Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings 2014

Transcription

1 TAX LAW AND ESTATE PLANNING SERIES Tax Law and Practice Course Handbook Series Number D-419 Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings 2014 Volume One Co-Chairs Linda E. Carlisle Matthew A. Rosen Eric Solomon To order this book, call (800) 260-4PLI or fax us at (800) Ask our Customer Service Department for PLI order number 51241, Dept. BAV5. Practising Law Institute 1177 Avenue of the Americas New York, New York 10036

2 12 Private Equity, Venture Capital and LBOs (PowerPoint slides) Deborah L. Paul Wachtell, Lipton, Rosen & Katz Donald E. Rocap Kirkland & Ellis LLP 2014 by Deborah L. Paul and Donald E. Rocap If you find this article helpful, you can learn more about the subject by going to to view the on demand program or segment for which it was written

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4 Private Equity, Venture Capital and LBOs Deborah L. Paul Wachtell, Lipton, Rosen & Katz Donald E. Rocap Kirkland & Ellis LLP 2014 by Deborah L. Paul and Donald E. Rocap 1-859

5 Life Cycle of an LBO Transaction Event Acquisition of Target Principal Tax Goals Obtain stepped-up basis in Target assets where feasible Avoid double tax to Target shareholders Achieve tax deferral for rollover shareholders Structure equity-based compensation for management Holding and Partial Exit Avoid phantom income from debt and preferred stock OID Avoid phantom income from subpart F inclusions Maximize deductibility of LBO interest For partial withdrawals of cash: Maximize basis recovery Maximize eligibility for 20% LTGG/QDI rate Minimize i i withholding taxes Complete Exit Deliver stepped up basis to buyer where feasible Maximize eligibility for 20% LTGG/QDI rate Minimize withholding taxes Capture tax benefits triggered by transaction

6 Life Cycle of a Leveraged Buyout in an Economic Downturn Event Principal Tax Concerns Acquisition of Target Amortizable stepped-up basis in Target assets Tax-free rollover for Target shareholders who retain equity Equity-based compensation for management Tax-efficient financing Repurchase of Debt by the Company Cancellation of debt income to Issuer Purchase of Debt by the Fund Cancellation of debt income to Issuer Original issue discount/market discount on resulting debt AHYDO limitations on resulting debt Debt-for-Debt Exchange or Modification of Debt Cancellation of debt Income to Issuer AHYDO limitations on resulting debt Gain or loss recognition to Holders Debt-for-Equity Exchange Cancellation of debt income to Issuer 382 ownership change for Issuer Gain or loss recognition to Holders Rollover of market discount to Holders

7 Acquisition Structure Whether to Structure for Stepped-Up Basis ( SUB ) or Carryover Basis ( COB ) Benefit of SUB Present value of incremental depreciation and amortization deductions; approximately 20% of SUB, assuming: 15 years straight-line amortization Buyer taxable at 40% rate 10% discount rate Buyers are typically willing to increase purchase price by some amount less than 20% of the potential SUB to obtain SUB, due to: Possible lack of post-acquisition taxable income may defer use of depreciation/amortization deductions Buyer may use a discount rate higher than 10%, particularly if paying the incremental purchase price requires additional equity investment Buyer typically anticipates an exit from the investment in, e.g., 5 years, and may doubt that a future buyer will fully pay for the remaining unused tax benefits

8 Acquisition Structure As rule of thumb, often assume that, to obtain SUB, buyers will be willing to pay an incremental purchase price of roughly 10% of the potential SUB If transaction is structured to produce SUB, important to ensure that the 197(f) anti-churning rules do not prevent amortization of SUB in goodwill and other intangible assets that do not have a reasonably ascertainable useful life. The anti-churning rules apply where: Some amount of the goodwill or similar intangible assets were held by the Target on or before August 10, 1993 and There is a greater than 20% overlapping ownership between the Target and the buyer (applying a number of alternative 20%-or-greater related party tests containing broad ownership attribution rules) immediately before or after the transaction Where some pre-august 11, 1993 goodwill or similar intangibles exist, all amortization of the SUB in such intangibles is subject to disallowance -- not limited to the August 10, 1993 value of the intangibles Where the Target or the buyer is a partnership/llc, the determination of whether, and to what extent, a SUB-producing transaction is treated as a 197 related party differs significantly depending on the transaction form (e.g., acquisition of assets vs. acquisition of equity interests) and the particular Code section that produces the SUB (e.g., 707 disguised sale vs. 734(b) cash distribution in excess of basis vs. 743(b) sale of partnership interest)

9 Acquisition of Target: Stepped Up Basis in Assets If (domestic) target is publicly traded or is a standalone C corp, a step up in target s asset basis is not likely to be viable (unless target has an NOL sufficient to absorb the asset sale gain). If (domestic) target is a subsidiary of a corporate parent or is an S corp, then a step up in target s asset basis can be achieved by: buying the assets of target converting target to an LLC treated as a disregarded entity or partnership and buying the LLC interests merging target into purchasing corporation or LLC buying the stock of target and making a 338(h)(10) or 336(c) election Acquisition of stock of Target S Corp or Target Bigco Sub with a 338(h)(10) or 336(e) election achieves stepped up tax basis in Target assets without requiring an actual transfer of Target assets, which may be undesirable for commercial law, regulatory or transfer tax purposes If target is a partnership for tax purposes, then a step up in target s asset basis can be achieved by buying target assets or by buying all the partnership s s equity interests or by buying some equity interests and making a 754 election

