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  • This really is just a brief overview. My job is just to make sure everyone has the basic vocabulary down for the presentations that will follow. The reason for the VC perspective is that I spend most of my time forming VC funds so the usage just comes naturally for me. Nearly everything I’m going to say applies equally to PE firms.
  • This is the most plain vanilla of classic structures. When I started working with VC funds almost 20 years ago, nearly all funds looked like this, except that LLCs hadn’t been adopted yet, so the GP entity might have been a limited partnership, S corporation or even a general partnership. Key attributes: No tax at entity level Ability to distribute appreciated securities without triggering gain Flow-through hits tax-exempts and foreigners. Typically covenants against UBTI and ECI. Particularly important, since majority of LPs are tax-exempts or foreigners. Flow-through benefits VCs. This is the target of the proposed legislation that we’ll discuss later. Continuing debate as to whether the GP actually needs to contribute capital to the Fund. Some practitioners believe that the check-the-box classification rules eliminated this requirement. Others, including me, think that contributing capital helps assure that the GP will be respected as a bona fide “partner,” even if it’s no longer relevant to classification of the entity itself. Discuss calculation of carry.
  • It’s generally helpful to think of a fund and its GP in the same manner as disposable syringes. They’re single use, and discarded when the investments have been made and disposed of, and the proceeds distributed. Most firms seek to raise a new fund at least every few years, some much more frequently than that. Need a perpetual back-office entity to handle all the “common” functions and assets. Discuss benefits of keeping GP free of trade or business. Qualifying for investment partnership status under Section 731(c), which allows extra flexibility on making disproportionate distributions of marketable securities. Avoiding NYC Unincorporated Business Income tax, etc. Note that the same person may be an equityholder of GP and Mgt. Co., while affirmatively an employee of Mgt. Co. to address employment law concerns. This, of course, raises a number of tax issues relating to employee/partners.
  • Typically, a “Fund” is really a collection of parallel funds. Reasons may include: Securities law, such as avoiding registration under Investment Company Act of 1940 by setting up a Qualified Purchaser Fund Different economics – e.g., Affiliates Fund Tax goals -- e.g., Non-MFO Fund and Principals Fund Note that the structure shown here gives only a hint of the many parallel entities that may be formed. The key thing about parallel entities is that they’re actually parallel. This is to be distinguished from “Alternate Investment Vehicles” which may be formed alongside a fund structure for specific investments or classes of investments. Note “client count” issue under Investment Advisers Act. I’m not going to address “blocker” entities, which will be addressed by another member of the panel.
  • This Series LLC structure is designed to address a problem arising under proposed regs regarding QSBS. Summarize QSBS rollover benefit Difficulty in finding replacement stock outside fund context Proposed regs would make reinvestment through a fund non-qualifying This gets around it if you can avoid having the series be in constructive partnership. Overall, pretty cutting edge with many unanswered questions. Goal is to have Principals Fund simply not exist for tax purposes.
  • There are several things to note about this slide. First, note that the Fund is organized outside the US. This often is preferable for Funds that will invest offshore. It utilizes flow-through analysis under the CFC rules to keep the Fund from being a 10%US Shareholder, and thereby triggering CFC issues. Second, note the use of Mauritius Subs. as a conduit for investing into Indian companies. The purpose is to avoid Indian tax on capital gains by qualifying under the India/Mauritius tax treaty. Different types of subs may be used, depending on where investments will be made. For example, we recently started setting up Barbados subs for investing in Chinese companies. There can be big issues in organizing under foreign law. For example, penalty provisions for failing to contribute capital often are not enforceable under foreign law or are subject to greater restrictions than in Delaware. Also note the Advisory Co, which is actually organized in India. It houses the investment and support team on the ground in India, and is designed to prevent the Fund and the GP from having an Indian PE. It gets paid on a cost-plus basis. This is a common structure for funds targeted at non-US investments.
  • This really is just a brief overview. My job is just to make sure everyone has the basic vocabulary down for the presentations that will follow. The reason for the VC perspective is that I spend most of my time forming VC funds so the usage just comes naturally for me. Nearly everything I’m going to say applies equally to PE firms.
  • This really is just a brief overview. My job is just to make sure everyone has the basic vocabulary down for the presentations that will follow. The reason for the VC perspective is that I spend most of my time forming VC funds so the usage just comes naturally for me. Nearly everything I’m going to say applies equally to PE firms.
  • This really is just a brief overview. My job is just to make sure everyone has the basic vocabulary down for the presentations that will follow. The reason for the VC perspective is that I spend most of my time forming VC funds so the usage just comes naturally for me. Nearly everything I’m going to say applies equally to PE firms.
  • This really is just a brief overview. My job is just to make sure everyone has the basic vocabulary down for the presentations that will follow. The reason for the VC perspective is that I spend most of my time forming VC funds so the usage just comes naturally for me. Nearly everything I’m going to say applies equally to PE firms.
  • This really is just a brief overview. My job is just to make sure everyone has the basic vocabulary down for the presentations that will follow. The reason for the VC perspective is that I spend most of my time forming VC funds so the usage just comes naturally for me. Nearly everything I’m going to say applies equally to PE firms.
  • Typically, a “Fund” is really a collection of parallel funds. Reasons may include: Securities law, such as avoiding registration under Investment Company Act of 1940 by setting up a Qualified Purchaser Fund Different economics – e.g., Affiliates Fund Tax goals -- e.g., Non-MFO Fund and Principals Fund Note that the structure shown here gives only a hint of the many parallel entities that may be formed. The key thing about parallel entities is that they’re actually parallel. This is to be distinguished from “Alternate Investment Vehicles” which may be formed alongside a fund structure for specific investments or classes of investments. Note “client count” issue under Investment Advisers Act. I’m not going to address “blocker” entities, which will be addressed by another member of the panel.
  • Typically, a “Fund” is really a collection of parallel funds. Reasons may include: Securities law, such as avoiding registration under Investment Company Act of 1940 by setting up a Qualified Purchaser Fund Different economics – e.g., Affiliates Fund Tax goals -- e.g., Non-MFO Fund and Principals Fund Note that the structure shown here gives only a hint of the many parallel entities that may be formed. The key thing about parallel entities is that they’re actually parallel. This is to be distinguished from “Alternate Investment Vehicles” which may be formed alongside a fund structure for specific investments or classes of investments. Note “client count” issue under Investment Advisers Act. I’m not going to address “blocker” entities, which will be addressed by another member of the panel.
