Advanced Tax Strategies in Structuring Private Investment Funds - - PowerPoint PPT Presentation

Advanced Tax Strategies in Structuring Private Investment Funds

Balancing the Competing Interests of Fund Investors When Structuring Investment Funds

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1pm East ern | 12pm Cent ral | 11am Mount ain | 10am Pacific THURS DAY, MAY 1, 2014

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

Christian M. McBurney, Partner, Nixon Peabody, Washington, D.C. Jeremy Naylor, Partner, Cooley, New Y

• rk

Elizabeth Norman, Attorney, Goulston & Storrs, Boston

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5

Advanced Tax Strategies in Structuring Private Investment Funds

Christian McBurney, Nixon Peabody LLP, Washington, D.C. office Jeremy Naylor, Cooley LLP, New York office Elizabeth Norman, Goulston & Storrs, Boston office May 1, 2014

6

Fund Characteristics

• Types of Funds

— Private Equity — Venture Capital — Hedge — Distressed Debt — Real Estate — LBO — Fund of funds

7

Fund Characteristics (cont’d)

• Ot her import ant fund charact erist ics

— 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 S ection 212 › Trade or business: fees deductible under S ection 162; but UBTI, ECI and CAI concerns

8

Type of Fund Investors

• U.S

. Taxable Individual or Corporat ion

• U.S

. S t at e and Local Government

— Pension Funds

• U.S

. Tax-Exempt Invest ors

— Corporate Pension Plans — University and College Endowment Funds — Private Foundations — Charity Endowment Funds — Individual Retirement Accounts (IRAs)

9

Type of Fund Investors (cont’d)

• Non-U.S

. Invest ors

— 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 Invest ors (S ect ion 892)

— S

• vereign Wealth Funds

— Pension Funds

10

U.S. Taxable C Corp.

35% c.g. and o.i.

Fund L.P . Portfolio Corp. Portfolio LLC

• Gain on interest sale
• Gain on asset sale
• Interest
• Gain on debt sale

U.S. Taxable Individual

• 20%

c.g.

• 39.6%
• .i.
• 3.8%

nii

• Gain on stock sale
• Dividends
• Interest
• Gain on debt sale

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

• U. S. Taxable Individuals and Corporations

11

• U. S. State and

Local Government

0% U.S . tax rate

Fund L.P . Portfolio Corp. Portfolio LLC

Gain/ income

No Fund Blocker desired Unblocked can also claim treaty benefits

Gain/ income

• U. S. State and Local Government

12

U.S. Tax-Exempt

0% U.S . tax rate

Fund L.P . Portfolio Corp. Portfolio LLC

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

noninventory property

• U. S. Tax-Exempt Investors

13

U.S. Tax-Exempt

35% U.S . tax rate

Fund L.P . Portfolio LLC

Fees earned by L.P .

Fund Blocker often desired Unrelated business taxable income (UBTI)

• Operating income
• Gain on sale of inventory
• U. S. Tax-Exempt Investors (cont’d)

14

U.S. Tax-Exempt

35% U.S . tax rate

Fund L.P . Portfolio Corp. Portfolio LLC

Debt -Financed:

• Gain on interest sale
• Interest
• Gain on debt sale

Debt -Financed:

• Gain on stock sale
• Dividends
• Interest
• Gain on debt sale

Debt-financed income is UBTI Fund Blocker often desired

Debt -Financed:

• Gain on sale
• f any property
• Operating Income
• U. S. Tax-Exempt Investors (cont’d)

15

U.S. Tax-Exempt Non-U.S. or U.S. Feeder Fund Non-U.S . Investments (No UBTI) U.S . Investments (No UBTI) U.S.

• Corp. Blocker

Investments (UBTI)

• U. S. Tax-Exempt Investors (cont’d)

Parallel Fund Structure

16

Non-U.S. Investors

• U.S

. t ax goals

— Avoid having to file a U.S . income tax return — Limit U.S . tax on “ Effectively Connected Income” (ECI). — If ECI:

› Must file U.S . federal, state, and local returns › Must pay income tax at regular, federal, state and local rates

• Non-U.S

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

— Limit U.S . tax on FDAP income

› 30% U.S . withholding tax rate unless U.S . tax treaty applies › Claim U.S . treaty benefits where possible

17

Non-U.S. Investors (cont’d)

• Effect ively Connect ed Income (ECI) is income recognized

by a non-U.S . person t hat is effect ively connect ed wit h a business carried on in t he U.S .