10 338(h)(10) and 336(e) Compared 338(h)(10) 336(e) 338(h)(10) requires that: 336(e) requires that: a corporation one or more persons (corporate, partnership, LLC or individual) acquires within a 12-month period acquires within a 12-month period from a single U.S. corporate seller or consolidated group (Bigco) or a group of S corporation shareholders from a single U.S. corporate seller or consolidated group (Bigco) or a group of S corporation shareholders stock of a U.S. corporation (Target Bigco Sub or Target S Corp) stock of a U.S. corporation (Target Bigco Sub or Target S Corp) representing at least 80% of Target stock (by vote and value, disregarding 1504(a)(4) preferred stock) representing at least 80% of Target stock (by vote and value, disregarding 1504(a)(4) preferred stock) by purchase, which does not include by disposition, which does not include any acquisition of Target stock in a carryover basis exchange or other exchange to which 351, 354, 355 or 356 applies, and any acquisition of Target stock in a carryover basis exchange or other exchange to which 351, 354, 355 or 356 applies, except for a 355 distribution that is taxable at the corporate level under 335(d) or (e), and any acquisition of Target stock from a person the ownership of whose stock would be attributed to the purchasing corporation any acquisition of Target stock from a related person. Two persons are related if stock owned by one of them would be under the 318 ownership attribution rules attributed to the other under the 318 ownership attribution rules (with attribution between a partner and a partnership limited to 5% or greater (by value) partners) Purchasing corporation and Bigco or all of Target S Corp shareholders (including non-selling shareholders) make joint 338(h)(10) election Target and Bigco or all of Target S Corp shareholders (including non-selling shareholders) make joint 336(e) election in case of overlap, a 338 QSP trumps a 336(e) QSD

11 Basic 338(h)(10) Fact Pattern Investors Purchasing Corporation Cash 100% of Target Stock Target Shareholders or Target S Corp 8 Bigco Target Bigco Sub 1-866

12 Basic 336(e) Fact Pattern Investors Purchasing Partnership/LLC Cash Purchasing Target 100% of Target Stock Target Shareholders or Target S Corp 9 Bigco Target Bigco Sub 1-867

13 Code 338(h)(10) Trap Recharacterization Receipt of any equity in the Purchasing Corporation by historic Target Shareholders who own more than 20% of Target, in direct (or possibly recharacterized) exchange for their Target stock, raises the risk that the acquisition from these shareholders is a 351 transaction ineligible for a 338 (or 336(e)) election. Investors Step 1 Cash Purchasing Corporation 100% of Target Stock Step 2 Cash Target Shareholder(s) > 50% of Purchasing Corp stock Target SCorpor Bigco Sub

14 Avoiding 351 Recharacterization Trap Investors Newco Corp Cash and Newco Shares Target Shareholder(s) Purchasing Corp Target shares Target SCorp or Bigco Sub In order to bolster eligibility for a 338 election, Purchasing Corp could provide cash and Newco shares to the historic Target Shareholders. Consider impact, if any, of Rev. Rul Target shareholders recognize gain on cash and Newco shares received. Even if a basis step-up is obtained, the anti-churning rules under 197 generally will prevent amortization of goodwill and certain other intangibles if there is greater than 20% overlap in ownership before or after the transaction (after attribution) and the target s goodwill or other intangibles existed on August 10, 1993, the date that 197 was enacted

15 338(h)(10) Trap 318 Attribution Investors Target Shareholder(s) cash 90% LLC equity Holdco LLC 100% Purchasing Corp Target S Corp or Bigco Sub

16 338 purchase definition excludes acquisition from person whose stock would be attributed to Purchasing Corp But 336(e) election permitted if no single historic Target Shareholder owns 5% Investors Holdco LLC or more (by value) of Purchasing Corp Holdco LLC Target Shareholder(s) 318(a)(3)(A) attribution (no threshold under 338, 5% threshold under 336) 318(a)(3)(C) attribution (> 50%) Target

17 Bifurcated Purchase Consistency Rules for Consolidated Group Investors Step 3 $50 cash Bigco Purchaser Entity Step 1 $50 cash Step 2 $50 dividend TB = 50 FV = 100 Target Sub TB = 0 TB = 0 FV = 50 FV = 50 Division 1 Division

18 Bifurcated Purchase Bigco has higher outside basis in Target Sub stock than Target Sub has in its assets One-step sale of Target Sub stock without 338(h)(10) or 336(e) election would trigger $50 Bigco gain, but produce no basis step-up for Purchaser Sale of Target Sub s assets or sale of Target Sub s stock with 338(h)(10) or 336(e) election would produce $100 basis stepup for Purchaser, but trigger $100 Bigco group gain Bifurcated purchase of Division 1 assets (triggering $50 gain to Bigco group but producing $50 increase in tax basis of Target Sub stock) triggers only $50 Bigco group gain and allows Purchaser to obtain $50 basis step-up If Purchaser is a corporation, Reg consistency rules disallow basis step-up in Division 1 assets if a 338 election is not made with respect to Target Sub stock

