% U.S. tax rate (unless treaty applies)
Fund L.P.Fund L.P.
U.S. Source:- Dividends
PortfolioCorp
- Non-portfolio interest
Treaty benefits can be claimed
Corp.
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yNon-U.S. pension fund from a treaty country – 0% U.S. tax rate
No Fund Blocker desired
Non‐U. S. Investors (cont’d)
Non-U.S. Investor
35%/39.6% U.S. tax rate
Fund L PFund L.P.
Gain on interest sale (ECI)
PortfolioLLC
U.S. Source:- Gain on sale of operating assests (ECI)
- Operating income (ECI)
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Fund Blocker usually desired
Non‐U. S. Investors (cont’d)Parallel Fund Structure
Non-U.S. Investor
Parallel Fund Structure
Non-U.S. or U.S.Feeder Fund
Non-U.S.Investments
(N ECI)
U.S.Investments
(N ECI)
U.S.Corp. Blocker
(No ECI) (No ECI)
U. S. Investments
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Investments(ECI)
U.S. Tax‐Exempt Investor (cont’d)Parallel Fund Structure
• Why use non-U.S. Feeder?
N h U S i— Not have to report non-U.S. investments
— Can avoid "controlled foreign corporation" (CFC) treatment where substantial investors are non-U.S. investors and fund owns 50% or more of the non-U.S. portfolio company
• 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-— Will relevant non-U.S. tax treaties flow-through a non-U.S. Feeder? See also Section 894(c).
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UBTI and ECI—Not Exactly the Same
• Some investments may generate UBTI, but not ECI
D b fi d i (i l di k l di id d — Debt-financed income (including stock sales, dividends, and interest)
• Some investments may generate ECI, but not UBTISome investments may generate ECI, but not UBTI
— Sale of partnership interests where partnership conducts a U.S. trade or business
— Investments in U.S. real property holding corporations (holding 50% or more of gross assets in U.S. real property)
— Loan commitment fees not UBTI but may be ECI— Loan commitment fees not UBTI, but may be ECI
• Accordingly, a blocker that avoids all ECI may be too broad for a U.S. tax-exempt investor; and a blocker that
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avoids all UBTI may be too broad for a non-U.S. Investor
Non‐U.S. Governmental Investors
• Non-U.S. Governments (including their controlled entities) are generally exempt from U S tax under IRC entities) are generally exempt from U.S. tax under IRC Section 892 on income from investments from securities, except income from the conduct of a "commercial activity" (CAI)
• If a controlled entity has CAI (either US or non-US), it could lose its Section 892 exemption (but recent relief in could lose its Section 892 exemption (but recent relief in proposed regulations—“inadvertent” and “de minimis” standards; interest in non-controlled LP)
• Investments in operating partnerships generate CAI
• Non-US Government owning U.S. real property or 50% or
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more of the stock of a United States Real Property Holding Corporation (USRPHC) can generate CAI
Non‐U. S. Governmental Investors (cont’d)
Non-U.S. Government
0% U.S. tax rate
dFund L.P. U.S. Source:- Interest- Gain on debt sale
Non-U.S.
U.S. Source:- Gain on stock sale- Interest- Dividends
PortfolioCorp
PortfolioLLCPortfolio
Source:- Gain/income
Corp. PortfolioCorp.
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No Fund Blocker desired
Non‐U. S. Governmental Investors (cont’d)
Non-U.S. Government
35% U.S. tax rate
Fund L PFund L.P.