— Does fund have a loan origination business? — “ S ecurities trading safe harbor” protects offshore funds

• ECI includes share of operat ing income from a pass-

t hrough ent it y conduct ing business in t he U.S .

— Non-U.S . partners are deemed engaged in a U.S . business — S ale of partnership interest in partnership that generates ECI: IRS takes the position that gain is ECI

• FIRPTA income t reat ed like ECI

18

Non-U.S. Investor

0% U.S . tax rate

Fund L.P . Portfolio Corp. Portfolio LLC

U.S . S

• urce:
• Portfolio interest
• Gain on debt sale

No Fund Blocker desired

Portfolio Corp.

Non-U.S . S

• urce:
• Gain/ income

U.S . S

• urce:
• Gain on stock sale

Non-U. S. Investors (cont’d)

19

Non-U.S. Investor

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

Fund L.P .

Treaty benefits can be claimed Non-U.S . pension fund from a treaty country – 0% U.S . tax rate No Fund Blocker desired

Portfolio Corp.

U.S . S

• urce:
• Dividends
• Non-portfolio interest

Non-U. S. Investors (cont’d)

20

Non-U.S. Investor

35% / 39.6% U.S . tax rate

Fund L.P .

Fund Blocker usually desired

Gain on interest sale (ECI)

Portfolio LLC

U.S . S

• urce:
• Gain on sale of operating assests (ECI)
• Operating income (ECI)

Non-U. S. Investors (cont’d)

21

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 (cont’d) Parallel Fund Structure

22

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

• Why use non-U.S

. Feeder?

— Not have to report non-U.S . investments — Can avoid "controlled foreign corporation" (CFC) treatment where substantial investors are non-U.S . investors and fund owns 50%

• r more of the non-U.S

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

23

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

• Why use U.S

. Feeder?

— Easier to claim U.S . treaty benefits—

• nly need to issue

W-8BEN to U.S . Feeder — Will treaty benefits "flow-through" a non-U.S . Feeder to a non-U.S . investor? Generally, non-U.S . entity must be fiscally transparent for non-U.S . as well as U.S . purposes

› S ee also S ection 894(c).

Slide Intentionally Left Blank

25

UBTI and ECI—Not Exactly the Same

• S
• me invest ment s may generat e UBTI, but not ECI

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

• S
• me invest ment s may generat e ECI, but not UBTI

— S ale of partnership interests where partnership conducts a U.S . trade or business — Investments in U.S . real property holding corporations (holding 50%

• r more of gross assets in U.S

. real property) — Loan commitment fees not UBTI, but may be ECI

• Accordingly, a blocker t hat avoids all ECI may be t oo

broad for a U.S . t ax-exempt invest or; and a blocker t hat avoids all UBTI may be t oo broad for a non-U.S . Invest or

26

Non-U.S. Governmental Investors

• Non-U.S

. Government s (including t heir cont rolled ent it ies) are generally exempt from U.S . t ax under IRC S ect ion 892 on income from invest ment s from securit ies, except income from t he conduct of a "commercial act ivit y" (CAI)

• If a cont rolled ent it y has CAI (eit her US
• r non-US

), it could lose it s S ect ion 892 exempt ion (but recent relief in proposed regulat ions— “ inadvert ent ” and “ de minimis” st andards; int erest in non-cont rolled LP)

• Invest ment s in operat ing part nerships generat e CAI
• Non-US

Government owning U.S . real propert y or 50%

• r

more of t he st ock of a Unit ed S t at es Real Propert y Holding Corporat ion (US RPHC) can generat e CAI

27

Non-U.S. Government

0% U.S . tax rate

Fund L.P . Portfolio Corp. Portfolio LLC

U.S . S

• urce:
• Interest
• Gain on debt sale

No Fund Blocker desired

Portfolio Corp.