19 Bifurcated Purchase If Purchaser is a partnership/llc, PLR held that the 338 consistency rules do not apply because purchase by a partnership/llc is not a QSP Reg (b) extends the principles of the 338 consistency rules to qualified stock dispositions Purchase of all of Target Sub s stock by a partnership/llc is a qualified stock disposition and basis step-up in Division 1 assets would be denied if a 336(e) election is not made with respect to Target Sub s stock If Bigco acquires 5% or more (by value) of the equity of Purchaser partnership/llc, the purchase should not be a QSD and the 336(e) consistency rules should not apply Bifurcated asset/stock purchase may be advantageous outside of the consolidated group context E.g., where Target S Corp owns 2 divisions or QSubs, one with potential Code 1374 liability and the other without 338/336 consistency rules do not apply outside the consolidated group context

20 Acquisition of Target S Corp: Stepped Up Basis in Assets S Corp shareholders may seek indemnification or higher purchase price to reflect: Higher federal tax if SUB transaction causes portion of the shareholders gain to be taxed as OI (e.g., depreciation recapture or gain on inventory) rather than LTCG Higher shareholder state tax if SUB transaction causes portion of the shareholders gain to be taxed in a state that imposes a higher tax rate than the state of the shareholders residence Accelerated federal and state gain recognition 338(h)(10) or 336(e) election triggers gain on any stock retained by the shareholders S corp gain allocated proportionately even if rollover is disproportionate Possible 1374 tax Possible state entity-level taxes

21 Drop-Down LLC as 338(h)(10)/336(e) Alternative Investors Target Shareholder(s) Target SCorp Assets LLC Equity Step 1 Newco LLC

22 Drop-Down LLC as 338(h)(10) Alternative Target Shareholder(s) Cash Step 2 Target Investors SCorp Newco LLC

23 Drop-Down LLC as 338(h)(10) Alternative Target Shareholder(s) Investors Target SCorp Purchased equity Newco LLC Rollover equity Target Shareholders defer gain recognition on retained Newco LLC equity held through Target S Corp Newco LLC obtains partial SUB Potential application of 197 anti-churning rules and allocation of benefits of SUB between Target Shareholders and Investors depends on details of transaction mechanics and 704(c) elections

24 Deemed Asset Drop Down Target Shareholders Step 1 New SCorp stock Target SCorp stock New SCorp Target SCorp Target LLC Step 2 State law conversion to LLC

25 Basis Step-Up Upon Acquisition Target Shareholders Investors Step 3 Cash all or part of Target LLC equity New SCorp Target LLC Target Shareholders contribution of Target S Corp stock to New S Corp and Target SCorp s conversion to LLC (or Q sub election) qualifies as F reorganization Investors obtain basis step-up on Target LLC assets Target Shareholders (through New SCorp) defer gain recognition on retained Target LLC equity Often desirable to cause Target LLC to be treated as a partnership for tax purposes (by admitting a second non-transitory equity owner) before the sale to Buyerco so that Buyerco obtains SUB under Code 743(b)

26 Special Issues Involving LBOs of Foreign Targets: Subpart F Principals Domestic General Partner Domestic Fund Limited Partners Foreign Fund Foreign General Partner Domestic Targets Foreign Targets 951(a) requires any United States shareholder (generally, a U.S. person who owns, within the meaning of 958(a) or (b), at least 10 percent of the voting power) of a CFC to include the shareholder s pro rata share of Subpart F income if the shareholder owns (within the meaning of 958(a)) stock in the CFC on the last day of the year

27 Special Issues Involving LBOs of Foreign Targets: Subpart F If either the Domestic Fund invests or the Foreign Fund invests, Foreign Target will often be a CFC and the Domestic Fund will often be a United States shareholder. IfForeign Fund invests, for purposes of determining CFC status, Foreign Fund s ownership in Foreign Target is attributed to Domestic Fund under 958(b). If Domestic Fund invests, Domestic Fund would be a United States shareholder and would own stock within the meaning of 958(a). As a result, Subpart F inclusions would be required under 951(a). If Foreign Fund instead invests, then 951(a) inclusions should be analyzed at the level of the Principals and Limited Partners, all of whom may avoid united States shareholder status. Additional planning at the general partner level is often required. A key issue is whether the Foreign Fund and the Domestic Fund will be respected as separate partnerships. If viewed as one partnership, is it domestic or foreign? Some funds are now organized solely as foreign funds

28 Special Issues Involving LBOs of Foreign Targets: Basis Step Up Techniques 338 elections are almost never made on a domestic target, unless the transaction is eligible for a 338(h)(10) election. For example, 338 elections are rarely made on publicly-traded domestic targets or on domestic targets that are privately-held by private equity funds. In the case of a foreign target, it is often desirable to have the transaction treated as an asset sale for U.S. tax purposes in order to eliminate historic E&P and Subpart F income and minimize future E&P and Subpart F income. Therefore, make a 338(g) election OR Check and sell : have the seller check the box on the entities that are being acquired so that those entities are treated as disregarded entities for U.S. tax purposes. See Dover v. Commissioner, 122 TC 324 (2004). 901(m) limits foreign tax credits after a 338(g) election, check and sell or similar transaction to the amount of foreign tax credits that would have been available absent the U.S. tax basis step-up