  • meetings.abanet.org

    1. 1. TAX ISSUES IN PRIVATE EQUITY & VENTURE CAPITAL ABA Section of Business Law August 12, 2007 Julie Divola Jonathan Axelrad Pillsbury Winthrop Shaw Pittman LLP Wilson Sonsini Goodrich & Rosati John Lorito John Simon Stikeman Elliott LLP KPMG LLP
    2. 2. Introduction to VC/PE Fund Structures plus Update on Proposed Changes to Taxation of Carried Interest
    3. 3. Introduction <ul><li>Venture Capital and Private Equity (VC/PE) firms traditionally have used partnership structures for the “Funds” that they use to raise capital and make investments </li></ul><ul><li>These structures vary significantly and have evolved over time </li></ul><ul><li>Key considerations are tax, securities law, alignment of interests, difficulty of valuing private securities, and liability compartmentalization </li></ul><ul><li>This presentation briefly provides an overview of certain “typical” fund structures, primarily from a VC perspective </li></ul><ul><li>Special Bonus! A brief update on proposed changes to the taxation of carried interest </li></ul>
    4. 4. Traditional Fund Structure Portfolio Securities ROI Management Fee Carry Investors (LP) $99% ROI VCs MM/MD $1% Key: L.L.C. = Limited Liability Company LP = Limited Partner L.P. = Limited Partnership MM/MD = Managing Member or Managing Director ROI = Return on Invested Capital All entities are organized under Delaware law. Fund, L.P. General Partner, L.L.C.
    5. 5. Traditional with Back-Office/Management Co. VCs Portfolio Securities $99% ROI Management Fee Carry ROI MM/MD $1% Key: L.L.C. = Limited Liability Company LP = Limited Partner L.P. = Limited Partnership MM/MD = Managing Member or Managing Director ROI = Return on Invested Capital All entities are organized under Delaware law. Management Co. has perpetual life and may provide services to multiple General Partner entities. All other entities are single-purpose and limited-term. Management Co., L.L.C. Venture Firm Name Office Equipment/Lease Payroll System Staff Relationships Assign Management Fee Back-Office Services General Partner, L.L.C. MM/MD Fund, L.P. Investors (LP)
    6. 6. Structure Often Includes Many Parallel Entities Notes: 1. Qualified Purchaser funds admit only investors that are “qualified purchasers” under the Investment Company Act of 1940 typically, individuals holding >$5 million, and entities holding >$25 million, in investment assets). 2. Affiliates funds have reduced/zero fees/carry. 3. Non-MFO fund does not have an offset against management fees for directors fees, etc. received by VCs from portfolio companies. 4. Principals fund allows VCs and their family/estate planning vehicles to co-invest on a tax-efficient, pro rata basis. It actually holds title as a mere nominee on behalf of its partners. VCs Portfolio Securities Qualified Purchaser Fund, L.P. Non-Qualified Purchaser Fund, L.P. Qualified Purchaser Affiliates Fund, L.P. Investors Non-Qual. Purchaser Affiliates Fund, L.P. Non-MFO Fund, L.P. General Partner, L.L.C. Principals Fund, L.P. Management Co., L.L.C. Investors (Non-U.S.) Investors Investors Investors
    7. 7. Alternative Structure For Principals Fund Portfolio Securities Investors General Partner, L.L.C. Principals Fund, L.L.C. Series 1 Series 2 Main Fund, L.P. AC = Additional Capital AC AC Fund Manager 2 Fund Manager 1
    8. 8. Sample Alternative For International Investing -- India FVCI Sub Mauritius Co. FII Sub Mauritius Co. Private Indian Investments Public Indian Investments Advisory Agreement Limited Partners Fund Cayman Islands LP Advisory Co Indian Co. General Partner
    9. 9. Proposed Changes to Taxation of Carried Interest <ul><li>S. 1624 </li></ul><ul><ul><li>Would amend IRC Sec. 7704(c) to eliminate corporate tax exemption for publicly traded partnerships with 90% passive income </li></ul></ul><ul><ul><li>Covers partnerships “providing certain investment adviser and related asset management services” </li></ul></ul><ul><ul><li>Often called the “Blackstone Bill” because thought to have been triggered by recent/proposed IPOs of large PE firms </li></ul></ul><ul><ul><li>Not expected to have a huge impact on VC/PE industry because so few firms in a position to go public </li></ul></ul>
    10. 10. Proposed Changes to Taxation of Carried Interest <ul><li>H.R. 2834 </li></ul><ul><ul><li>Would add new IRC Sec. 710 to treat carried interest “distributive share” as ordinary income for the performance of services, regardless of character of partnership’s underlying income </li></ul></ul><ul><ul><li>Essentially based on a profit share that is disproportionately large relative to capital contribution </li></ul></ul><ul><ul><li>Applies if there is provision of investment services in the active conduct of a trade or business </li></ul></ul><ul><ul><ul><li>Not clear how this would apply to a traditional fund structure, under which neither Fund nor General Partner typically would be engaged in a “trade or business” </li></ul></ul></ul><ul><ul><li>Per statements from Congress, intended to cover nearly all private investment partnerships, including VC/PE, real estate, oil and gas, etc. </li></ul></ul><ul><ul><li>This bill is really just a first draft </li></ul></ul><ul><ul><ul><li>Many technical issues/glitches </li></ul></ul></ul><ul><ul><ul><li>Hearings in process </li></ul></ul></ul>
    11. 11. Proposed Changes to Taxation of Carried Interest <ul><li>H.R. 2834 (cont) </li></ul><ul><ul><li>Extremely controversial </li></ul></ul><ul><ul><ul><li>Apparent loophole closer – rich fund managers paying capital gains taxes on income from their advisory services </li></ul></ul></ul><ul><ul><ul><li>Leading Democrats voicing support (Clinton, Obama, Edwards) </li></ul></ul></ul><ul><ul><ul><li>Republicans generally oppose (Treasury Dept., etc.) </li></ul></ul></ul><ul><ul><ul><li>Lobbyists heavily engaged, with focus on </li></ul></ul></ul><ul><ul><ul><ul><li>International competitiveness (fund managers moving offshore; foreign investors outbidding for US investments) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Impairment of innovation and capital formation </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Comparison with “founders stock” (if entrepreneurs can get capital gains treatment when their companies appreciate, why not VC/PE managers who also work hard for the companies’ success?) </li></ul></ul></ul></ul>
    12. 12. Proposed Changes to Taxation of Carried Interest <ul><li>H.R. 2834 (cont) </li></ul><ul><ul><li>It will be difficult for Congress to craft a statute that can’t be structured around </li></ul></ul><ul><ul><ul><li>At least without vast changes to the IRC </li></ul></ul></ul><ul><ul><ul><li>See lack of success in shutting down swap/exchange funds, despite several targeted IRC amendments </li></ul></ul></ul><ul><ul><li>Lack of definitive statutory text (assuming current bill really is just a first draft) makes it difficult to estimate what structures will be helpful </li></ul></ul><ul><ul><ul><li>Nevertheless . . . </li></ul></ul></ul>