Non-U.S . S

• urce:
• Gain/ income

U.S . S

• urce:
• Gain on stock sale
• Interest
• Dividends

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

28

Non-U.S. Government

35% U.S . tax rate

Fund L.P .

Fund Blocker desired

Gain on interest sale (CAI)

Portfolio LLC

U.S . S

• urce:
• Operating income (CAI)
• Gain on sale of operating assets (CAI)

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

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’d)

30

ECI, FDAP and CAI—Not Exactly the Same

• S
• me invest ment s may generat e ECI but not CAI

— Investments in U.S . real property holding corporations (US RPHC) (holding 50%

• r more of gross assets in U.S

. real property)

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

• f more
• f US

RPHC

• S
• me invest ment s may generat e CAI but not ECI

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

• S
• me invest ment s may generat e FDAP wit hholding

for non-U.S . Invest ors, but not for Non-U.S . Government al Invest ors

31

Parallel Fund Structure

• Most t ax efficient fund st ruct ure generally is t o use

separat e parallel funds for each t ype of invest or

— Administrative costs

• S

hould each invest ment have a newly-formed separat e blocker?

— This can avoid U.S . dividend withholding tax on exit — But if a single blocker is used for multiple investments, income and gain from one investment can be offset by losses from another

• Risk of aggregation of different fund entities used in

parallel/ AIV structure due to applying carried interest across all funds

32

Main Fund

Other Investors

Parallel Fund Portfolio LLC Intermediate Partnership GP

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

Blocker Corp. Portfolio Corp.

Carry Carry

Simplified Parallel Fund

33

AIF “A”

Other Investors

AIF “B” Portfolio LLC Intermediate Partnership GP Main Fund

All Investors

Blocker Corp. Portfolio Corp.

Carry Carry

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

Alternative Investment Fund

34

Other Investors

Portfolio LLC GP

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

Main Fund L.P . Feeder Fund (Offshore) Portfolio Corp.

Feeder Fund – No Flexibility

35

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

• Corp. Blocker

Taxable Investors Portfolio LLC

Taxable investor capital Sensitive investor capital

Subsidiary Blocker Structures

36

Subsidiary Blocker Structures

• S
• me funds use subsidiary “ blocker” corporat ions for ECI

and UBTI invest ment s

— Capital of tax sensitive investors channeled through blockers

› S pecial 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 invest ment

— S ale of assets and liquidation of blocker — S ale of blocker shares?

› Allocation of discount?

37

Other Types of US Funds

• Hedge Funds
• Dist ressed Debt
• Real Est at e (including oil and gas)

38

Other Types of US Funds – Hedge Funds

• Onshore/ offshore st ruct ure

— Typically Cayman “ master fund” – taxed as a partnership — Onshore feeder – Delaware LP or LLC

› Taxable investors invest here › S implifies reporting for U.S . taxable investors

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

› Tax-Exempts and Non-U.S . investors invest here › Offshore feeder may make sense for taxable investors given S ection 212 limitations on deductibility of management and

• ther fees and NII Medicare tax

39

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

• Issues for t axable invest ors

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

› deductibility of management fees and expenses

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

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

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

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

— Investment in offshore feeder may offer tax advantages

› Deferral of 3.8% Medicare tax on NII until distribution › Effective deduction of management fees in non-trader fund

40

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

• Issues for Non-U.S

./ U.S . Tax-Exempt invest ors

— Trading in stocks and securities safe harbor for feeder — Offshore feeder is effective “ blocker” for UBTI and ECI

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

— Non-U.S . government investors cannot access 892 benefits through offshore feeder — Allocation of F ATCA risk

41

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

• Issues for Invest ment Manager

— Treatment of incentive compensation

› Allocation allows for potential for capital gains › Generally not a large portion of hedge fund’s revenues › Not available for funds that mark-to-market

— Incentive fees

› S ection 457A/ 409A issues if paid by offshore feeder › Potentially avoid self-employment tax and new 3.8% Medicare tax on NII

42

Other Types of US Funds – Distressed Debt

• Typically st ruct ured similar t o hedge funds wit h same

general issues

• Dist ressed debt -specific issues

— Portfolio Interest — Market Discount; OID — Recovery of basis treatment for deeply discounted debt? — Loan origination activities