Gain on interest sale (CAI)
PortfolioLLC
U.S. Source:- Operating income (CAI)- Gain on sale of operating assets (CAI)
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Fund Blocker desired
Non‐U. S. Governmental Investors (cont’d)
Non-U.S. Government
Non-U.S. or U.S.Feeder Fund
Non-U.S.Investments
(N CAI)
U.S.Investments
(N CAI)
U.S.Corp. Blocker
(No CAI) (No CAI)
U. S. Investments
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Investments(CAI)
ECI, FDAP and CAI—Not Exactly the Same
• Some investments may generate ECI but not CAI
I i U S l h ldi i — 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 ECISome 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
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for non U.S. Investors, but not for Non U.S. Governmental Investors
Parallel Fund Structure
• Most tax efficient fund structure generally is to use separate parallel funds for each type of investorseparate parallel funds for each type of investor
— Administrative costs
• Should each investment have a newly-formed Should each investment have a newly formed separate blocker?
— This can avoid U.S. dividend withholding tax on exit
— But if a single blocker is used for multiple investments, income and gain from one investment can be offset by losses from anotherlosses from another
• Risk of aggregation of different fund entities used in parallel/AIV structure due to applying carried interest across ll f d
29
all funds
Simplified Parallel Fund
Other Investors
Electing U.S. Tax‐Exempt, Non‐U.S. and Non‐U.S. Governmental Investors
Parallel Fund
GP
Blocker Corp.Carry Carry
Main Fund IntermediatePartnership
PortfolioLLC
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Portfolio Corp.
Alternative Investment Fund
Other Investors
All Investors
Electing U.S. Tax‐Exempt, Non‐U.S. and Non‐U.S. Governmental Investors
AIF “B”
GPCarry
AIF “A”
AIF B
Main Fund Blocker Corp.
IntermediatePartnership
Carry
PortfolioLLC
Portfolio Corp.
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Feeder Fund – No Flexibility
Other
Electing U.S. Tax‐Exempt, Non‐U.S. and Non‐U.S. Governmental Investors
Other Investors
GPFeeder Fund(Offshore)
Main Fund L.P.
PortfolioLLC
Portfolio Corp.LLC
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Qualified Small Business (“QSB”) Stock
U.S. Individuals U.S. Tax-Exempt Investors
Non-U.S. Investors
Fund L.P.
QSB St k
US PortfolioCorp.
QSB Stock
• Section 1202: 0% tax rate for noncorporate taxpayers on sale of QSB stock held for more than five years
• Some businesses excluded• Corporation’s total gross assets may not exceed $50m
at issuance; Fund must acquire stock at original issue
33
• Exclusion limited to greater of $10m or 10x aggregate tax basis of QSB stock
Subsidiary Blocker Structures
Non-U.S./U.S. Tax-ExemptInvestorsTaxable Investors Investors
Fund Sensitiveinvestor capital
U.S.Corp. Blocker
Taxable investor capital
PortfolioLLC
p
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Subsidiary Blocker Structures
• Some funds use subsidiary “blocker” corporations for ECI and UBTI investmentsand 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 — 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?
35
› Allocation of discount?
Other Types of US Funds
• Hedge Funds
d b• Distressed Debt
• Real Estate (including oil and gas)
36
Other Types of US Funds – Hedge Funds
• Onshore/offshore structure
T i ll C “ f d” d hi— Typically Cayman “master fund” – taxed as a partnership
— Onshore feeder – Delaware LP or LLC
› Taxable investors invest here› Taxable investors invest here
› Simplifies reporting for U.S. taxable investors
— Offshore feeder – Cayman company (or LP that box checks t b t t d )to be treated as a corp)
› Tax-Exempts and Non-U.S. investors invest here
› Offshore feeder may make sense for taxable investors given y gSection 212 limitations on deductibility of management and other fees and NII Medicare tax
37
Other Types of US Funds – Hedge Funds (cont’d)
• Issues for taxable investors
I h f d “ d ” f ?— Is the fund a “trader” for tax purposes?
› deductibility of management fees and expenses
— GP’s performance compensation structured as a G s pe o a ce co pe sat o st uctu ed as a partnership allocation of profits
› If paid as fee and fund is not trader – Section 212 deductibility limitationsdeductibility limitations
— Management fees and other expenses should be paid at the master fund level
› Risk that under logic of Rev. Rul. 2008-39, if paid at the feeder level may not be deductible.
