Disguised Payments for Services: Proposed Regulations Review

Transcription

1 Disguised Payments for Services: Proposed Regulations Review May 2, 2017 Mayer Brown is a global legal services provider comprising legal practices that are separate entities (the "Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP and Mayer Brown Europe-Brussels LLP both limited liability partnerships established in Illinois USA; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales (authorized and regulated by the Solicitors Regulation Authority and registered in England and Wales number OC ); Mayer Brown, a SELAS established in France; Mayer Brown JSM, a Hong Kong partnership and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.

2 Speaker Biography Matt McDonald is a partner in the Tax Transactions practice of Mayer Brown's Chicago office. As a member of the firm s Fund Formation & Investment Management practice, Matt regularly represents fund sponsors in all aspects of the structuring and operation of private investment funds with a particular focus on real estate and real estate-related assets. Matt also represents a variety of taxable, taxexempt and non-us investors in structuring tax-efficient investments in real estate, private equity and hedge funds. Matt's experience includes matters involving the formation and operation of partnerships, limited liability companies and real estate investment trusts (REITs), foreign investment in the United States under FIRPTA and outbound investment in foreign jurisdictions. He also advises U.S. and foreign corporations and partnerships on acquisitions, divestitures and other restructuring transactions. 2

3 Agenda Background on distributive share/guaranteed payment/non-partner capacity payments Fee waivers Proposed Regulations Modification of Rev. Proc Effects on Publicly Traded Partnerships ( PTPs ) Additional Considerations Effective Date and Grandfathering 3

4 Background Three ways to characterize payments by a partnership to a partner for the performance of services Distributive share Guaranteed payment Transaction in which partner is acting in a non-partner capacity (e.g., as a fee) 4

5 Background Distributive Share Allocations determined with regard to partnership income and that are made to a service partner are treated as distributive shares of income. General partnership tax principles apply (e.g., character flow through). Right to distributive share may qualify as a profits interest as defined in Rev. Proc Guaranteed Payment To the extent determined without regard to income of the partnership, payment to a partner for services is treated as made to a non-partner. Ordinary income to recipient and deductible or capitalized expense for partnership. 5

6 Background Partner Acting in a Non-Partner Capacity General Rule: A partner who engages in a transaction with the partnership other than in its capacity as a partner is treated as a nonpartner. Legislative history states the provision was intended to apply in two principal scenarios Purchase of property by a partner from the partnership Rendering of services by a partner to the partnership Historically, it remained unclear when a partner s services were rendered in a non-partner capacity rather than in a partner capacity. 6

7 Background Section 707(a)(2)(A) Disguised payments for services. If i. a partner performs services for a partnership, ii. iii. there is a related allocation of income and distribution from the partnership to the partner, and the services and the allocation/distribution, when viewed together, are properly characterized as a transaction in which the partner is acting other than in its capacity as a partner (i.e., as a service provider), then the allocation/distribution will be treated as a payment for such services rather than as an allocation and distribution of partnership income. How to distinguish an allocation for services rendered by a partner acting in a partner capacity from an allocation for services rendered by a partner acting other than in a partner capacity? 7

8 Background Section 707(a)(2) grants Treasury broad regulatory authority to identify transactions involving disguised payments for services. Congress was concerned that partnerships and service providers were improperly treating payments as allocations and distributions to a partner even when the partner acted in a non-partner capacity. Congress determined that allocations and distributions that are, in substance, direct payments for services should be treated as fees. Partners extract the profits of the partnership with reference to the business success of the venture, while third parties generally receive payments which are not subject to this risk. (REG ) 8

9 Background: Fee Waivers Private equity fund managers are typically compensated in two ways: An annual management fee (e.g., 2% of the amount invested in the fund) A carried interest (or profits interest ) in the fund (e.g., 20% of the profits generated by the fund, sometimes subject to the fund first achieving a minimum return hurdle) The management fee is taxed as ordinary income when earned. The carried interest is taxed when the fund recognizes income that is allocated to the manager. The income allocated to the manager retains its character, which, in many cases, will be long-term capital gain. The manager is also frequently required to invest in the fund, which investment may be drawn over time through periodic capital calls. 9