    13. 13. Proposed Changes to Taxation of Carried Interest <ul><li>H.R. 2834 (cont) </li></ul><ul><ul><li>Potential gold mine for tax lawyers </li></ul></ul><ul><ul><ul><li>The stakes are high enough to pay for almost any degree of complex structuring </li></ul></ul></ul><ul><ul><ul><li>Example: Assume $1 billion fund, which yields a 3x return </li></ul></ul></ul><ul><ul><ul><ul><li>20% carry to GP: $400 million </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Ordinary income vs. LTCG tax differential: $80 million </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Employment taxes and timing differences would make spread even larger </li></ul></ul></ul></ul></ul><ul><ul><ul><li>If the bill (or anything like it) passes . . . </li></ul></ul></ul>
    14. 14. Expect This: VCs Portfolio Securities Qualified Purchaser Fund, L.P. Non-Qualified Purchaser Fund, L.P. Qualified Purchaser Affiliates Fund, L.P. Investors Non-Qual. Purchaser Affiliates Fund, L.P. Non-MFO Fund, L.P. General Partner, L.L.C. Principals Fund, L.P. Management Co., L.L.C. Investors (Non-U.S.) Investors Investors Investors
    15. 15. To Be Replaced By This:
    16. 16. Tax Issues in Private Equity and Venture Capital: Blocker Corporations
    17. 17. Taxation of Pass-Through Entities vs. Corporations
    18. 18. Pass-Through Entities <ul><li>What is a Pass-Through Entity? </li></ul><ul><ul><li>An entity in which, for Federal income tax purposes, all of the income and losses of the entity flow through and are taxed to the owners of the entity </li></ul></ul><ul><ul><li>Owners are taxed directly on the entity-level income, regardless of whether cash is distributed </li></ul></ul><ul><ul><li>Income maintains same character (e.g. capital gain) </li></ul></ul><ul><li>Examples of Pass-Through Entities: </li></ul><ul><ul><li>Partnerships </li></ul></ul><ul><ul><li>S Corporations </li></ul></ul><ul><ul><li>Limited Liability Companies </li></ul></ul>
    19. 19. Corporations <ul><li>C corporations are subject to “double taxation” </li></ul><ul><li>Income of a corporation is taxed first at the corporate level </li></ul><ul><ul><li>Shareholders of a corporation are not directly taxable on this income </li></ul></ul><ul><li>Second level of tax is at the shareholder level - when a corporation distributes the income in the form of dividends, the shareholders pay tax </li></ul><ul><ul><li>Not a direct share of entity income </li></ul></ul><ul><ul><li>Dividends, return of capital, capital gain </li></ul></ul>
    20. 20. Private Equity Funds
    21. 21. Private Equity Funds <ul><li>Private equity funds (“Funds”) are organized frequently as entities classified as partnerships (pass-through entities) for Federal tax purposes </li></ul><ul><ul><li>LLCs </li></ul></ul><ul><ul><li>Limited Partnerships </li></ul></ul><ul><li>Typical Fund investors include: </li></ul><ul><ul><li>State pension plans </li></ul></ul><ul><ul><li>Other tax-exempt organizations </li></ul></ul><ul><ul><li>Corporate sponsored retirement plans </li></ul></ul><ul><ul><li>Foreign investors </li></ul></ul><ul><ul><li>Other U.S. investors </li></ul></ul>
    22. 22. Significance of Types of Fund Investors <ul><li>Tax-exempt and foreign investors generally qualify for certain exemptions from U.S. federal income tax </li></ul><ul><li>However: </li></ul><ul><ul><li>Tax-exempt investors are taxed on Unrelated Business Taxable Income (“UBTI”) </li></ul></ul><ul><ul><li>Foreign investors are taxed on Effectively Connected Income (“ECI”) </li></ul></ul>
    23. 23. Significance of Types of Fund Investors <ul><li>If a Fund that is classified as a pass-through entity has UBTI or ECI, its tax-exempt or foreign owners may be required to pay U.S federal income tax on such income because the income flows through to them </li></ul><ul><li>Requires filing US tax return </li></ul>
    24. 24. What is UBTI?
    25. 25. Unrelated Business Income Tax <ul><li>Overview and General Rules </li></ul><ul><li>Internal Revenue Code (“IRC”) Section 501 grants tax exempt status to a variety of tax-exempt and mutually beneficial organizations </li></ul><ul><li>IRC Section 511 may tax otherwise tax-exempt organizations on their unrelated business income (the “Unrelated Business Income Tax,” or “UBIT”) </li></ul><ul><li>Unrelated Business Taxable Income (“UBTI”) is income from a trade or business regularly carried on by an exempt organization that is not substantially related to the organization’s exempt purpose </li></ul>
    26. 26. Unrelated Business Taxable Income <ul><li>The following are excluded from UBTI unless they are derived from debt-financed property, or, in the case of interest, from controlled organizations: </li></ul><ul><ul><li>Gains from the sale of stock </li></ul></ul><ul><ul><li>Interest </li></ul></ul><ul><ul><li>Dividends </li></ul></ul>
    27. 27. Sources of UBTI <ul><li>For private investment funds the principal areas of concern are: </li></ul><ul><ul><li>Fund investments in portfolio pass-through entities </li></ul></ul><ul><ul><li>Unrelated debt-financed income </li></ul></ul><ul><ul><li>Fees earned by the Fund </li></ul></ul>
    28. 28. Sources of UBTI – Operating Partnerships <ul><li>Unrelated trade or business of a partnership is imputed to the tax-exempt partners </li></ul><ul><ul><li>The tax-exempt partner’s share of the income for the trade or business is UBTI </li></ul></ul><ul><li>Trade or business can be attributed up through partnerships </li></ul><ul><ul><li>If a Fund invests in a pass-through entity that is engaged in a trade or business, a tax-exempt partner’s share of the entity’s income would be UBTI </li></ul></ul>
    29. 29. Portfolio Investments in Partnerships? <ul><li>Why would a Fund invest in a partnership? </li></ul><ul><li>Existing target is a partnership (e.g. an LLC) </li></ul><ul><li>Single level of tax on target earnings </li></ul><ul><ul><li>Stepped up basis from earned income </li></ul></ul><ul><li>Exit strategy: sale of partnership can give buyer stepped-up basis in target assets </li></ul><ul><ul><li>May result in higher sale price </li></ul></ul><ul><li>Tax Distributions </li></ul>
    30. 30. Partnership acquisition structure <ul><li>Fund can get basis step up through 754 election </li></ul><ul><li>Maintains single level of tax </li></ul><ul><li>May avoid potential anti-churning problem </li></ul><ul><li>Next buyer can get basis step up on sale of New Portfolio LLC </li></ul>Target New Portfolio Sellers Fund Investors Target Assets
    31. 31. Unrelated debt-financed income <ul><li>Capital gain, interest and dividends normally excluded from UBTI are treated as UBTI to the extent the property generating the income is financed by debt </li></ul><ul><li>Includes both direct debt of the investor and investor’s allocable share of Fund or portfolio company (if a pass-through) debt </li></ul>
    32. 32. Sources of UBTI – Fees <ul><li>Fees may constitute UBTI </li></ul><ul><li>May result from dealings with a portfolio company </li></ul><ul><li>Examples include: </li></ul><ul><ul><li>Management and monitoring fees </li></ul></ul><ul><ul><li>Origination and commitment fees </li></ul></ul><ul><ul><li>Break-up and finder’s fees </li></ul></ul><ul><ul><li>Underwriting commissions </li></ul></ul><ul><ul><li>Other transaction-related payments </li></ul></ul>
    33. 33. What is ECI?