› Workouts/ loan modifications resulting in reissuances/ deemed new originations › “ S eason and S ell” –

• ther strategies to avoid being considered

in loan origination/ active financing business › Impact of 2009 GLAM (Chief Counsel Mem. AM2009010)

43

Foreign Investment in Real Property Tax Act (FIRPTA)

• In general, non-US

persons generally do not pay U.S . t ax

• n disposals of st ock or securit ies of U.S

. issuers

• FIRPTA is an except ion t o t his general t reat ment
• FIRPTA imposes a t ax on gains realized from t he

disposit ion of a U.S . real propert y int erest , which includes direct real est at e holdings and:

— Partnership/ flow-throughs that hold U.S . real estate — Interests in a “ U.S . real property holding corporation” (US RPHCs) — Direct or indirect rights to share in proceeds, appreciation

• r profit of U.S

. real estate

44

FIRPTA (cont’d)

• US

RPHCs

— 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%

• f the class of

stock being traded — FIRPTA Traps

› Distressed companies › Publicly traded stock de-listed

45

FIRPTA (cont’d)

• Tax imposed at U.S

. t ax rat es

• Collect ed part ially t hrough wit hholding
• Gains t reat ed as ECI
• Non-U.S

. person wit h FIRPTA gain also incurs a U.S . federal income t ax filing obligat ion

• Branch profit s t ax may also apply

46

FIRPTA (cont’d)

• U.S

. blockers frequent ly used t o hold U.S . real est at e asset s, which blocks applicat ion of FIRPTA t ax and filing obligat ions

• Not e, however, t hat t he U.S

. blocker it self may be a “ US RPHC” which would t rigger FIRPTA gain if sold (unlikely exit )

• Trap for unwary: S

ect ion 1445(e) wit hholding on non- dividend dist ribut ions from a US RPHC

47

FIRPTA (cont’d)

Non-U.S. Fund Non-U.S . Investments (No FIRPTA) U.S . Non-Real Estate Investments (No FIRPTA) U.S.

• Corp. Blocker
• U. S

. Real Estate Investments

48

FIRPTA (cont’d)

Non-U.S. Fund Non-U.S . Investments (No FIRPTA) U.S . Non-Real Estate Investments (No FIRPTA) U.S.

• Corp. Blocker
• U. S

. Real Estate Investments Offshore Blocker

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

49

• U. S. Tax-Exempt Investors: 514(c)(9)
• Cert ain t ax-exempt invest ors (“ Qualified Organizat ions” ,
• r QOs) are eligible for an except ion t o debt -financed

UBTI in cert ain circumst ances

— Most common QOs are pension funds and educational

• rganizations
• Provided cert ain requirement s are met , S

ect ion 514(c)(9) provides t hat debt incurred t o acquire or improve “ real propert y” won’ t give rise t o UBTI for QOs

— Definition of “ real property” unclear

• Compliance wit h 514(c)(9) poses challenges, part icularly

for funds

50

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

• S

atisfy the “ Fractions Rule” , and

• Have “ S

ubstantial Economic Effect”

• Pot ent ial Legal and Economic Consequences of

complying wit h t he Fract ions Rule and t he S ubst ant ial Economic Effect Rules

Slide Intentionally Left Blank

52

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

• S

ame general st ruct ural considerat ions as above

— Non-U.S . Investors will be focused on ECI — If fund holds real estate assets, FIRPTA may also apply — S pecial 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 = F ATCA implicat ions for fund and it s invest ors

53

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

• S
• me considerat ions:

— PFIC/ CFC issues (want non-U.S . fund to be pass-through) — Tax filing obligations in non-U.S . j urisdictions — 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

• n indirect gains, which has led to an increase in the use
• f “ filing blockers”

54

US Funds Investing Overseas

• S

ame general st ruct ural considerat ions as have been illust rat ed, wit h some addit ions

— 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)

• S
• me of t hese are incompat ible

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

55

U.S. Taxable/U.S. Government Investors Fund (taxed as partnership) Non-U.S./U.S. Tax-Exempt Investors Non-U.S. Investments

US Funds Investing Overseas – Parallel Funds

Fund (taxed as corporation)