10 Background: Fee Waivers Fund managers realized that they can convert ordinary income to capital gain (and also achieve deferral) if they give up (or waive ) some of their management fees in exchange for an additional profits interest in the fund. The management fee must be waived before it is earned in order to avoid income under the constructive receipt doctrine. Also, to the extent the fund manager can satisfy its obligation to make ongoing capital contributions to the fund by getting credit for waived management fees, the sponsor is effectively able to invest in the fund on a pre-tax basis. A fund manager takes on additional risk by waiving a guaranteed management fee in exchange for a speculative profits interest, but some managers structured the profits interest in a manner intended to reduce that risk. 10

11 Background: Fee Waivers Fee waivers outside of the private investment fund context-- Guaranty fees Acquisition fees Mechanics of fee waiver arrangements can vary Elective vs hard-wired Fixed amount vs variable amount Differing levels of economic risk (e.g., gross versus net allocations) Overall objective is to convert ordinary income into long-term capital gain and defer recognition of income. 11

12 Background: Fee Waivers Example 1: No Fee Waiver. In 2015, the fund pays the Manager a $10 million management fee, which is taxed at 40% ($6 million after tax). Also in 2015, the Manager is required to invest $5 million in the fund. Manager is left with $1 million net cash plus a partnership interest in the fund that is worth $5 million. Example 2: Fee Waiver. Same as above, except, prior to 2015, the Manager waives 50% of the upcoming management fee. The fund pays the Manager a $5 million management fee, which is taxed at 40% ($3 million after tax). The Manager s $5 million of waived fees is credited toward the Manager s obligation to invest $5 million in the fund, resulting in no cash investment, leaving the Manager with $3 million net cash. The Manager also receives an interest in the first $5 million of profits generated by the fund, on which the Manager will pay tax only when such profits are recognized and possibly at long-term capital gain rates (i.e., $1 million of additional deferred tax, assuming the profits constitute long-term capital gain that is taxed at a 20% rate). 12

13 Background: Fee Waivers Rev. Proc The receipt of a profits interest in a partnership (i.e., an interest that would not entitle the partner to any distribution if the partnership is immediately liquidated, because it is an interest only in the future profits of the partnership) in exchange for services to the partnership in a partner capacity, or in anticipation of becoming a partner, is not subject to current taxation if certain safe harbor requirements are met: The profits interest must not relate to a substantially certain and predictable stream of income, The partner must not dispose of the profits interest for two years, and The profits interest cannot be a limited partnership interest in a publicly traded partnership. 13

14 Proposed Regulations: Fee Waivers Proposed regulations under Section 707(a)(2)(A), issued on July 22, 2015, provide six nonexclusive factors that may indicate that arrangement constitutes a disguised payment for services: 1. The arrangement lacks significant entrepreneurial risk. This is the most important factor, and the lack of significant entrepreneurial risk will cause the arrangement to be treated as a payment for services regardless of the absence of any other factors. But, even if the arrangement has significant entrepreneurial risk, the other factors may indicate that the arrangement is a disguised payment for services. 2. The partner status of the service provider is transitory. 3. The allocation and distribution are close in time to the performance of services. 14

15 Proposed Regulations: Fee Waivers 4. The service provider became a partner primarily to obtain tax benefits not otherwise available to a service provider. 5. The value of the service provider s interest in general and continuing partnership profits is small in relation to the allocation. 6. The arrangement provides for different allocations or distributions for different services received, the services are provided by one person or by related persons, and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly. For example, the fund manager or its affiliate receives a profits interest in exchange for a fee waiver, and that profits interest is subject to significantly less business risk than the (typically 20%) carried interest that is also held by the fund manager or another affiliate. 15

16 Proposed Regulations: Fee Waivers Significant Entrepreneurial Risk. The following arrangements are presumed to lack significant entrepreneurial risk (and thus constitute a disguised payment for services) unless facts and circumstances establish the presence of significant entrepreneurial risk by clear and convincing evidence: 1. Capped allocations of partnership income if the cap would reasonably be expected to apply in most years. 2. Allocations for a fixed number of years under which the service provider s share of partnership income is reasonably certain. 3. Allocations of gross income. 16

17 Proposed Regulations: Fee Waivers Presumed Lack of Significant Entrepreneurial Risk (con t): 4. An allocation (under formula or otherwise) that is predominantly fixed in amount is reasonably determinable under all the facts and circumstances or is designed to ensure that sufficient net profits are highly likely to be available to make the allocation to the service provider (e.g., an allocation of net profits from specific transactions or accounting periods that does not depend on the overall success of the enterprise). 5. The service provider either waives its right to receive payment for the future performance of services in a manner that is non-binding or fails to notify the partnership and its partners of the waiver and its terms. 17

