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  1. 1. Panel: Update on tax issues impacting private equity real estate funds <ul><li>Moderator : Harry Shannon, Tax Principal, Global </li></ul><ul><li>Real Estate Group, Ernst & Young LLP Panel Members : </li></ul><ul><li>Erica Herberg, Principal, The Carlyle Group </li></ul><ul><li>David S. Miller, Partner, Cadwalader, </li></ul><ul><li>Wickersham & Taft LLP </li></ul>
  2. 2. Case Study <ul><li>Assume that the mezzanine loan will soon default and is probably worth about $.50/$1.00 </li></ul><ul><li>The PE fund would like to restructure the loan in a tax-efficient manner </li></ul>USActive 17418885.1 REMIC Mezz Borrower LLC Property Owner LLC Property Managers Real Estate Private Equity Fund Investors Mezz Lenders Senior Lenders U.S. Investors Offshore hedge funds and CLOs Mezzanine Loan Mortgage
  3. 3. <ul><li>Tax Issues for the PE Fund and Its Investors </li></ul><ul><li>Cancellation of Indebtedness (COD) Income if the Debt Is Cancelled </li></ul><ul><li>Gain Upon Foreclosure (Difference between Face Amount of Debt and Basis in Property) if the Property is Foreclosed </li></ul><ul><li>Tax Issues for Offshore Hedge Fund and CLO Investors </li></ul><ul><li>Trade or Business Issues if Debt Is Restructured </li></ul><ul><li>FIRPTA, Trade or Business, and Withholding Issues if Foreclosure </li></ul><ul><li>Tax Issues for the REMIC </li></ul><ul><li>Ensuring that its mortgages remain “qualified mortgages” </li></ul>Tax Considerations
  4. 4. Avoiding COD Income <ul><li>Modify the Debt in a Manner that Does Not Give Rise to a </li></ul><ul><li>Taxable Exchange for Tax Purposes </li></ul><ul><li>Temporary Forbearance </li></ul><ul><ul><li>Two years following the issuer ’ s initial failure to perform </li></ul></ul><ul><ul><li>Any additional period during which the parties conduct good faith negotiations or during which the Issuer is in a title 11 or similar case </li></ul></ul><ul><li>Defer Payments; Extend Maturity </li></ul><ul><ul><li>Scheduled payments may be deferred for a period that begins on the original due date and extends for a period equal to the lesser of five years or 50% of the original term of the debt instrument </li></ul></ul><ul><li>Change the Yield </li></ul><ul><ul><li>The yield of the modified instrument may be changed so long as it varies by no more than the greater of: </li></ul></ul><ul><ul><ul><li>¼ of one percent (i.e., 25 basis points) or </li></ul></ul></ul><ul><ul><ul><li>5% of the annual yield (0.05 x annual yield) </li></ul></ul></ul>
  5. 5. <ul><li>Change the Collateral </li></ul><ul><ul><li>Recourse loan: Collateral may be released, substituted, added, or altered, or a guarantee or other credit enhancement added, so long as the change does not change payment expectations </li></ul></ul><ul><ul><li>Nonrecourse loan: Cannot release, substitute, add or otherwise alter a “ substantial amount ” of the collateral for, or provide a guarantee or add credit enhancement, for a nonrecourse loan. However, collateral may be substituted if the collateral is fungible or otherwise of a type where there particular units pledged are unimportant </li></ul></ul>Avoiding COD Income (cont ’ d)
  6. 6. <ul><li>Rely on the “ Privately-Traded ” Debt Rules </li></ul><ul><li>If the debt is not publicly traded, modify the terms of debt (i.e., extend maturity, provide for PIK interest, reduce interest rate to AFR), but do not change the principal amount </li></ul><ul><li>To avoid being publicly traded, debt must not </li></ul><ul><ul><li>be listed on a national securities exchange, </li></ul></ul><ul><ul><li>be listed on an “interdealer quotation system,” </li></ul></ul><ul><ul><li>be listed on certain foreign exchanges or boards of exchange, or </li></ul></ul><ul><ul><li>appear on a “system of general circulation” that provides a reasonable basis to determine fair market value by disseminating recent price quotations of one or more identified brokers, dealers or traders or actual prices of recent sales transactions </li></ul></ul><ul><li>Debt-for-tax issues </li></ul><ul><ul><li>If the modified loan does not constitute debt-for-tax purposes, then COD income will arise </li></ul></ul>Avoiding COD Income (cont ’ d)
  7. 7. Avoiding COD Income (cont ’ d) Have an “ Unrelated Party ” Acquire the Debt at a Discount <ul><li>If the PE Fund were to buy the mezzanine loan for $.50/$1.00, the REIT would realize COD income under the “related party” rules of section 108(e)(4) </li></ul>Managers Investors Mezz Lenders Senior Lenders Mezzanine Loan Mortgage REMIC Mezz Borrower LLC Property Owner LLC Property REIT Real Estate Private Equity Fund U.S. Investors Offshore hedge funds and CLOs
  8. 8. Avoiding COD Income (cont ’ d) Have an “ Unrelated Party ” Acquire the Debt at a Discount <ul><li>Two corporations are not treated as “related parties” so long as five or fewer individuals do not own 50% or more of the value of each </li></ul><ul><li>An Irish section 110 company or Luxembourg securitization company that qualifies for U.S. treaty benefits is needed to avoid 30% U.S. withholding tax on interest. (The REIT and the Irish/Lux company are related for portfolio interest purposes.) </li></ul>Managers Investors Senior Lenders Mortgage REMIC Irish section 110 company Mezz Borrower LLC Property Owner LLC Property REIT Real Estate Private Equity Fund Mezzanine Loan Interest