56

U.S. Taxable/U.S. Government Investors Master Fund (taxed as partnership) Non-U.S./U.S. Tax-Exempt Investors Non-U.S. Investments

US Funds Investing Overseas – Master/Feeder

Feeder Fund (taxed as corporation)

57

US Funds Investing Overseas (cont’d)

• PFIC/ CFC issues for US

t axable invest ors

— Anti-deferral regimes

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

— Look-through 25%

• wned subsidiaries
• Recharact erizat ion of dist ribut ions, gain as ordinary

income + penalt y int erest charge

— No chance for qualified dividend income

58

US Funds Investing Overseas (cont’d)

• Make “ check t he box elect ion” t o t reat as a pass-t hrough

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

• QEF Elect ion –

modified look-t hrough

— 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%

• wned subsidiaries

59

US Funds Investing Overseas (cont’d)

• CFC –

more t han 50%

• f a foreign corporat ion owned by

“ U.S . S hareholders”

— U.S . persons with 10%

• r more voting power

› U.S . partnership = 1 U.S . person

— S tructure Fund and management entities as Cayman vehicles to apply 10% voting power test on look-through basis — Or elect to treat foreign portfolio corporation as a pass- through

60

Luxembourg Investment Structure into Europe

• Luxco set up wit h

minimal capit al

• PECs yield 8%

per year

• CPECs can be redeemed for

FMV of shares int o which CPECs are convert ible

• 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

61

Luxembourg Investment Structure into Europe (cont’d)

• Lit t le or no Lux

wit hholding t ax

• Luxco benefit s from EU

t ax t reat ies

• Luxco disregarded for

U.S . t ax purposes

• S
• me US

t ax issues: debt - equit y (including debt mat urit y); S ect ion 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

62

Issue for Canadian Investors in U.S. Fund

• Canada treats U.S

. Blocker LP as a partnership

• Under U.S

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

• Avoided if U.S

. Blocker is instead an LLC

Distribution

US Investors Canadian Corporation (Taxable) Canadian Pension Fund (Non-Taxable) U.S. Fund Main LP U.S. Blocker LP U.S. Portfolio L.P.

Distribution CTB to be Taxed as a Corporation

63

Another Issue for Canadian Investors

• Canada treats LLC as a corporation
• Under U.S

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

• Avoided if U.S

. Portfolio LLC is instead U.S . Portfolio LP

US Investors Canadian Corporation (Taxable) Canadian Pension Fund (Non-Taxable) U.S. Main Fund LP U.S. Portfolio LLC

Dividends

U.S. Corporation

64

Structuring Fund Manager Entities

• Funds generally have separat e General Part ners and

Invest ment Managers

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

› Generally special purpose entity for each fund

— Investment Manager receives management fees

› Generally single Management Company across all funds › Employees, contracts › Franchise value

65

Structuring Fund Manager Entities (cont’d)

• Reasons for separat ion?

— Ensure proper tax treatment of separate income streams

› Carried interest – capital gains › Management fees –

• rdinary income

— S tate/ local tax reasons

› NYC unincorporated business tax

— Often separate ownership stakes

› Carried interest more widely distributed than ownership of Management Company › Deal-by-deal; fund-by-fund

66

Limited Partners Fund General Partner Investments Management Company Principals

Carried interest Management Fees

Structuring Fund Management Entities (cont’d)

67

Structuring Fund Manager Entities (cont’d)

• Considerat ions?

— 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

• f fee income?

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

• S

tatutory exception from S ECA for distributive share of a limited partner

• Impact of recent case law?

68

Structuring Fund Manager Entities (cont’d)

• Considerat ions?