    34. 34. Effectively Connected Income <ul><li>Overview and General Rules </li></ul><ul><li>Section 871(b) subjects foreign persons to U.S. federal income tax on income effectively connected with the conduct of a trade or business within the U.S. </li></ul><ul><li>Section 875 treats a foreign person that is a partner in a partnership as being engaged in any trade or business in which the partnership is engaged </li></ul><ul><li>Both the Fund and the foreign investors are deemed to be engaged in the U.S. trade or business in which any of the portfolio companies taxed as pass-through entities are engaged </li></ul>
    35. 35. Consequences of ECI <ul><li>ECI generated by the portfolio company is taxed on a net basis in the same manner and at the same rates as income of a U.S. person </li></ul><ul><li>The foreign investor must file a U.S. tax return, regardless of whether it actually recognizes income in any given year </li></ul>
    36. 36. Sources of ECI <ul><li>In private investment funds, the principal areas of concern are: </li></ul><ul><ul><li>Fund investments in portfolio pass-through entities </li></ul></ul><ul><ul><li>Investments in U.S. real property interests </li></ul></ul><ul><ul><li>Fees earned by the Fund </li></ul></ul>
    37. 37. Sources of ECI – Fund Investments in Portfolio Pass-Through Entities <ul><li>If a Fund invests in a pass-through entity that is engaged in a trade or business, a foreign partner’s share of the entity’s income would be ECI </li></ul><ul><li>A portion of any gain realized by the foreign investor upon the sale of its interest in a Fund that directly or indirectly conducts a US trade or business would be ECI to the extent of the foreign investor’s share of gain or loss on sale of Fund assets would be ECI. </li></ul><ul><li>Sale by Fund of investment in pass through entity can create ECI if assets used in US trade or business </li></ul>
    38. 38. Sources of ECI – U.S. Real Property Interests <ul><li>Investments in U.S. Real Property Interests are always treated as ECI </li></ul><ul><li>U.S. Real Property Interests include: </li></ul><ul><ul><li>Real property located in the U.S. </li></ul></ul><ul><ul><li>Fixtures on such real property </li></ul></ul><ul><ul><li>Stock in a U.S. Real Property Holding Company (“USRPHC”) </li></ul></ul><ul><li>A USRPHC is any domestic corporation if more than 50% of the fair market value of such corporation’s assets is attributable to U.S. real property interests </li></ul><ul><li>A blocker corporation structure is NOT effective to avoid the recognition of ECI from U.S. real property interests </li></ul>
    39. 39. Sources of ECI – Income from Fees <ul><li>Fees may be considered ECI, including: </li></ul><ul><ul><li>Management, consulting and monitoring fees </li></ul></ul><ul><ul><li>Origination and commitment fees </li></ul></ul><ul><ul><li>Break-up and finder’s fees </li></ul></ul><ul><ul><li>Closing fees </li></ul></ul><ul><ul><li>Equity commitment fees </li></ul></ul><ul><ul><li>Guarantee fees </li></ul></ul><ul><li>More inclusive then UBTI </li></ul>
    40. 40. Branch Profits Taxes <ul><li>Foreign investors that are corporations, or that invest through a foreign corporation, may be subject to an additional tax (the “branch profits tax”) </li></ul><ul><li>Branch profits tax is equal to 30% of the “dividend equivalent amount,” which is the earnings and profits of a U.S. branch of a foreign corporation attributable to its ECI </li></ul><ul><li>Triggered by changes in US net equity </li></ul><ul><li>Avoided by complete termination of US trade or business </li></ul><ul><li>May be modified by treaty </li></ul>
    41. 41. What is a Blocker Corporation?
    42. 42. What is a Blocker Corporation? <ul><li>A “blocker corporation” is a corporation that is placed between the tax-exempt or foreign investors and the source of UBTI and ECI </li></ul><ul><li>The blocker corporation incurs and pays tax on the operating income that is allocated to it from the pass-through entity, and thus “blocks” such income from reaching the tax-exempt and foreign investors </li></ul><ul><li>Any net after-tax proceeds distributed by the blocker corporation to the tax-exempt and foreign investors should be non-UBTI, non-ECI distributions </li></ul>
    43. 43. Structures Using Blocker Corporations <ul><li>There are generally three types of blocker structures: </li></ul><ul><ul><li>Parent Blocker , in which the blocker is positioned “above the Fund” as a direct investor in the Fund </li></ul></ul><ul><ul><li>Subsidiary Blocker , in which the blocker is positioned “below the Fund” as a wholly-owned subsidiary of the Fund </li></ul></ul><ul><ul><li>Parallel Blocker , in which the blocker is positioned below a parallel Fund that is formed to invest side-by-side with the main Fund </li></ul></ul>
    44. 44. Tax Consequences of Using a Blocker Corporation <ul><li>The U.S. tax consequences of holding a pass-through investment through a blocker corporation depends on the chosen structure </li></ul><ul><li>Specifically, the tax consequences depend on: </li></ul><ul><ul><li>Whether the blocker is domestic or foreign </li></ul></ul><ul><ul><li>Whether the blocker holds all or only a subset of the fund investments </li></ul></ul><ul><ul><li>Whether the blocker resides above, below, or parallel to the Fund </li></ul></ul><ul><li>Threshold question is whether the blocker will be respected as the tax owner of the investment </li></ul>
    45. 45. Blocker Structuring Examples
    46. 46. Fund Invests in Corporation <ul><li>Investors contribute capital to Fund </li></ul><ul><li>Fund invests in portfolio corporation </li></ul>GP Fund Foreign Investor Exempt Investor Corp Other Investors
    47. 47. Fund Invests in LLC <ul><li>Investors contribute capital to Fund </li></ul><ul><li>Fund invests in portfolio LLC </li></ul>GP Fund Foreign Investor Exempt Investor LLC Other Investors
    48. 48. No Blocker <ul><li>Pros </li></ul><ul><ul><li>Structural simplicity </li></ul></ul><ul><ul><li>Not all gain on sale of LLC interest will necessarily be UBTI or ECI </li></ul></ul><ul><li>Cons </li></ul><ul><ul><li>Exempt Investor and Foreign Investor probably have UBTI and ECI </li></ul></ul><ul><ul><ul><li>Foreign Investor is required to file US tax return </li></ul></ul></ul><ul><ul><ul><li>Exempt Investor may have to file tax return </li></ul></ul></ul><ul><ul><li>Sale of one (of multiple) LLC by Fund could trigger branch profits tax on Foreign Investor </li></ul></ul>