29 Special Issues Involving LBOs of Foreign Targets: Investing through an Intermediate Holding Company to Address Foreign Withholding and Capital Gains Taxes Investors The country in which Foreign Target is organized may impose withholding tax on distributions out of Foreign Target and may impose capital gains tax on sales by large holders of stock in Foreign Target. Often, in order to address those issues, it is desirable to invest in Luxco Foreign Target through a holding company organized in a jurisdiction (such as Luxembourg) with a favorable treaty network or that is eligible for the EU Parent/Subsidiary Directive. If such a holding company is used, consider whether to treat Luxco as a corporation or partnership for U.S. tax purposes: Foreign Target Eligibility for 20% rate on dividends from Luxco (if Luxco is a corporation) versus Foreign Target Potential PFIC status of Luxco if Luxco is a corporation and ownership by Luxco of Foreign Target drops below 25% Publicly traded partnership status of Luxco if Luxco is a partnership Avoid trade or business at Luxco and debt at Luxco if Luxco is a partnership, because of UBTI rules Tax consequences of exit via a sale of Foreign Target (sale or exchange treatment flows through if Luxco is a partnership) Tax consequences ces of exit via asale of Luxco Phantom income on non pro rata redemption of Luxco shares if Luxco is a partnership, because income at Luxco is not necessarily allocated to redeemed Luxco shareholders Tax treatment of preferred stock if Luxco is a partnership (is yield an allocation of income or a guaranteed payment?)

30 Capital Structure of the Target Going Forward: All Common vs. Tranches of Common, Preferred and Subordinated Debt Advantages of subordinated debt and preferred For debt, interest deduction, subject to limitations For debt, allows tax-free return of capital as principal is repaid Provides senior position over holders of common (or options/warrants to acquire common) in flat or downside scenario Provides a return hurdle (i.e., the interest or dividend rate) prior to participation in upside by holders of common/options/warrants Depresses value of common stock, allowing management to purchase cheap common stock which represents small interest in current value but larger interest in future appreciation For investor purchasing debt/preferred and common, allows most of tax basis to be concentrated in debt/preferred If exit is IPO, underwriters more likely to permit existing owners to take cash out in repayment of debt or preferred than in sale or redemption of common

31 Potential Disadvantages of Subordinated Debt and Preferred Stock For debt, potential limits on interest deductibility, OID accrual to holders, withholding tax on payments to non-us holders For preferred, potential phantom income inclusions to holders and withholding tax on payments to non-us holders

32 Possible Capital Structure Rollover Investors VC 20% 80% Holdco $40m Holdco capital $15m jr. subordinated debt $24m preferred stock $1m common stock warrants to mezzanine lender $100m T capital $50m Sr. debt T $10m Sr. subordinated debt $40m common stock

33 Subordinated Debt: Limits on Interest Deductibility Common law debt-equity rules Code 163(e)(5) (AHYDO) Code 279 (Corporate acquisition indebtedness) Code 163(j) (Earnings stripping) Code 163(l) (Debt payable in stock) Code 163(e)(3) (related foreign holders of debt with OID) Code 267(a)(3) (payments to related foreign holders)

34 Subordinated Debt Provided by VC and Rollover Investors: Limits on Interest Deductibility Common law debt/equity rules High degree of overlap with equity ownership Because of subordination to senior debt, high debt-equity ratio

35 Subordinated Debt: Limits on Interest Deductibility 163(e)(5) AHYDO: Deferral and/or Disallowance Senior lenders will require term to be more than 5 years Subordinated position typically will dictate an arms-length interest rate greater than AFR + 5% Cash flow constraints and senior debt covenants typically will require accrual of all or part of interest yield in early years Typically seek to avoid 163(e)(5) limits by providing for interest catchup in 6th year following issuance. Interest catch-up represents unconditional obligation as between issuer and holder, with normal default remedies, but holder often enters into subordination agreement with senior lenders agreeing not to assert default without permission of senior lenders if lenders have not been repaid

36 Subordinated Debt: Limits on Interest Deductibility 163(j) Earnings Stripping: Deferral VC often owns more than 50% of borrower s equity. If VC is a partnership 10% or more of the capital or profits interests in which are owned by TEOs or FPs, interest is disqualified interest subject to 163(j) Under 163(j), interest deduction deferred to extent borrower s net interest expense exceeds 50% of tax EBITDA Frequently impossible to structure to avoid 163(j) where subordinated loan made by majority owner VC; must rely on EBITDA increases to grow out of the interest limitations

37 Subordinated Debt: Phantom Income to Holders Holder taxed on accruing yield on current basis Typically seek to negotiate with senior lenders to permit portion (e.g., 45%) of interest to be paid in cash to fund holders tax payments, subject to cutoff if borrower s performance lags Accrual method precedent supports ending accrual of interest income if substantial doubt as to ultimate collectibility Spring City Foundry, Rev. Rul IRS takes position that OID rules override this precedent -- TAM

38 CERT Limits on NOL Carryback Corporate equity reduction ("CERT") rules limit carry back by C corporation of NOLs attributable to interest expense following a "major stock acquisition" ("MSA") or "excess distribution" ("ED") to the extent aggregate annual interest expense exceeds average during 3 prior years Detailed proposed regulations issued 9/12 MSA is acquisition of 50% or more of stock of another corporation Under proposed regulations: Would include tax-free stock acquisitions as well as taxable Where redemption occurs as part of MSA, tested as MSA rather than as ED

39 CERT Limits on NOL Carryback ED occurs where distributions during a taxable year exceed the greater of (a) 150% of average distributions in 3 prior years or (b) 10% of FMV of stock as of beginning of year Under proposed regulations, distributions would include tax-free distributions -- e.g., tax-free distributions under Code sec. 355 Consolidated group treated as a single entity for purposes of determining and tracking a CERT Under proposed regulations, a corporation leaving a consolidated group would take with it a proportionate share of the group's CERT, interest and distribution history, unless election made to permanently waive any carryback of losses to the consolidated group