— Investment in offshore feeder may offer tax advantages
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y g
› Deferral if 3.8% Medicare tax on NII until distribution
› Effective deduction of management fees in non-trader fund
Other Types of US Funds – Hedge Funds (cont’d)
• Issues for Non-U.S./U.S. Tax-Exempt investors
T di i k d i i f h b f f d— Trading in stocks and securities safe harbor for feeder
— Offshore feeder is effective “blocker” for UBTI and ECI
› But corporate income tax and branch profits tax on any ECI› But corporate income tax and branch profits tax on any ECI
— Non-U.S. government investors cannot access 892 benefits through offshore feeder
— Allocation of FATCA risk
— Stop Tax Haven Abuse Act?
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Other Types of US Funds – Hedge Funds (cont’d)
• Issues for Investment Manager
T f i i i— Treatment of incentive compensation
› Allocation allows for potential for capital gains
› Generally not a large portion of hedge fund’s revenuesy g p g
› Not available for funds that mark-to-market
— Incentive fees
S i 457A/409A i if id b ff h f d› Section 457A/409A issues if paid by offshore feeder
› Potentially avoid self-employment tax and new 3.8% Medicare tax on NII
40
Other Types of US Funds – Distressed Debt
• Typically structured similar to hedge funds with same general issuesgeneral issues
• Distressed debt-specific issues
— Portfolio Interesto t ol o te est
— Market Discount; OID
— Recovery of basis treatment for deeply discounted debt?
— Loan origination activities
› Workouts/loan modifications resulting in reissuances/deemed new originationsg
› “Season and Sell” – other strategies to avoid being considered in loan origination/active financing business
› Impact of 2009 GLAM (Chief Counsel Mem AM2009010)
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› Impact of 2009 GLAM (Chief Counsel Mem. AM2009010)
Foreign Investment in Real Property Tax Act (FIRPTA)
• In general, non-US persons generally do not pay U.S. tax on disposals of stock or securities of U S issuers 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 • FIRPTA imposes a tax on gains realized from the disposition of a U.S. real property interest, which includes direct real estate holdings and:
— Partnership/flow-throughs that hold U.S. real estate
— Interests in a “U.S. real property holding corporation” (USRPHCs)(USRPHCs)
— Direct or indirect rights to share in proceeds, appreciation or profit of U.S. real estate
42
FIRPTA (cont’d)
• USRPHCs
FIRPTA l li i h l h lf f — FIRPTA also applies to companies where at least half of the fair market value of the company’s trade or business assets is attributable to U.S. real property assets
› Five-year lookback
— Carve-out for investments in publicly traded stocks where the investor does not hold more than 5% of the class of the investor does not hold more than 5% of the class of stock being traded
— FIRPTA Traps
› Distressed companies
› Publicly traded stock de-listed
43
FIRPTA (cont’d)
• Tax imposed at U.S. tax rates
C ll d ll h h hh ld• Collected partially through withholding
• Gains treated as ECI
N U S ith FIRPTA i l i U S • Non-U.S. person with FIRPTA gain also incurs a U.S. federal income tax filing obligation
• Branch profits tax may also applyBranch profits tax may also apply
44
FIRPTA (cont’d)
• U.S. blockers frequently used to hold U.S. real estate assets which blocks application of FIRPTA tax estate assets, which blocks application of FIRPTA tax and filing obligations
• Note, however, that the U.S. blocker itself may be , , ya “USRPHC” which would trigger FIRPTA gain if sold (unlikely exit)
• Trap for unwary: Section 1445(e) withholding on non-dividend distributions from a USRPHC
45
FIRPTA (cont’d)
Non-U.S. Fund