    49. 49. Parent Blocker <ul><li>Mechanics: </li></ul><ul><ul><li>Exempt Investor and Foreign Investor contribute capital for investment in LLC to a corporation (“Blocker Corp”) in exchange for 100% of the stock </li></ul></ul><ul><ul><li>Blocker Corp contributes capital to Fund and participates in investment in same manner as all Other Investors </li></ul></ul><ul><ul><ul><li>New Blocker Corp for each investment </li></ul></ul></ul><ul><ul><li>Blocker Corp will generally be a foreign corporation </li></ul></ul>
    50. 50. Parent Blocker GP Fund LLC Foreign Investor Blocker Corp Exempt Investor Other Investors
    51. 51. Parent Blocker <ul><li>Pros </li></ul><ul><ul><li>Exempt Investor and Foreign Investor will not have to report UBTI or ECI </li></ul></ul><ul><ul><li>Foreign and Exempt Investors will not have to file US tax return </li></ul></ul><ul><ul><li>GP’s carried interest is not affected by Blocker Corp </li></ul></ul><ul><li>Cons </li></ul><ul><ul><li>Difficult to avoid Blocker Corp level tax on disposition </li></ul></ul><ul><ul><li>Potential Branch Profits Tax issue </li></ul></ul><ul><ul><li>Tax rate to Foreign Investor </li></ul></ul>
    52. 52. Subsidiary Blocker <ul><li>Mechanics: </li></ul><ul><ul><li>Fund forms Blocker Corp as wholly-owned subsidiary </li></ul></ul><ul><ul><li>Fund agreement provides: </li></ul></ul><ul><ul><ul><li>Fund contributes capital contributions of Exempt Investor and Foreign Investor to Blocker Corp, which uses them to acquire pro rata share of portfolio LLC </li></ul></ul></ul><ul><ul><ul><li>Exempt Investor and Foreign Investor share in distributions and allocations to extent they are derived from distributions or sales proceeds attributable to Blocker Corp </li></ul></ul></ul><ul><ul><ul><li>Distributable cash of Fund attributable to Blocker Corp is divided between Exempt Investor, Foreign Investor and GP </li></ul></ul></ul><ul><ul><ul><li>All other distributable cash and allocations of income and losses attributable to LLC are allocated among Other Investors and GP </li></ul></ul></ul>
    53. 53. Subsidiary Blocker GP Fund LLC Other Investors Foreign Investor Blocker Corp Exempt Investor
    54. 54. Subsidiary Blocker <ul><li>Pros </li></ul><ul><ul><li>Fund can sell Blocker Corp as part of sale of portfolio LLC </li></ul></ul><ul><ul><li>Exempt Investor and Foreign Investor not taxable on disposition of stock </li></ul></ul><ul><li>Cons </li></ul><ul><ul><li>Substantial economic effect issues </li></ul></ul><ul><ul><li>Buyer will not get a step up on sale of Blocker Corp </li></ul></ul><ul><ul><li>Other ECI or UBTI at Fund? </li></ul></ul><ul><ul><li>Effect on GP’s carry </li></ul></ul>
    55. 55. Subsidiary Blocker (alternative) GP Fund LLC Foreign Investor Blocker Corp Exempt Investor LLC Other Investors
    56. 56. Parallel Blocker <ul><li>Mechanics: </li></ul><ul><ul><li>Parallel investment vehicle (“Parallel Fund”) is established for Exempt and Foreign Investors </li></ul></ul><ul><ul><li>Parallel Fund will incorporate wholly-owned subsidiary for each pass-through investment </li></ul></ul>
    57. 57. Parallel Fund Other Investors Parallel Fund LLC GP Foreign Investor Blocker Corp Exempt Investor Fund Corporate Investments
    58. 58. Blocker Corp Debt <ul><li>Use capital contribution of Exempt Investor and Foreign Investor to loan capital to Blocker Corp </li></ul><ul><li>Creates deductions at Blocker Corp that offset gain in sale of portfolio LLC </li></ul><ul><ul><li>Reduces corp level tax at Blocker Corp </li></ul></ul><ul><ul><li>Interest non-taxable to Exempt Investor and maybe Foreign Investor </li></ul></ul><ul><ul><ul><li>Earnings stripping (Section 163(j)) </li></ul></ul></ul><ul><ul><ul><li>Portfolio interest limitations </li></ul></ul></ul>
    59. 59. Blocker Corp Debt GP Fund LLC Other Investors Foreign Investor Blocker Corp Exempt Investor Debt
    60. 60. Debt and Warrant Structure <ul><li>Structure portfolio investment as straight debt coupled with warrants </li></ul><ul><li>Debt/equity issues </li></ul><ul><li>Basic tax objective is to avoid status as a &quot;partner&quot; for tax purposes </li></ul><ul><ul><li>If the investor is not a partner of the portfolio company, it will not be deemed to be engaged in the trade or business of the portfolio company </li></ul></ul>
    61. 61. Debt and Warrant Structure Fund LLC Debt Other Investors Warrant Foreign Investor Exempt Investor GP
    62. 62. Debt and Warrant Structure <ul><li>UBTI/ECI Risks </li></ul><ul><li>Debt could be treated as equity </li></ul><ul><li>Warrant could be treated as profits interest in operating company, resulting in UBTI and ECI </li></ul><ul><ul><li>particularly if warrant holders have rights typically held by equity holders (such as voting rights) </li></ul></ul>
    63. 63. Structuring Investments in or Acquisitions of Portfolio Companies
    64. 64. Portfolio Investments <ul><li>Providing for dividend vs. capital gain in a “partial exit” </li></ul><ul><li>Acquisitions utilizing Section 338(h)(10) in transactions involving management rollovers </li></ul><ul><li>Minimizing taxes on ‘PIK’ preferred stock </li></ul>
    65. 65. Dividend vs. Capital Gain in a “Partial Exit”
    66. 66. Dividend vs. Capital Gain Exempt Exempt 35% + Basis Offset 15% + Basis Offset LTCG                     Exempt Exempt 35% + Basis Offset 35% + Basis Offset STCG                       Reduced Treaty Rate   No Basis Offset   Exempt Withholding at 30% or 10.5% (after DRD) 15% if QDI/ Dividend                     Tax-Exempt Foreign US Corporate Individual Character of Income Investor  
    67. 67. Leveraged Recap in < One Year (assumes e&p > total distribution) <ul><li>Investor </li></ul><ul><li>Individual* </li></ul><ul><li>US Corporate* </li></ul><ul><li>Foreign </li></ul><ul><li>Tax-Exempt </li></ul><ul><li>Prefer Dividend or Capital Gain? </li></ul><ul><li>Dividend if (15% x (Distribution)) < (35% x (Distribution - Basis)) </li></ul><ul><li>Dividend if (35% x (Distribution x (1 - 70%)) < (35% x (Distribution - Basis)) </li></ul><ul><li>Capital Gain </li></ul><ul><li>Indifferent </li></ul>* Assumes full use of &quot;lost basis&quot; to reduce future capital gain
    68. 68. Leveraged Recap in > One Year (assumes e&p > total distribution) <ul><li>Investor </li></ul><ul><li>Individual* </li></ul><ul><li>US Corporate* </li></ul><ul><li>Foreign </li></ul><ul><li>Tax-Exempt </li></ul><ul><li>Prefer Dividend or Capital Gain? </li></ul><ul><li>Capital Gain </li></ul><ul><li>Dividend if (35% x (Distribution x (1 - 70%)) < (35% x (Distribution - Basis)) </li></ul><ul><li>Capital Gain </li></ul><ul><li>Indifferent </li></ul>* Assumes full use of &quot;lost basis&quot; to reduce future capital gain