40 Preferred Stock: Taxation of Stated Yield Cash and accrual method holders generally not taxed on accruing stated dividend yield until paid If preferred sold to third party or redeemed (e.g., in connection with IPO) and redemption not recharacterized as a dividend under 302, redemption proceeds in respect of accrued dividends taxed as capital gain, provided that the accrued dividends not declared prior to redemption Capital gain treatment generaly avoids withholding tax on dividends to non-us holders Accrued yield on non-participating preferred is taxed (to the extent of E&P) if paid in kind (including conversion into common, e.g., in connection with IPO)

41 Preferred Stock: Taxation of Yield OID on non-participating preferred taxed as accrues (to the extent of e&p) Where preferred is issued in unit with common or warrants, risk that more than stated value may be attributed to common or warrants and less than stated value attributed to preferred, creating preferred OID Relevant factors bearing on valuation of preferred include whether stated yield is lower than an arms-length rate and whether common equity is too thin Risk that stated yield may be treated as disguised redemption premium (creating OID) if no intention to pay currently

42 Preferred Stock: Taxation of Yield Taxation of preferred OID and dividends paid in kind generally applies only if stock is preferred stock under 305, i.e., stock that does not participate in corporate growth to a significant extent Ignore participation through right to convert into different class of stock Can add a participation feature to preferred stock, avoiding 305 preferred stock characterization, by creating a class of stock that combines some or all of the holder s common stock and preferred stock rights Assume Investors invest $100 in Target at the time of the acquisition. They could invest, e.g., $9 in nine shares of common stock and $91 in participating preferred with a liquidation preference of $90, a fixed annual yield and a right to 10% of the value of Target in excess of the liquidation preference on the preferred. Unfavorable dividend or recapitalization basis recovery rules may apply if the preferred element of the participating preferred is paid off (e.g., in connection with IPO) while the common element remains outstanding

43 Cheap Common Issues If yield on preferred or subordinated debt is too low or common is too thin (resulting in option value for common), FMV of common stock may be greater than purchase price Resulting Risks Executives purchasing common stock may have ordinary income under 83 Company may have GAAP compensation charges under FASB 123R Employee options on common stock may be in-the-money at grant, triggering 409A penalties Holder of preferred or subordinated debt may have OID

44 Cheap Common Issues Might alleviate 83 cheap common concerns by creating partnership/llc holding company and issuing to management profits interests rather than common corporate shares. But: Some accountants are concerned that Rev. Proc (allowing use of 83 liquidation value methodology for partnership/llc interests) may not apply to this fact pattern May result in ordinary income on exit without compensation deduction if carried interest legislation enacted

45 Preferred Stock Issued to Rollover Investors Nonqualified preferred ( NQ Pfd ) stock is treated as boot. Stock is NQ Pfd if it does not participate significantly in corporate growth and is mandatorily redeemable within 20 years after issuance, puttable within 20 years after issuance or callable within 20 years after issuance, with it being more likely than not to be called. Although NQ Pfd is treated like debt for gain recognition purposes, recognized gain cannot be deferred under the installment sale rules

46 Preferred Stock Issued to Rollover Investors Can avoid NQ Pfd treatment by issuing to rollover investors a separate class of preferred stock that is neither mandatorily redeemable nor puttable within 20 years Company may desire call right (e.g., in connection with IPO). Is right more likely than not to be exercised? 305 regulations provide safe harbor under similar rules if issuer and holder are not related, call is not compelled and call would not reduce yield to maturity. This safe harbor should apply by analogy but no definitive guidance exists. Holder right to convert (or issuer s right to force conversion) into common stock at IPO price should not be treated as a put right for this purpose because conversion is not a redemption or purchase If preferred stock received by rollover investor is not NQ Pfd and receipt of cash would have been treated as a dividend, preferred stock may be 306 stock

47 Preferred Stock Issued to Rollover Investors Can avoid NQ Pfd treatment by issuing to rollover investors a class of stock (treated as common stock) that combines some or all of the holder s common stock and preferred rights Unfavorable dividend or recapitalization basis recovery rules may apply if subsequently the preferred element of the stock is paid (e.g., in connection with IPO) while the common element remains outstanding. Not important issue for rollover investors if tax basis in rollover shares is low

48 Withdrawal of Cash from Target: Leveraged Recap Investors Cash 301(c) (1) Dividend to the extent of earnings and profits (2) Basis recovery (3) Capital gain Lenders Cash Target If Target borrows funds and then distributes the funds to the Investors, the first dollars paid to the Investors could qualify as 301(c)(2) basis recovery if Target has no current or accumulated earnings and profits

49 Withdrawal of Cash from Target: Leveraged Recap Investors Cash Purchasing Lenders Cash Corp or Cash Lenders Cash Target If a 338 or 336(e) election was made on the acquisition, the pre-acquisition E&P of Target was eliminated. If a 338 or 336(e) election was not made on the acquisition, the pre-acquisition E&P of Target would generally not flow up to Purchasing Corp. Whether or not a 338 or 336(e) election is made, post-acquisition E&P, if any, of Target would generally flow up to Purchasing Corp (unless Purchasing Corp and Target do not file consolidated returns)