Non-U.S.Investments(No FIRPTA)
U.S.Non-Real Estate
U.S.Corp. Blocker
Investments
(No FIRPTA) U. S. Real Estate
I t t
46
Investments
FIRPTA (cont’d)
Financing the U.S. Blocker: Potential
Non-U.S. Fund
Complications (Withholding Tax, Earnings Stripping, AHYDO, Section 267)
Offshore Blocker
Non-U.S.Investments(No FIRPTA)
U.S.Non-Real Estate
U.S.Corp. Blocker
Loan
Interest(No FIRPTA) Estate
Investments
(No FIRPTA) U. S. Real Estate
47
Investments
U. S. Tax‐Exempt Investors: 514(c)(9)
• Certain tax-exempt investors (“Qualified Organizations”, or QOs) are eligible for an exception to debt financed or QOs) are eligible for an exception to debt-financed UBTI in certain circumstances
— Most common QOs are pension funds and educational porganizations
• Provided certain requirements are met, Section 514( )(9) id th t d bt i d t i 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” unclearDefinition of real property unclear
• Compliance with 514(c)(9) poses challenges, particularly for funds
48
U. S. Tax‐Exempt Investors (cont’d): 514(c)(9)
• Section 514(c)(9): General Requirements for Debt-Financed Acquisition of Real EstateFinanced Acquisition of Real Estate
— Purchase Agreements
— Borrowing AgreementsBorrowing Agreements
› General rule
› Eligible lenders
› Multi-property loans
— Leasing Agreements
49
U. S. Tax‐Exempt Investors (cont’d) : 514(c)(9)
• Requirements for a 514(c)(9)-Compliant Fund
F d l i h l i— Fund must comply with general requirements
— AND
› All of the partners must be QOs or› 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:› The partnership’s allocation provisions for tax purposes:• Satisfy the “Fractions Rule”, and
• Have “Substantial Economic Effect”
P t ti l L l d E i C f • Potential Legal and Economic Consequences of complying with the Fractions Rule and the Substantial Economic Effect Rules
50
Non‐U.S. Funds with U.S. Investments
• Same general structural considerations as above
N U S I ill b f d ECI — 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— 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 i FATCA i li ti f f d d • U.S. source income = FATCA implications for fund and its investors
51
Non‐U.S. Funds with U.S. Investors: Investing Overseas
• Some considerations:
PFIC/CFC i ( U S f d b h h)— 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— Non-U.S. withholding tax
— Treaty analysis
— U.S. tax-exempt investors will still be concerned about pUBTI, and may wish to invest through a blocker if there will be debt-financing or investments in operating pass-throughspass throughs
— Certain countries (India, China) have begun imposing tax on indirect gains, which has led to an increase in the use f “fili bl k ”
52
of “filing blockers”
US Funds Investing Overseas
• Same general structural considerations as have been illustrated with some additionsillustrated, with some additions
— UBTI on debt-financed investments/pass-through income
— Treaty benefitsTreaty benefits
— PFIC/CFC
— Foreign tax credit flow-through
— Commercial activities income still a concern for controlled commercial entities (but 892 benefits generally irrelevant)
S f h i ibl• Some of these are incompatible
— E.g., flow-through structures for taxable investors, but UBTI issues for tax-exempts
53
UBTI issues for tax exempts
US Funds Investing Overseas Parallel Funds
U S T bl /U S S / S
– Parallel Funds
U.S. Taxable/U.S.Government Investors
Non-U.S./U.S.Tax-Exempt Investors
Fund (taxed as
partnership)Fund
(taxed as corporation)partnership) ( p )
Non-U.S.Investments
54
Investments
US Funds Investing Overseas Master/Feeder
U S Taxable/U S Non U S /U S
– Master/Feeder
U.S. Taxable/U.S.Government Investors
Non-U.S./U.S.Tax-Exempt Investors
Feeder Fund (taxed as corporation)
Master Fund(taxed as(taxed as
partnership)
Non-U.S.