    69. 69. Parial Exit: Leveraged Recap Target Holdco Midco <ul><ul><ul><li>Holdco incurs debt to finance distribution of investors. Newco designed to minimize E&P. (It has no other debt so need for distributions to Newco is eliminated.) </li></ul></ul></ul><ul><ul><ul><li>Distributions are taxed: First, as dividends to the extent of earnings and profits; Second, as tax-free return of capital; and Third, as capital gain (once basis is offset). </li></ul></ul></ul><ul><ul><ul><li>Query whether result can be changed to “boot dividend” treatment if existing shares are exchanged for new shares. Boot dividend is taxed as a dividend, but only to the extent of any built-in gain. </li></ul></ul></ul>Loan Fund Fund Fund
    70. 70. Partial Exit Target Holdco Midco <ul><ul><ul><li>Alternatively, structure could have Holdco owning all Midco common but with each Fund owning Midco nonvoting preferred in proportion to their common interests in Holdco. </li></ul></ul></ul><ul><ul><ul><li>Midco uses loan proceeds to redeem preferred shares. Redemption should be entitled to capital gain treatment under section 302(a). See Trea. regs. § 1.302-2(a) and Rev. Rul. 77-426. </li></ul></ul></ul><ul><ul><ul><li>Another alternative in some cases: Convert Midco to an LLC, treatd as a deemed liquidation. Sale or exchange treatment under section 331 should be available as long as preferred stock is not “plain vanilla” preferred under section 1504(a). </li></ul></ul></ul>33% Common Fund Fund Fund Loan 33% Common 33% Common 33% Pfd 33% Pfd 33% Pfd
    71. 71. Section 338(h)(10) Transactions Involving Management Rollovers
    72. 72. Section 338(h)(10) Election <ul><li>Election to Treat a Stock Sale as an Asset Sale </li></ul><ul><li>Can Apply to a Subsidiary in a Consolidated/Affiliated Group or to an S Corporation </li></ul><ul><li>Purchaser must be a corporation </li></ul><ul><li>Qualified Stock Purchase (QSP)— Acquiring must purchase amount of stock described in section 1504(a)(2) in one or more transactions within a 12-month period. See section 338(d)(3) </li></ul>
    73. 73. Section 338(h)(10) Election <ul><li>Section 1504(a)(2): Generally 80% voting power and 80% value (excluding certain plain vanilla preferred) </li></ul><ul><li>Purchase under section 338(h)(3) means: </li></ul><ul><ul><li>T he stock basis is not determined, in whole or part, by reference to its basis in the hands of the seller </li></ul></ul><ul><ul><li>The stock is not acquired in an exchange that is subject to section 351 or section 354 </li></ul></ul><ul><ul><li>The stock is not a acquired from a person whose stock would be attributed to the acquiring person under section 318(a) (ignoring option attribution) </li></ul></ul>
    74. 74. Section 338(h)(10) Election: Example 1 Target Target Stock (20%) Newco Mgmt Newco Stock Merger Sub $150 P <ul><ul><ul><li>X forms Newco to acquire Target </li></ul></ul></ul><ul><ul><ul><li>Target’s FMV is $200. </li></ul></ul></ul><ul><ul><ul><li>P corp. owns 80% of Target; Mgt. owns 20% of Target </li></ul></ul></ul><ul><ul><ul><li>Mgmt. will “rollover” their 20% interest by contributing their Target stock to Newco </li></ul></ul></ul><ul><ul><ul><li>X contributes $150 to Newco </li></ul></ul></ul><ul><ul><ul><li>Newco forms Merger Sub and contributes the $150 received from X </li></ul></ul></ul><ul><ul><ul><li>Merger Sub borrows $10 </li></ul></ul></ul><ul><ul><ul><li>Merger Sub merges into Target with Target surviving; P receives $160 in the merger </li></ul></ul></ul>X $150 $10 Loan 20% 80% Reverse Merger Newco Stock
    75. 75. Section 338(h)(10) Election: Example 1 Target Target Stock (20%) Newco Mgmt Newco Stock $150 P <ul><ul><li>Are the QSP requirements satisfied? </li></ul></ul><ul><ul><ul><li>Newco is treated as acquiring Target stock. Rev Rul. 73-427, Rev. Rul. 78-250 and Rev. Rul. 79-273. </li></ul></ul></ul><ul><ul><ul><li>Transfer of P shares is treated as part-sale and part-redemption. </li></ul></ul></ul><ul><ul><ul><li>Mgmt. shares acquired tax-free under section 351. Rev. Rul. 84-71. </li></ul></ul></ul><ul><ul><ul><li>However, Mgmt. shares represent 21% of total Target shares. P only acquires 79% of Target shares by “purchase.” (Where Section 338(h)(10) election is respected Target recognizes 100% of the gain on the deemed sale of its assets.) </li></ul></ul></ul><ul><ul><li>What if the loan is to Newco? </li></ul></ul>X $150 $10 Loan $160 Newco Stock
    76. 76. Section 338(h)(10) Election: Example 2 Target Target Stock (100%) Newco 5% Newco Stock & $190 P <ul><ul><ul><li>X forms Newco to acquire Target </li></ul></ul></ul><ul><ul><ul><li>Target’s FMV is $200. </li></ul></ul></ul><ul><ul><ul><li>P receives $190 plus 5% of the Newco stock </li></ul></ul></ul><ul><ul><ul><li>Are the QSP requirements satisfied? </li></ul></ul></ul><ul><ul><ul><ul><li>P’s shares of Target were acquired in a section 351 transaction with boot </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Any difference if all of P’s gain is recognized? See section 338(h)(3)(A)(ii). </li></ul></ul></ul></ul>X $190 Newco Stock
    77. 77. Section 338(h)(10) Election: Example 3 Target (S Corp.) Target Stock (30%) Newco A Newco Stock & $40 Merger Sub $140 <ul><ul><ul><li>X forms Newco to acquire Target </li></ul></ul></ul><ul><ul><ul><li>Target is an S corporation with a FMV of $200. </li></ul></ul></ul><ul><ul><ul><li>P owns 70% of Target; A owns 30% of Target </li></ul></ul></ul><ul><ul><ul><li>X contributes $180 to Newco </li></ul></ul></ul><ul><ul><ul><li>A will “rollover” a third of her shares. A receives 10% of the stock of Newco and $40 </li></ul></ul></ul><ul><ul><ul><li>Newco forms Merger Sub and contributes $140 </li></ul></ul></ul><ul><ul><ul><li>Merger Sub merges into Target with Target surviving; P receives $140 in the merger </li></ul></ul></ul>X $180 30% 70% Merger P Newco Stock
    78. 78. Section 338(h)(10) Election: Example 3 Target (S Corp.) Target Stock (30%) Newco A Newco Stock & $40 $140 X $180 $140 P <ul><ul><li>Are the QSP requirements satisfied? </li></ul></ul><ul><ul><ul><li>A’s shares (equal to 30% of Target) were acquired in a section 351 transaction </li></ul></ul></ul>Newco Stock
    79. 79. Section 338(h)(10) Election: Example 4 Target Target Stock (20%) Newco Newco Stock X $160 A <ul><ul><ul><li>P and A (Target shareholders) contribute Target stock to Newco in exchange for Newco shares in a section 351 transaction </li></ul></ul></ul><ul><ul><ul><li>At the same time, P sells its Newco shares to X pursuant to a binding written agreement </li></ul></ul></ul><ul><ul><ul><li>Transaction fails section 351 “control immediately after” test. See Rev. Rul. 70-140. </li></ul></ul></ul><ul><ul><ul><li>Can Newco and P make the section 338(h)(10) election? </li></ul></ul></ul><ul><ul><ul><li>What if A receives a note convertible into Newco shares? </li></ul></ul></ul>Target Stock (80%) P (1) (2) Newco Stock Newco Stock