— General Partner – Choice of Entity

› Less of an issue than Management Company as distributions are generally not subj ect to self-employment taxes › Use of LP may avoid new Medicare tax on NII

— General Partner – Issuances of Interests; Vesting

› Issuance of profits interest; no interest in current value › 83(b) election › Catch-up allocations › Vesting/ forfeiture/ allocations to other partners

Slide Intentionally Left Blank

70

Foreign Account Tax Compliance Act (FATCA)

• “ Foreign Account Tax Compliance Act ” or F

ATCA

• Int ended t o ensure t hat U.S

. persons holding asset s t hrough offshore ent it ies and account s pay U.S . t axes on relat ed income

• Compels non-U.S

. financial ent it ies t o eit her (1) document and report informat ion about t heir U.S . account holders/ invest ors or (2) face a wit hholding t ax of 30%

• n most U.S

. source gross income or gross proceeds

71

FATCA (cont’d)

• F

ATCA does not replace t he current wit hholding and report ing regime for non-U.S . persons

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

72

FATCA (cont’d)

• Cat egories Under Regulat ions
• U.S

. Wit hholding Agent s

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

• Foreign Financial Inst it ut ions (FFIs)

— Non-U.S . funds likely FFIs — Multiple categories: Participating FFI, Deemed Compliant FFI, and Non-Participating FFI

• Non-Financial Foreign Ent it ies (NFFEs)
• Exempt Beneficial Owners

— Generally not subj ect to F ATCA withholding as long as necessary documentation is provided to withholding agent

73

FATCA (cont’d)

• Wit hholding Under F

ATCA

• FFIs: 30%
• f any “ wit hholdable payment ” paid t o non-

part icipat ing FFIs and recalcit rant account holders

— Tiered implementation of withholdable payments

› July 1, 2014: U.S . source FDAP income › 2017: U.S . source gross proceeds on sale of stock or securities › 2017: “ foreign pass-through payments”

• Other withholding agents: Non-FFI wit hholding agent s

must wit hhold 30%

• f any wit hholdable payment paid t o

non-part icipat ing FFIs and passive NFFEs t hat fail t o report on t heir significant U.S . owners

• “ Wit hholding agent ” broadly const rued under F

ATCA

74

FATCA (cont’d)

• Two-pronged approach t o F

ATCA compliance

— IRS Regulations — Intergovernmental Agreements (IGAs)

75

FATCA (cont’d)

U.S . Funds: U.S . Wit hholding Agent s

• Wit hholding by U.S

. Fund: If an invest or fails t o provide necessary informat ion t o U.S . Fund, 30% F ATCA wit hholding may be deduct ed from invest or’s share of wit hholdable payment s

• Tax wit hheld under F

ATCA is paid by U.S . Fund t o IRS

76

FATCA (cont’d)

• Non-U.S

. Funds (and non-US blockers): Are t hey FFIs?

— Definition of FFI in the final regulations includes (among

• thers) 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 t o comply wit h F

ATCA?

— Material U.S . source income? — Legal and practical considerations — Various classifications for compliant FFIs

77

FATCA (cont’d)

• S

pecial Considerat ions for Funds Organized as Part nerships for U.S . Tax Purposes

— F ATCA withholding applies not j ust to withholdable payments, but also to allocations of income — Timing of F ATCA 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 F ATCA

78

FATCA (cont’d)

• F

ATCA and Fund Document at ion

— Fund organizational and operational documents

› Operating agreements › Investor subscription documents and account applications › Fund offering documents › S ide letters

— S ervice provider agreements (transfer agent, custodian, administrator, withholding agent, adviser, etc) — Credit agreements/ IS DAs/ repo & securities lending agreements

79

FATCA (cont’d)

• How t o avoid 30%

wit hholding aft er June 30, 2014?

• For an FFI not organized in a country with a Model 1 IGA in

effect, FFI should provide withholding certificate or statement claiming status as a participating FFI or registered deemed-compliant FFI. Withholding agent then has 90 days to confirm that the FFI's GIIN appears on the IRS FFI List. — For an FFI organized in a country with a Model 1 IGA, but with branches in a country without a Model 1 IGA— same — For FFIs organized in a country with a Model 1 IGA, and with no branches in countries without a Model 1 IGA, deadline for GIIN registration is December 31, 2014

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

June 2, 2014 list

80

New 3.8% Medicare Contribution Tax

• Imposed on U.S

. individuals t axpayers, and est at es and t rust s

• Not imposed on corporat ions or pass-t hrough ent it ies—

but “ net invest ment income” passes t hrough t o U.S . individuals, and est at es and t rust s

• Not imposed on non-resident individuals
• Effect ive dat e: January 1, 2013

81

New 3.8% Medicare Contribution Tax (cont’d)