  9. 9. Avoiding COD Income (cont ’ d) Have an Unrelated Party Acquire the Debt at a Discount and Enter Into a Total Return Swap with the Owner of the Borrower Mezz Borrower LLC Property Owner LLC Property REIT Managers Investors Senior Lenders Mortgage REMIC Investment Bank Total Return Swap Mezzanine Loan Real Estate Private Equity Fund Interest <ul><li>Risk that PE fund is treated as the “tax owner” of the mezzanine loan (which would cause the REIT to realized COD income). </li></ul>
  10. 10. <ul><li>For debt cancelled in 2009 or 2010: </li></ul><ul><ul><li>COD income is deferred until 2014 and </li></ul></ul><ul><ul><li>Then included ratably in each year from 2014 to 2018 </li></ul></ul>Section 108(i) Section 108(a) <ul><li>I f a taxpayer is insolvent or bankrupt, COD is not recognized, but tax attributes (NOLs, basis) are reduced on a dollar-for-dollar basis. (But if a partnership is the borrower, section 108(a) is applied at the partner level (i.e., the partners have to be insolvent or bankrupt).) </li></ul>
  11. 11. <ul><li>A foreclosure on nonrecourse debt is treated as a sale of the property for the face amount of the debt. </li></ul><ul><li>Assume that the debtor has $100 basis in property that is subject to $90 of debt and the property is now worth $50 </li></ul><ul><ul><li>If $40 of debt is cancelled, the taxpayer realizes $40 of COD income </li></ul></ul><ul><ul><li>If the creditor forecloses on the property, the taxpayer has a $10 capital loss and no COD, even though the foreclosure is the economic equivalent of the cancellation of $40 of debt and a sale of the property for $50 (i.e., $40 COD and $50 capital loss) </li></ul></ul>COD Versus Realization for Nonrecourse Debt
  12. 12. <ul><li>Workout Activity </li></ul><ul><li>The IRS takes the position that origination activities cause an offshore fund or CLO that has a U.S. manager to be engaged in a “trade or business” in the United States and subject to U.S. corporate income tax. IRS Office of Chief Counsel Memorandum (September 22, 2009) </li></ul><ul><li>A workout that gives rise to a taxable event under section 1001 is treated as a redemption of the original loan and an origination of the modified loan. </li></ul><ul><li>Working out a nonperforming loan will generally increase its value; the increase in value is entirely attributable to services performed in the United States (as opposed to changes in the credit of the borrower or changes in market conditions). </li></ul>Tax Issues For Offshore Hedge Funds and CLOs
  13. 13. <ul><li>Risk for offshore hedge fund or CLO </li></ul><ul><ul><li>Least risk if the fund purchased a performing loan that was not expected to default, the debtor subsequently defaulted, and the U.S. manager is negotiating or agreeing to a workout to preserve its investment </li></ul></ul><ul><ul><li>Most risk if the fund purchases the loan when it is distressed in order to work it out and sell it at a profit. </li></ul></ul>Tax Issues For Offshore Hedge Funds and CLOs (cont ’ d)
  14. 14. <ul><li>Income from the real estate subject to a 30% withholding tax or 35% net income tax </li></ul><ul><li>Gain on the sale of the real estate (measured from its value on the date of foreclosure) subject to 35% net income tax </li></ul><ul><li>Many offshore funds are prohibited from directly owning real estate </li></ul><ul><li>If an offshore fund owns an interest in U.S. real estate, the real estate will often be held in a U.S. “blocker” corporation (and the fund may, in turn, hold this U.S. corporation through a foreign “blocker” corporation) </li></ul>Tax Issues For Offshore Funds and CLOs Owning Real Estate
  15. 15. Tax Issues For Offshore Funds and CLOs Owning Real Estate (cont ’ d) Foreign Fund Cayman “blocker” corporation U.S. “blocker” corporation Interest in U.S. real property
  16. 16. <ul><li>If a REMIC agrees to a “significant modification” of a mortgage loan when the loan is not in default or default is not “reasonably foreseeable,” the mortgage may fail to be a qualified mortgage, which could jeopardize the REMIC’s status as a REMIC. A REMIC’s governing documents may have other (non-tax) limitations on modifications. </li></ul><ul><ul><li>Revenue Procedure 2009-45 (September 15, 2009) expands the definition of “reasonably foreseeable” default and provides that a mortgage may be modified without losing its status as a qualified mortgage if there is a “significant risk of default” upon maturity or before based on a “diligent contemporaneous determination (including credible written representations from the borrower).” The risk of default may be a year (or possibly later) in the future. </li></ul></ul>Tax Issues For REMICs That Hold Distressed Real Estate Loans