55
Non U.S.Investments
US Funds Investing Overseas (cont’d)
• PFIC/CFC issues for US taxable investors
A i d f l i— Anti-deferral regimes
• PFIC - ≥ 50% passive assets or ≥ 75% passive income
Look through 25% owned subsidiaries— Look-through 25% owned subsidiaries
• Recharacterization of distributions, gain as ordinary income + penalty interest chargep y g
— No chance for qualified dividend income
56
US Funds Investing Overseas (cont’d)
• Make “check the box election” to treat as a pass-through
C b diffi l d l l k US — Can be difficult to persuade local owners to make US tax election
• QEF Election – modified look-throughQEF Election modified look through
— Losses and FTCs generally don’t flow through
— Often covenants to make election and obtain information to make US tax filings
— Can be burdensome for funds to gather required information including from 25% owned subsidiaries information, including from 25% owned subsidiaries
57
US Funds Investing Overseas (cont’d)
• CFC – more than 50% of a foreign corporation owned by “U S Shareholders”U.S. Shareholders
— U.S. persons with 10% or more voting power
› U.S. partnership = 1 U.S. personp p p
— Structure Fund and management entities as Cayman vehicles to apply 10% voting power test on look-through basislook-through basis
— Or elect to treat foreign portfolio corporation as a pass-through
58
Luxembourg Investment Structure into Europe
• Luxco set up with • Luxco set up with minimal capital
• PECs yield 8% per yearU.S. Main
U.S. Investors
PECs yield 8% per year
• CPECs can be redeemed for FMV of shares into which
U.S. MainFund LP
Cash PECsCPECs
CPECs are convertible
• PECs and CPECs
LuxcoCTB to be Taxed as a i d d
Cash
• Debt for Luxemburg tax purposes
E i f U S
GermanPortfolioCompany
Disregarded EntityGerman
PortfolioCompany
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• Equity for U.S. tax purposes (99/1 debt-equity ratio)
CompanyCompany
Luxembourg Investment Structure into Europe (cont’d)
Littl L • Little or no Lux withholding tax
• Luxco benefits from EU
U.S. Investors
• Luxco benefits from EU tax treaties
• Luxco disregarded for
U.S. Fund LP
DividendsCapital Gains g
U.S. tax purposes
• Some US tax issues: debt-
Luxco
CTB to be Taxed as a Disregarded
DividendsCapital Gains
equity (including debt maturity); Section 305
GermanPortfolioCompany
gEntity
p
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Company
Issue for Canadian Investors in U.S. Fund
US Canadian Canadian
Distribution
USInvestors
CanadianCorporation(Taxable)
CanadianPension Fund(Non‐Taxable)
DistributionU.S. FundMain LP
U.S.Blocker LP
CTB to be Taxed as a
C d U S Bl k LP hi
U.S. PortfolioDistribution Corporation
• Canada treats U.S. Blocker LP as a partnership
• Under U.S.-Canada tax treaty, U.S. 30% withholding tax applies (hybrid entity)
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( y y)
• Avoided if U.S. Portfolio LP is instead an LLC
Another Issue for Canadian Investors
USCanadian
CorporationCanadian
Pension Fund USInvestors
Corporation(Taxable)
Pension Fund(Non‐Taxable)
U.S. MainFund LPFund LP
U.S. PortfolioU.S. PortfolioLLC
Di id d
CTB to be Taxed as a Corporation
C d t t LLC ti
Dividends
U.S. Corporation
• Canada treats LLC as a corporation
• Under U.S.-Canada tax treaty, U.S. 30% withholding tax applies (hybrid entity)
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• Avoided if U.S. Portfolio LLC is instead U.S. Portfolio LP
Structuring Fund Manager Entities
• Funds generally have separate General Partners and Investment ManagersInvestment Managers
— GP (or special LP owned by principals) receives carried interest
› Generally special purpose entity for each fund
— Investment Manager receives management fees
G ll i l M C ll f d› Generally single Management Company across all funds
› Employees, contracts
› Franchise value
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Structuring Fund Manager Entities (cont’d)
• Reasons for separation?