50 Withdrawal of Cash from Target Funded by Sale of a Business Investors Cash Business Target Cash The distribution of cash could qualify as a partial liquidation under 302(b)(4). If so, certain Investors would recover a portion of their basis and be taxed at capital gains rates. Partial liquidation treatment is desirable if the Investors have held Target stock for more than one year, but undesirable if they have held for one year or less (and qualified dividend income treatment would otherwise be available). Qualification as a partial liquidation is highly formal. For example, a sale of stock of a subsidiary (without a 338 (h)(10) (or 336(e)) election) followed by a distribution of the proceeds is not a partial liquidation, but an actual or deemed sale of assets by Target (or a sale of assets by a subsidiary of Target followed by a liquidation of the subsidiary) and a subsequent distribution of the proceeds could qualify. Rev. Ruls ,

51 Partial Exit through an Initial Public Offering Investors Secondary Sale Cash Target shares Public Primary Sale and Distribution/Redemption/Recapitalization Investors Public Target shares Cash Cash Target shares Target Target If structured as a secondary sale, Investors would have sale or exchange treatment on the shares sold. If structured as a primary sale of shares by Target to the public followed by a payment of cash by Target to the Investors, the transaction raises a number of issues, such as (1) whether it will be recast as a secondary sale under the step transaction doctrine, see Waterman Steamship v. Commissioner, 430 F.2d 1185 (5 th Cir. 1970); Rev. Ruls , , and , and (2) if not recast as a secondary sale, whether the transaction between Target and the Investors will be analyzed as a 301 distribution, a 302 redemption, a 356/368(a)(1)(E) recapitalization with boot or, if a holding company is used, a 304 transaction

52 Partial Exit Through an Initial Public Offering If 302 or 356 applies, the reduction in percentage interest experienced by the Investors as a result of the public obtaining shares in Target should be taken into account in determining whether the Investors percentage interest has gone down sufficiently to result in sale or exchange treatment under 302 or 356. See Zenz v. Quinlivan, 213 F.2d 914 (1954), Rev. Ruls , , Cf. Bazley v. Commissioner, 331 U.S. 737 (1947); Treas. Reg. Sec (l). If 301(c)(1) applies and the Target is U.S., then withholding would be required with respect to non-u.s. investors

53 Partial Exit Through an Initial Public Offering: Tax Receivables Agreements Market is thought not to value tax attributes (e.g., basis, net operating losses) of IPO company since not reflected in GAAP earnings. Tax Receivables Agreement causes IPO company to pay historic owners a portion (e.g., 85%) of IPO company s tax savings as tax attributes are used. May cover basis step-up arising from exchange of partnership interests for IPO company stock in connection with or after IPO May cover historic stepped-up tax basis or NOLs Treatment of TRA to historic investors depends on structure. In basis step-up case, TRA payments are often viewed as installment payments

54 Partial Exit through an Initial Public Offering: Basis Concentration Using Participating Preferred Stock Investors Cash low basis common high basis participating converts preferred to common at IPO New Investors Target Suppose Investors invested $100 in Target at the time of the acquisition. They would invest, e.g., $9 in nine shares of common stock and $91 in participating preferred. The participating preferred has a liquidation preference of $90, a fixed annual yield and a right to 10% of the value of Target in excess of the liquidation preference on the preferred. At the time of an IPO, the preferred converts into a number of common shares having a value equal to the liquidation preference plus common shares representing 10% of the remaining value of Target. For example, suppose an IPO is going to occur at $10 per common share at a time when the value of the Target is $200 (and assume the preferred liquidation preference has grown to $100). The preferred would convert into 11 shares (equal to $100 liquidation preference/$10 per share plus one additional common share representing 10% of the value of the company in excess of $100) with a basis of $8.27 per share. A portion of these high-basis common shares would be sold to New Investors in the IPO resulting in only a small amount of gain recognized

55 Partial Exit through an Initial Public Offering: Basis Concentration Using Participating Preferred Stock Treasury Regulation (c) permits specific identification of shares sold. Valuation of the preferred at the time of original investment is a key issue as it determines the Investors basis in the preferred. Preferred is intended not to be preferred stock for 305 and 306 purposes as a result of the participation feature

56 Restructurings/Workouts Cancellation of Indebtedness Income ( CODI ) and related tax issues can arise in three principal situations: Debtor repurchases its own debt at a discount to par, either for cash, stock or a new debt instrument; A party related related to the debtor acquires the debtor s debt at a discount; or The debtor and creditor agree to modify the terms of a debt instrument, and the debt instrument has been traded at a discount on an established securities market (broadly defined) during the 31-day period ending 15 days after the modification

57 Restructurings/Workouts Mitigation of CODI Income Use of Net Operating Losses against CODI Income. Note that NOL carryovers will not completely eliminate tax, because of AMT. Bankruptcy Exception Insolvency Exception State tax consequences also must be considered as State results do not always conform to federal

58 Situation 1: PC Purchases Debt at Discount Partners Other Shareholders Equity Fund 40% 60% $350m cash PC $500m face Notes $2B Notes Lenders

59 Debt Purchase Tax Issues PC s purchase of $500m debt for $350m triggers $150m CODI CODI excluded from PC s taxable income If purchase occurs in PC s bankruptcy proceeding, or To extent PC was insolvent prior to the purchase CODI excluded under bankruptcy or insolvency exception applied to reduce PC s NOLs and other tax attributes If PC is a partnership or LLC, bankruptcy and insolvency exceptions applied at the partner/member level and hence are generally unavailable