    80. 80. Section 338(h)(10) Election: Example 5 Target Target Stock (20%) Newco A Newco Stock $160 P <ul><ul><li>Facts are the same as in Example 1 except: </li></ul></ul><ul><ul><ul><li>Pursuant to a binding written agreement, X sells Newco shares to friendly bank. </li></ul></ul></ul><ul><ul><ul><li>What if the Newco shares sold by X are a special class of nonvoting preferred stock? What if there is only one share of the special class of preferred? </li></ul></ul></ul><ul><ul><ul><li>See PLR 8817079 (2/4/88), supplemented by PLR 8822062 (3/7/88) (single share of non-voting preferred stock sold to affiliate is sufficient to disqualify transaction under section 368(a)(2)(E)). </li></ul></ul></ul>X $160 $160 Newco Stock (common & preferred) FB $$ Newco preferred stock (1) (2)
    81. 81. Section 338(h)(10) Election: Example 6 Target Target Pref. Stk. & Com. Stk. (20%) Newco A Newco Stock $150 P <ul><ul><li>Facts are the same as in Example 1 except: </li></ul></ul><ul><ul><ul><li>A’s interest in Target is recapitalized immediately before the incorporation of Newco. A receives “plain vanilla” preferred stock. </li></ul></ul></ul><ul><ul><ul><li>Can A get section 351 treatment this way without impacting the section 338(h)(10) election? See Rev. Rul. 57-114 (transitory ownership not respected). </li></ul></ul></ul><ul><ul><ul><li>Does it help if A gets plain vanilla preferred stock of Newco? </li></ul></ul></ul>X $150 $10 Loan $160 Newco Stock
    82. 82. Alternatives to Section 338(h)(10)
    83. 83. Asset Sale through Forward Merger Target Newco A Newco Stock Merger Sub $150 P <ul><ul><li>Same as Example 1 except: </li></ul></ul><ul><ul><ul><li>Target merges into Merger Sub in a forward subsidiary merger. </li></ul></ul></ul><ul><ul><ul><li>P receives cash and A receives Newco stock. </li></ul></ul></ul><ul><ul><ul><ul><li>A does not achieve rollover treatment </li></ul></ul></ul></ul>X $150 $10 Loan 20% 80% Merger Newco Stock $160
    84. 84. Asset Sale through LLC Conversion Target LLC Newco Mgmt Newco Stock P <ul><ul><li>Same as Example 1 except: </li></ul></ul><ul><ul><ul><li>Target is converted into an LLC immediately before the transaction. Mgmt. is taxed in connection with the deemed liquidation of Target. </li></ul></ul></ul><ul><ul><ul><li>No merger. Instead Mgmt. receives Newco stock and P receives cash in exchange for Target LLC interests. </li></ul></ul></ul><ul><ul><ul><li>Target is a disregarded entity in Newco hands; Newco is treated as owning assets for tax purposes. </li></ul></ul></ul>X $150 20% 80% Newco Stock $160 Target LLC interests Target LLC interests $10 Loan
    85. 85. Asset Sale through LLC Conversion Target LLC Mgmt Newco LLC interests P <ul><ul><li>LLC conversion allows asset sale treatment without the requirement that assets continue to be held by a corporate buyer: </li></ul></ul><ul><ul><ul><li>Target is converted into an LLC immediately before the transaction. </li></ul></ul></ul><ul><ul><ul><li>Mgmt. and P are taxed on the deemed liquidation of Target, but liquidation is tax-free to P under section 332. </li></ul></ul></ul><ul><ul><ul><li>Mgmt. receives Newco LLC interests and P receives cash in exchange for Target LLC interests. </li></ul></ul></ul><ul><ul><ul><li>Section 754 election for Target LLC provides stepped-up basis in assets </li></ul></ul></ul>X $150 20% 80% Newco LLC interests $160 Target LLC interests Target LLC interests $10 Loan Newco LLC
    86. 86. Asset Sale through LLC Conversion (S Corp. Target) Target LLC Mgmt Newco LLC interests & $160 X $150 20%* 80% New Target Shares Newco LLC interests $160 Target LLC interests $10 Loan Newco LLC P New Target (S Corp.) <ul><ul><li>Same facts as prior example except that Target is an S corp. </li></ul></ul><ul><ul><li>Target is converted to an LLC as part of an “F reorganization. New Target (holding company) is formed. Old Target is contributed to New Target. Old Target is converted into an LLC. </li></ul></ul><ul><ul><li>New Target is treated as the alter ego of Old Target for tax purposes. Target LLC is disregarded. </li></ul></ul><ul><ul><li>New Target sells Target LLC (deemed asset sale) for cash and Newco LLC interests. Cash is distributed to P in exchange for P’s shares. </li></ul></ul><ul><ul><li>S corporation mechanics mean that only 20% of Mgmt’s gain will be deferred. </li></ul></ul>
    87. 87. Minimizing Dividend Taxes on ‘PIK’ Preferred Stock
    88. 88. Significance to Participants <ul><li>Foreign Investors </li></ul><ul><ul><li>Avoid U.S. withholding taxes </li></ul></ul><ul><ul><li>Avoid accelerated liability for tax </li></ul></ul><ul><ul><li>Potential tax exemption </li></ul></ul><ul><li>U.S. Investors </li></ul><ul><ul><li>Avoid accelerated liability for tax </li></ul></ul><ul><ul><li>Capital gain conversion </li></ul></ul>
    89. 89. “ Pre-Money” Valuation Disputes <ul><li>Conversion Price = LP / # of Common Shares </li></ul><ul><li>Conversion Price usually ‘at-the-money’ </li></ul><ul><li>PIK Preferred to bridge </li></ul>
    90. 90. A Common Valuation Dispute <ul><li>The founders of XYZ Corp need to raise $20 million. They value the business at $30 million. VentureCo proposes to invest $20 million in exchange for newly-issued convertible preferred stock, but values the business at only $20 million. So the founders propose that the preferred be convertible into 40% of the common stock (i.e., $20/($20 + $30)), VentureCo proposes that the preferred be convertible into 50% of the common stock (i.e., $20/($20 + $20)). </li></ul>
    91. 91. The ‘PIK’ Solution <ul><li>XYZ Co issues PIK preferred stock, initially convertible into 40% of the underlying common. The PIK dividend rate is 8.5%. </li></ul><ul><li>After 5 years, the preferred stock is now convertible into 50% of the common stock (i.e., ($20M x 1.085)^5 = $30M). </li></ul><ul><li>By “PIKing” the dividends, VentureCo receives its desired conversion price after 5 years, even though it invested at a pre-money valuation of $30 million. </li></ul>
    92. 92. § 305 Issues with PIK Preferred <ul><li>PIK dividend is taxed to the extent of E&P: </li></ul><ul><li>§ 305 (b)(4): distributions ‘on’ preferred stock. </li></ul><ul><li>§ 305 (b)(5): distributions ‘of’ convertible preferred stock </li></ul><ul><li>§ 305 (b)(2): cash to some, increase in proportionate interest to others </li></ul>