E f i — Ensure proper tax treatment of separate income streams
› Carried interest – capital gains
› Management fees – ordinary incomeg y
— State/local tax reasons
› NYC unincorporated business tax
Of hi k— Often separate ownership stakes
› Carried interest more widely distributed than ownership of Management Company
› Deal-by-deal; fund-by-fund
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Structuring Fund Management Entities (cont’d)
Li it d P t P i i l
(contd)
Limited Partners Principals
GeneralPartner
ManagementCompany
Carriedinterest
Fund
interest
Management Fees
Investments
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Investments
Structuring Fund Manager Entities (cont’d)
• Considerations?
M C Ch i f E i— 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-y; q p y;employment taxes on distributive share of fee income
• Statutory exception from SECA for distributive share of a limited partner
• Impact of Renkemeyer?
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Structuring Fund Manager Entities (cont’d)
• Considerations?
G l P Ch i f E i— 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› Issuance of profits interest; no interest in current value
› 83(b) election
› Catch-up allocations
› Vesting/forfeiture/allocations to other partners
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Foreign Account Tax Compliance Act (FATCA)
• “Foreign Account Tax Compliance Act” or FATCA, is generally effective as of January 28 2013generally effective as of January 28, 2013
• Intended to ensure that U.S. persons holding assets through offshore entities and accounts pay U.S. taxes on g p yrelated 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 g g p
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FATCA (cont’d)
• FATCA does not replace the current withholding and reporting regime for non U S personsreporting 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 January 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 requirements not only on non-U.S. entities, but also on certain U.S. financial entities
69
FATCA (cont’d)
• Categories Under Regulations
S hh ld A• U.S. Withholding Agents
— U.S. hedge and private equity funds may be required to act as withholding agents under FATCAact as withholding agents under FATCA
• Foreign Financial Institutions (FFIs)
— Non-U.S. funds likely FFIsy
— Multiple categories: Participating FFI, Deemed Compliant FFI, and Non-Participating FFI
• Non-Financial Foreign Entities (NFFEs)
• Exempt Beneficial Owners
G ll bj FATCA i hh ldi l
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— Generally not subject to FATCA withholding as long as necessary documentation is provided to withholding agent
FATCA (cont’d)
• Withholding Under FATCA
30% f “ hh ld bl ” d • FFIs: 30% of any “withholdable payment” paid to non-participating FFIs and recalcitrant account holders
— Tiered implementation of withholdable paymentsTiered 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 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
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• “Withholding agent” broadly construed under FATCA
FATCA (cont’d)
• Two-pronged approach to FATCA compliance
IRS R l i— IRS Regulations
— Intergovernmental Agreements (IGAs)
• Important Guidance to Come• 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”
IGA• IGAs
72
FATCA (cont’d)
U.S. Funds: U.S. Withholding Agents
i hh ldi b S d f f l d • Withholding by U.S. Fund: If an investor fails to provide necessary information to U.S. Fund, 30% FATCA withholding may be deducted from investor’s share of g ywithholdable payments
• Tax withheld under FATCA is paid by U.S. Fund to IRS
73
FATCA (cont’d)
• Non-U.S. Funds (and non-US blockers): Are they FFIs?
D fi i i f FFI i h fi l l i i l d ( — 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
N dit f d f 30% ithh ldi t if f d — 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?