60 Situation 2: Related Party Purchases Debt Partners Other Shareholders Equity Fund 40% 60% $350m $500m face Notes PC $2B Notes Lenders

61 Purchase of Debt by Related Party Code 108(e)(4) and Reg Where debt acquired by person related to issuer from an unrelated person at discount: Acquisition discount = CODI to issuer New debt deemed to be issued with issue price = purchase price of debt Whether person acquiring debt treated as related to issuer tested under 267(b) and 414(b) and (c) Partnership and corporation treated as related if same persons own > 50% of value of corporation s stock and capital or profits interest in partnership ( 267(b)(10)) Stock owned by partnership or corporation treated as constructively owned by the entity s owners ( 267(c)(1)) Result: Partners of Equity Fund own 100% of Equity Fund and treated as constructively owning 60% of PC

62 Purchase of Debt by Related Party Hence Equity Fund s purchase of PC debt triggers 108(e)(4): $150m taxable CODI to PC For 2009 and 2010 transactions, PC may elect to defer CODI recognition under Code 108(i) $150m OID income (rather than market discount) to Equity Fund accrued over remaining term of debt $150m OID deductions to PC, but may be limited by 163(e)(5) (AHYDO rules) or 163(j) (interest stripping rules) Upon resale of debt by Equity Fund, debt has same CUSIP as other PC notes but is not fungible because of OID taint

63 Determining Related Party Status -- Partnership with Overlapping Ownership Purchases Debt Non-Overlapping Partners Overlapping Partners Non-Overlapping Partners 70% 30% 55% 45% Other Shareholders Equity Fund Distressed Debt Fund 40% 60% $350m $500 face Notes PC Lenders $2B Notes

64 Determining Related Party Status -- Partnership with Overlapping Ownership Purchases Debt Actual common ownership of PC and Distressed Debt Fund <50% But assume that one or more of Overlapping Partners is an individual An individual who owns stock (directly or constructively through an entity) in a corporation treated as owning stock owned by his partner ( 267(c)(3)) Individual Overlapping Partner treated as constructively owing 100% of PC stock owned by Equity Fund Therefore Overlapping Partners own 55% of Distressed Debt Fund and treated as constructively owning 60% of PC

65 Determining Related Party Status -- Corporation Owned by Equity Fund Purchases Debt Partners Other Equity Fund Shareholders $350m 40% 60% Cayman Corp $500m face Notes $350m PC $2B Notes Lenders

66 Determining Related Party Status -- Corporation Owned by Equity Fund Purchases Debt Whether PC and Cayman Corp treated as related persons is tested under 267(f) and 414(b) and (c) PC and Cayman Corp treated as related if: 5 or fewer individuals, trusts or estates own > 50% of both PC and Cayman Corp, Under applicable constructive ownership rules, individual not treated as owning stock owned by partner Equity Fund is treated as the parent of a chain of trades or businesses under common control that includes PC and Cayman Corp Equity Fund should not be treated as engaged in a trade or business and hence this test should not apply (see, e.g., Rev. Rul ) 1 st Circuit has held (in Sun Capital case) that a private equity fund may be the parent of a chain of trades or businesses under common control for purposes of ERISA controlled group tests

67 Determining Related Party Status -- Corporation Owned by Equity Fund Purchases Debt Cayman Corp subject to 30% withholding tax on interest income if treated as a 10% shareholder of PC under Code 871(h)(3) Applying 871(h)(3)(C) constructive ownership rules, Cayman Corp would own > 10% of PC Therefore, portfolio interest exemption apparently not available Tax leakage may be reduced if corporation purchasing PC debt is formed in jurisdiction that may make available tax treaty reductions in withholding tax May make QEF election for Cayman Corp, which is likely a PFIC, to preserve capital gain treatment on eventual sale of debt

68 Determining Related Party Status -- Corporation with Overlapping Ownership Purchases Debt Partners $350m Other Shareholders Equity Fund Cayman Corp 40% 60% $350m $500m face Notes PC $2B Notes Lenders

69 Determining Related Party Status -- Corporation with Overlapping Ownership Purchases Debt PC and Cayman Corp should not be treated as related for purpose of 108(e)(4) Applying 871(h)(3)(C) constructive ownership rules, Cayman Corp apparently treated as owning < 10% of PC Therefore, portfolio interest exemption apparently available

70 Situation 3: Debt Restructuring SHs Distressed Debt Fund PC $1.5B Notes $1.5B face New Notes Other Holders In debt restructuring transaction: Other Holders exchange $1.5B face old Notes for $1.5B face New Notes with revised terms (e.g., extended maturity, higher or lower interest rate, revised covenants) Distressed Debt Fund exchanges $200m face old Notes for $200 face New Notes $300m face old Notes for 60% of PC s post-restructuring equity FMV of old Notes and New Notes = 70% of face

71 Debt Restructuring Tax Issues Exchange of new debt for old debt held by Distressed Debt Fund and other holders may trigger CODI Upon exchange of old Notes for New Notes with significantly modified terms (or upon significant modification of old Note terms by amendment), old Notes treated as satisfied for amount equal to issue price of New (or amended) Notes Whether change in terms represents a significant modification is determined under Treas. Reg (b) Increase in interest rate is a significant modification if greater than a de minimis safe harbor Payment of a fee to a lender to cure a covenant default or obtain a waiver or consent is treated as an increase in the interest rate Extension of the term of a debt instrument beyond safe harbor levels can be a significant modification