    93. 93. Tax Considerations in Capitalizing Holdcos: Debt vs. Preferred Stock <ul><li>Debt provides an immediate deduction for portfolio companies operating as C corporations (and reduce income subject to double taxation) </li></ul><ul><li>Funds will be immediately taxable on interest income. </li></ul><ul><li>Excess deductions in C corporations are deferred and used only as net operating loss carryovers. In contrast, Funds may use interest deductions generated at the pass-through level. </li></ul><ul><li>Certain tax rules that eliminate, reduce or defer interest deductions must be considered: </li></ul><ul><ul><li>Basic debt vs. equity rules </li></ul></ul><ul><ul><li>Section 163(e) (AHYDO Rules). Applies to debt instruments held more than 5 years, if interest rate is greater than AFR + 5% and there is significant OID. </li></ul></ul><ul><ul><li>Section 279: Acquisition indebtedness that is convertible (or issued with options and warrants) and subordinated. </li></ul></ul><ul><ul><li>Section 163(j): Interest paid to related party that is not subject to tax on the income (or where debt is guaranteed by tax-exempt party) if debt-equity ration is greater than 1.5 to 1. </li></ul></ul>
    94. 94. Tax Considerations in Capitalizing Holdcos: Debt vs. Preferred Stock <ul><li>Dividends on preferred stock generally are not taxed until actual or constructive receipt. See Treas. reg. § 1.301-1(b). </li></ul><ul><li>Preferred “original issue discount” may be created if preferred stock is issued at a discount (i.e., redemption price exceeds issue price). </li></ul><ul><ul><li>Arises where preferred stock is issued as part of an investment unit (with common stock or warrants) unless the value of the preferred stock is equal to its face amount. </li></ul></ul><ul><ul><li>Only applies if stock is preferred for tax purposes (i.e., stock that does not participate in corporate growth to a significant extent). </li></ul></ul><ul><li>Dividend arrearages are generally taxed at capital gain rates upon a sale or redemption of preferred (unless dividends have been previously declared). </li></ul><ul><li>Dividend arrearages may be taxes as dividends (to the extent of E&P) if preferred stock is converted to common stock in a recapitalization. See Treas. Reg. § 1.305-7(c). </li></ul>
    95. 95. Tax Considerations in Making Private Equity Investments in Canada
    96. 96. Tax Considerations in Making Private Equity Investments in Canada <ul><li>General Canadian tax rules applicable to non-resident investors </li></ul><ul><li>Treaty considerations </li></ul><ul><li>Using alternative investment vehicles </li></ul><ul><li>Maximizing tax shelter in the target </li></ul>
    97. 97. General Canadian Tax Rules Applicable to Non-Resident Investors <ul><li>Interest and dividends subject to 25% withholding tax </li></ul><ul><li>Gains on “taxable Canadian Property” subject to capital gains tax </li></ul><ul><li>Rollovers available for conversion of securities </li></ul><ul><li>Clearance certificate requirements </li></ul>
    98. 98. “Taxable Canadian Property” <ul><li>Shares of Canadian resident corporations not listed on a prescribed stock exchange </li></ul><ul><li>Shares of non-resident corporations not listed on a prescribed stock exchange if more than 50% of property is taxable Canadian property or Canadian resource property and more than 50% of property is Canadian real property or resource property </li></ul><ul><li>Listed shares of corporations described above if seller held 25% or more of shares of any class in 60 months preceding sale </li></ul><ul><li>Also includes certain partnership and trust interests </li></ul><ul><li>Includes rights to acquire above property, therefore includes debt convertible into any of the foregoing </li></ul>
    99. 99. Convertible Securities <ul><li>Rollovers available for debt for share and share for share exchanges </li></ul><ul><li>Property acquired deemed to be taxable Canadian property if converted property was taxable Canadian property </li></ul>
    100. 100. Clearance Certificates <ul><li>Section 116 clearance certificate required when non-resident sells taxable Canadian property that is not “excluded property” </li></ul><ul><li>Excluded property includes shares listed on a prescribed stock exchange, debt obligations and “deemed” taxable Canadian property </li></ul><ul><li>Information required for all vendors including partners of partnerships </li></ul><ul><li>Could be administratively burdensome procedure </li></ul>
    101. 101. Treaty Considerations <ul><li>Treaties lower withholding rate on interest and dividends </li></ul><ul><li>Generally exempt gains from Canadian tax unless value of property sold derived primarily from Canadian real property or resource property </li></ul><ul><li>Some treaties provide better protection on gains by excluding real property used in business from definition of real property </li></ul><ul><li>Additional exemptions available for tax-exempts </li></ul><ul><li>LLC issues – resolved? </li></ul>
    102. 102. Alternative Investment Vehicles <ul><li>Canadian investments may be made through intermediary entities in offshore jurisdictions such as Barbados, Luxembourg </li></ul><ul><li>Advantages: </li></ul><ul><ul><li>added treaty protection </li></ul></ul><ul><ul><li>simplified clearance certificate procedures </li></ul></ul><ul><li>Disadvantages: </li></ul><ul><ul><li>maintenance costs, inconvenience </li></ul></ul><ul><ul><li>assessment risk </li></ul></ul>
    103. 103. Maximizing Tax Shelter in the Target <ul><li>Maximize shelter for US tax purposes by structuring acquisition as asset acquisition for US tax purposes </li></ul><ul><li>Achieved by converting target to unlimited liability company before or after acquisition or by making s.338 election </li></ul><ul><li>Generally no step-up in asset basis for Canadian tax purposes on share acquisition </li></ul><ul><li>Shelter created for Canadian tax purposes through leverage </li></ul>
    104. 104. Leveraged Equity <ul><li>Equity to be used for acquisition can be structured as two-thirds debt for Canadian tax purposes </li></ul><ul><li>2:1 debt to equity ratio required to comply with Canadian thin capitalization rules </li></ul><ul><li>Possible to structure so no immediate income inclusion for interest on debt by using “blocker” entity </li></ul><ul><li>35% tax savings achieved in exchange for 10% withholding tax </li></ul>
    105. 105. Leveraged Equity – Typical Structure Fund Luxco Acquisition Co Finance LP Target Loan $200 $100 Equity $200
    106. 106. QUESTIONS & ANSWERS

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