74
— Legal and practical considerations
— Various classifications for compliant FFIs
FATCA (cont’d)
• Special Considerations for Funds Organized as Partnerships for U S Tax PurposesPartnerships 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
R l ti d ’t dd h th l f t hi — Regulations don’t address how the sale of a partnership interest will be treated under FATCA
75
FATCA (cont’d)
• FATCA and Fund Documentation
F d i i l d i l d— Fund organizational and operational documents
› Operating agreements
› Investor subscription documents and account applicationsp pp
› Fund offering documents
› Side letters
Service provider agreements (transfer agent custodian — Service provider agreements (transfer agent, custodian, administrator, withholding agent, adviser, etc)
— Credit agreements/ISDAs/repo & securities lending agreements
76
New 3.8% Medicare Contribution Tax
• Imposed on U.S. individuals taxpayers, and estates and trustsand trusts
• Not imposed on corporations or pass-through entities—but “net investment income” passes through to U.S. p gindividuals, and estates and trusts
• Not imposed on non-resident individuals
• Effective date: January 1, 2013
77
New 3.8% Medicare Contribution Tax (cont’d)
• The Medicare contribution tax is 3.8% on the lesser of:
“N i i ” — “Net investment income” or
— The excess of modified adjusted gross income (MAGI) over the applicable “threshold amount”pp
• 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
78
New 3.8% Medicare Contribution Tax (cont’d)
• Three Buckets of Net Investment Income:
G i f i di id d i i — Gross income from interest, dividends, annuities, royalties, and rents
— Gross income derived from a business constituting a gpassive activity to the taxpayer under IRC Section 469 (and gross income derived from a trade or business comprised of trading in financial instruments or commodities)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
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bucket cannot
New 3.8% Medicare Contribution Tax (cont’d)
U.S. Taxable Individual
OtherInvestors
(and certain Trust and Estate) Investors
3.8% nii
Fund L.P.- Gain on interest sale- Gain on stock sale
- Gain on asset sale- Interest- Gain on debt sale
- Dividends- Interest- Gain on debt sale
PortfolioCorp.
PortfolioLLC
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New 3.8% Medicare Tax
• Impact on Fund Managers and Planning
C i d I— Carried Interest
› Passive investment income subject to new tax
› Additional 3.8% tax on top of 20% LTCG (or 39.6% for interest, p ( ,STCG and nonqualified dividend income)
— Incentive compensation in hedge fund?
If paid as fee may be subject to 3 8% self employment tax › 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› If paid as allocation, subject to new Medicare tax• Even if fund is a “trader” hedge fund
81
New 3.8% Medicare Tax (cont’d)
• Impact on Fund Managers and Planning
C i d I— Carried Interest
› Passive investment income subject to new tax
› Additional 3.8% tax on top of 20% LTCG (or 39.6% for interest, p ( ,STCG and nonqualified dividend income)
— Incentive compensation in hedge fund?
If paid as fee may be subject to 3 8% self employment tax › 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 taxE if f d i “t d ” h d f d• Even if fund is a “trader” hedge fund
82
New 3.8% Medicare Tax (cont’d)
• Planning Opportunities
M i i f d f l i— More incentive for deferral transactions
— 1031s – gain not picked up under NII rules until recognized
Restructure carried interests as incentive fees— Restructure carried interests as incentive fees
› If majority of income is already ordinary (STCG, interest, rent, royalties)
› If carried interest is taxed as OI, further incentive to convert fees (even if self-employment taxes would apply as the new Medicare tax is nondeductible against recipient’s income)
› Potential bad result for taxable investors in fund due to 212 limitation on deductibility of incentive fee
83
New 3.8% Medicare Tax (cont’d)
• Planning Opportunities
C LLC S C LP— 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
84
New 3.8% Medicare Tax (cont’d)
• Planning Opportunities
U i i— Using corporations
› Corporations pay low tax rates on income up to $50,000.
› Incentive fees up to such amounts could be paid to a p pcorporation 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 taxPotential double state tax
85
What is a Carried Interest?