• The Medicare cont ribut ion t ax is 3.8%
• n t he lesser of:

— “ Net investment income” or — The excess of modified adj usted gross income (MAGI) over the applicable “ threshold amount”

• The t hreshold amount s are:

— Married individuals filing j ointly - $250,000 — Married individuals filing separately - $125,000 — Qualifying widow(er) with dependent child - $250,000 — Trust and estates - $12,150 for 2014

82

New 3.8% Medicare Contribution Tax (cont’d)

• Three Bucket s of Net Invest ment 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 S ection 469 (and gross income derived from a trade or business comprised

• f trading in financial instruments or commodities)

— Net gains from the disposition of property, such as the sale

• f stocks, partnership interests, bonds, and real estate
• Under proposed regs, t he first t wo bucket s can be

negat ive and offset ot her bucket s, but t he t hird bucket cannot

83

New 3.8% Medicare Contribution Tax (cont’d)

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

84

New 3.8% Medicare Tax

• Impact on Fund Managers and Planning

— Carried Interest in private equity fund

› Passive investment income subj ect to new tax › Additional 3.8% tax on top of 20% LTCG and QDI (or 39.6% for interest, S TCG and nonqualified dividend income)

— Incentive compensation in hedge fund?

› If paid as fee, may be subj ect 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, subj ect to new Medicare tax

• Even if fund is a “ trader” hedge fund

85

New 3.8% Medicare Tax (cont’d)

• Planning Opport unit ies

— More incentive for deferral transactions — 1031s – gain not picked up under NII rules until recognized — Restructure carried interests as incentive fees?

› If maj ority of income is already ordinary (S TCG, 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

86

New 3.8% Medicare Tax (cont’d)

• Planning Opport unit ies

— 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 subj ect to the tax › Member in LLC on same facts arguably subj ect to self- employment taxes on same income › Meaning of “ Materially participating” going to be very important

87

New 3.8% Medicare Tax (cont’d)

• Planning Opport unit ies

— 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 subj ect to 20% top federal tax + 3.8% NII tax

• Effective federal tax rate of 35.8%

as compared with 43.4%

› S tate and local taxes to be considered

• Potential double state tax

88

What is a Carried Interest?

• Privat e equit y and hedge fund managers st ruct ure funds

wit h a 2 & 20 compensat ion st ruct ure

— 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

89

Some Partnerships Covered Include:

• Privat e equit y funds
• Hedge funds
• Vent ure capit al funds
• LBO funds
• Real est at e funds and part nerships
• Market able securit ies funds and part nerships
• Oil and gas funds and part nerships?

? ?

90

Fund Documents – Key Tax Provisions

• Offering Memorandum
• Limit ed Part nership Agreement
• S

ubscript ion Document s

• S

ide Let t ers

• Tax Opinions

91

Fund Documents – Key Tax Provisions

• Private Placement

Memorandum

• S

ummary of key t ax provisions

• General overview of tax

treatment

• Limit ed Part nership Agreement

(Operat ing Agreement )

Examples of key t ax-relat ed provisions:

• ECI and UBTI Covenant s
• GP Clawback
• Management fee waivers
• Management fee offset s
• Wit hholding
• Allocat ions
• Tax Dist ribut ions
• Non-U.S

. Taxes and Ret urns

• Tax informat ion report ing
• Tax mat t ers part ner

92

Fund Documents – Key Tax Provisions (cont’d)

• S

ubscription Documents

• Investor tax representations
• PTP representations
• Transfer restrictions
• Electronic K-1 consent
• S

ide Letters

• PFIC/ QEF election and CFCs
• Foundation issues
• ERIS

A 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

93

Today’s Speakers

• Christian McBurney, Part ner, Nixon Peabody LLP

, Washingt on, D.C. Office, (202) 585-8358, cmcburney@ nixonpeabody.com

• Jeremy Naylor, Part ner, Cooley, New Y
• rk Cit y Office,

(212) 479-6580, j naylor@ cooley.com

• Elizabeth Norman, Associat e, Goulst on & S

t orrs, Bost on Office, (617) 574-3568, enorman@ goulst onst orrs.com