72 Determining Issue Price of New Notes: If neither old Notes nor New Notes are treated as market traded, issue price equals the principal amount of the New Notes, unless interest rate less than applicable federal rate ( AFR ) If either old Notes or New Notes are treated as market traded, issue price of New Notes generally equals the FMV of the New Notes at the time of the exchange

73 Debt-for-Debt Exchange Tax Consequences -- Notes Not Market Traded If Notes not treated as market traded: PC treated as satisfying $1.7B old Notes with New Notes having issue price of $1.7B No CODI for PC Holders realize gain or loss on exchange based on $1.7B face amount, generally deferred under recapitalization tax rules if the old Notes and New Notes are securities for tax purposes No OID for holders

74 Debt-for-Debt Exchange Tax Consequences -- Notes Market Traded If Notes are treated as market traded: PC treated as satisfying $1.7B old Notes with New Notes having issue price of $1.19B (FMV = 70% of face) PC realizes $510m CODI Holders realize gain or loss on exchange based on $1.19B FMV, generally deferred under recapitalization tax rules if the old Notes and New Notes qualify as securities for tax purposes New Notes have $510m OID OID deductions for debtor, potentially limited under AHYDO rules OID income for holders

75 Broad Definition of Market Traded Under Treas. Reg (f), old Notes or New Notes are traded on an established market if at any time during the 31-day period ending 15 days after the exchange date: An actual sales price for the old Notes or New Notes is reasonably available to market participants; One or more firm quotes for the old Notes or New Notes is available from a broker or dealer, or One or more indicative quotes for the old Notes or New Notes is available from a broker or dealer. Value is presumed to be sales price or quotes price. If indicative price materially misrepresents value, taxpayer can use any method that provides reasonable basis to determine value. Small issuance exception: outstanding stated principal amount of $100 million or less Issuer s s determination binding unless holder discloses on tax return for year that includes acquisition date

76 Anti-Abuse Rule If a temporary restriction on trading is implemented, a purpose of which is to avoid characterization of a debt as market traded, then the debt instrument or property is treated as market traded under Treas. Reg (f)(7) This anti-abuse rule applies even if a third party (and not the issuer) has imposed the restriction, e.g., the holders themselves or a federal bankruptcy court

77 AHYDO In a debt-for-debt exchange or modification where the face amount of the debt is unchanged, but CODI is triggered because the new debt is treated as having an issue price less than face, the new debt will generally have an equivalent amount of OID, the debtor s deduction of which may offset the tax cost of the CODI However, for applicable high-yield debt obligations (those with terms >5 years and YTM > AFR + 5% and OID accruals in excess of cash payments plus one year s worth of interest) ( AHYDOs ): No deduction is available for OID to the extent that it exceeds AFR + 6%, and the remaining OID is only deductible when paid in cash or property

78 Debt Restructuring Tax Issues CODI on equity-for-debt exchange Distressed Debt Fund's exchange of PC debt for PC equity triggers CODI equal to excess of issue price of exchanged PC debt over FMV of PC equity received in exchange 382 ownership change Distressed Debt Fund's acquisition of > 50% of PC's equity triggers ownership change of PC under 382, resulting in limits on use of PC's NOLs and built-in losses If debt issuer is a subsidiary of equity issuer, consider application of Treas. Reg , 351 and Revenue Ruling

79 Debt Restructuring Tax Issues Potential additional CODI as result of Distressed Debt Fund becoming related to PC Distressed Debt Fund's original acquisition of PC debt at a discount did not trigger CODI because Distressed Debt Fund was unrelated to PC But CODI also triggered under Treas. Reg if Distressed Debt Fund treated as acquiring PC debt "in anticipation of becoming related to PC

80 Debt Restructuring Tax Issues If Distressed Debt Fund acquires > 50% of PC's stock within 6 months of purchasing PC's debt at a discount: Purchase deemed to be in anticipation of becoming related PC has CODI on restructuring date equal to excess of face of debt purchased by Distressed Debt Fund over Distressed Debt Fund's purchase price PC deemed to issue new debt instrument to Distressed Debt Fund with issue price equal to Distressed Debt Fund's purchase price, resulting in OID equal to discount

81 Debt Restructuring Tax Issues If Distressed Debt Fund acquires > 50% of PC's stock more than 6 months after purchasing PC's debt at a discount, whether Distressed Debt Fund purchased the PC debt "in anticipation of becoming related" to PC determined based on all relevant facts, including: Distressed Debt Fund's intent at time of debt purchase Any pre-purchase purchase discussions with PC Period of time between purchase of debt and acquisition of stock and Significance of PC debt as a proportion of Distressed Debt Fund's total assets

82 Debt Restructuring Tax Issues If Distressed Debt Fund becomes related to PC more than 6 months after purchase of PC debt at a discount and purchase treated as "in anticipation of becoming related" to PC: CODI measured by reference to FMV of PC debt on date Distressed Debt Fund becomes related to PC (rather than Distressed Debt Fund's purchase price)

83 Restructurings/Workouts Holders treatment Recapitalization treatment of debt-for-debt ( securities ) or debt-for-stock exchange Determination of issue price of new debt is key (e.g., OID on new debt if traded at a discount) Worthless stock deduction

84 NOTES 1-939

85 NOTES 1-940