• Private equity and hedge fund managers structure funds with a 2 & 20 compensation structurewith a 2 & 20 compensation structure
— Fixed percentage of gains over losses
› Typically 20%yp y
— Often, most income/gain allocated to the 20% carry is taxed at favorable capital gain rates
N l i l i ld l h 20% — New legislation would apply to the 20% carry
86
Carried Interest Tax Proposals
• In President Obama’s 2014 budget
d l l dd C 0• Proposed legislation to add new IRC section 710
• Proposal would tax as ordinary income a fund manager’s share of income from an “investment services 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)
87
Carried Interest Tax Proposals (cont’d)
• Applies to persons (or related persons) who:
Di l i di l id f h f ll i i — 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 assetg g, q g, p g p
› Arranging financing with respect to a specified asset; or
› Any activity in support of any of the previously described activitiesdescribed activities
88
Definition of Specified Assets
• The term “specified asset” means:
S i i ( i 475( )(2))— Securities (section 475(c)(2))
— Real estate held for rental or investment
Partnership interests— Partnership interests
— Commodities (section 475(e)(2))
— Options or derivative contracts with respect to p pthese assets
89
Some Partnerships Covered Include:
• Private equity funds
d f d• Hedge funds
• Venture capital funds
LBO f d• LBO funds
• Real estate funds and partnerships
M k t bl iti f d d t hi• Marketable securities funds and partnerships
• Oil and gas funds and partnerships???
90
Some Partnerships Not Covered:
• Partnership operates an active business
E fi i i d i id b — 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 Obama budget: proposal is not intended to affect qualification of a REIT owning a carried interest in a real estate partnership
91
Tax Acceleration
• Tax on Carried Interest is accelerated if:
C i d I h ld f C i d I ( — 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— 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 gto the new partnership (e.g., a partnership merger, division or termination under section 708(b)(1)(B))
92
Other Consequences
• Where an individual is engaged in the trade or business of providing specified services income taken into of providing specified services, income taken into account as ordinary income would become subject to self-employment tax
— This is regardless of whether the partner is a limited partner and regardless of whether the underlying partnership income would be exempt from self-partnership income would be exempt from selfemployment 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
93
Qualified Capital Exception
• Carried Interest holder can exclude “Qualified Capital” that is acquired for invested capital and intended to be that is acquired for invested capital and 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 holderon the same basis as the Carried Interest holder
• One exception: Carried Interest rule does not apply if all allocations, distributions and capital contributions , phave been pro rata
94
Qualified Capital Exception ‐ Loans
• Carried Interest holder will not be treated as having a Qualified Capital Interest to the extent that contributed 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 • Other loans to Carried Interest holder are not disqualified
95
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95
Sale of Interests in Fund Manager Entity
BA C
LLC
A, B and C Sell LLC Interests
XYZ Fund Managers
GP
GoodwillLLC
20 GP 20GP 20%
GP 20%
Investors InvestorsLP LP
• 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
96
recharacterization where the business has goodwill or other assets unrelated” to services
Fund Documents – Key Tax Provisions
• Offering Memorandum
d h A • Limited Partnership Agreement
• Subscription Documents
Sid L tt• Side Letters
• Tax Opinions
97
Fund Documents – Key Tax Provisions
• Private Placement Memorandum
• Summary of key tax provisions
• Limited Partnership Agreement (Operating Agreement)Examples of key tax-related provisions:
• General overview of tax treatment
• 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
98
• Tax matters partner
Fund Documents – Key Tax Provisions (cont’d)
• Subscription Documents
• Investor tax representations
• Tax Opinions
• Partnership Tax Opinion
• 514(c)(9) Opinion• PTP representations
• Transfer restrictions
• Electronic K-1 consent
( )( )
Electronic K 1 consent
• Side Letters
• PFIC/QEF election and CFCs
• Prohibited transactionsCFCs
• Foundation issues
• ERISA issues
d
• 892 Non-U.S. Governmental Investors
• Non-U.S. investor-specific i
99
• Tax reporting, and much more
issues
Today’s Speakers
• Christian McBurney, Partner, Nixon Peabody LLP, Washington D C Office (202) 585 8358 Washington, D.C. Office, (202) 585-8358, [email protected]
• Jeremy Naylor, Partner, White & Case, New York City Office, (212) 819-8760, [email protected]
• Elizabeth Norman, Associate, Goulston & Storrs, Boston Offi (617) 574 3568 lOffice, (617) 574-3568, [email protected]
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