18 Proposed Regulations: Fee Waivers Example 1 in the Proposed Regulations Partnership ABC constructed a building that will generate $100,000 of gross income annually. A provides services for which its normal fee would be $40,000 and contributes cash for a 25% interest in ABC. In exchange, A receives (i) a 25% distributive share for the life of ABC and (ii) a special $20,000 gross income allocation for years one and two. The special allocation to A is capped in amount, and the cap is reasonably expected to apply. The special allocation is made out of gross income. The arrangement lacks significant entrepreneurial risk and is a disguised payment for services. 18

19 Proposed Regulations: Fee Waivers Example 3 in the Proposed Regulations M performs services for which a fee would normally be charged to partnership ABC, and M also contributes $500,000 in exchange for a 1% interest in ABC s capital and profits. M is entitled to a priority allocation and distribution of ABC s net gain from the sale of any one or more assets during any 12-month accounting period in an amount intended to approximate the fee that would normally be charged for the services M performs. A is a company that controls M and is also the general partner of ABC. A will be allocated 10% of the net profits and losses of ABC earned over the lifetime of the partnership and is subject to a clawback obligation. 19

20 Proposed Regulations: Fee Waivers Example 3 (con t) The arrangement with M is a disguised payment for services. ABC s assets are not readily tradable, and A (a party related to M) controls the timing of asset dispositions and thus the timing of recognition of gains and losses. The arrangement lacks significant entrepreneurial risk, because the allocation to M is reasonably determinable under the facts and circumstances and sufficient net profits are highly likely to be available to make the priority allocation. The arrangement with A is not a disguised payment for services. A s arrangement creates significant entrepreneurial risk, because it is an allocation of net profits over the life of the partnership, is subject to a clawback obligation, and is not reasonably determinable or highly likely to be available. 20

21 Proposed Regulations: Fee Waivers Example 5 in the Proposed Regulations A is the general partner of ABC and is responsible for providing management services to ABC but has delegated that responsibility to M, a company controlled by A. ABC will pay M an amount equal to 1% of capital invested by ABC s partners. A will contribute nominal capital to ABC and will receive a 20% interest in ABC s net profits over the life of ABC. A is also entitled to an interest in ABC s net profits determined by a formula (approximately equal to the present value of 1% of capital invested by ABC s partners annually), subject to a clawback obligation. Comparable funds pay the manager a fee equal to 2% of capital invested and require the general partner to contribute 1% of such capital. 21

22 Proposed Regulations: Fee Waivers Example 5 (con t) A s interest in ABC s net profits has significant entrepreneurial risk, because the allocation is of net profits, the allocation is subject to a clawback obligation over the life of ABC, and the allocation is neither reasonably determinable nor highly likely to be available. The arrangement is not a disguised payment for services. 22

23 Proposed Regulations: Fee Waivers Example 6 in the Proposed Regulations Similar to Example 5, except that M is entitled to an annual fee equal to 2% of capital invested by ABC s partners but may waive all or a portion of that fee in exchange for an interest in future net profits determined by a formula (approximately equal to the estimated present value of the fee that was waived). M must provide written notice of its intention to waive the fee at least 60 days prior to the commencement of the partnership taxable year in which the fee is payable. M s interest in ABC s net profits has significant entrepreneurial risk, because the allocation is of net profits, the allocation is subject to a clawback obligation over the life of ABC, and the allocation is neither reasonably determinable nor highly likely to be available. The arrangement is not a disguised payment for services. 23

24 Proposed Regulations: Fee Waivers Preamble identifies a problem associated with the application of Rev. Proc to waivers of fees for profits interests. The Treasury Department and the IRS are aware of transactions in which one party provides services and another party receives a seemingly associated allocation and distribution of income or gain. (REG ) Other Investors Related Party Mgmt Company Profits Interest Services Waive Fees Fund 24

25 Proposed Regulations: Fee Waivers Preamble states that Treasury and the IRS have determined that Rev. Proc does not apply to fee waivers that benefit a related party. Arrangements fail the safe harbor on two accounts Profits interest not received for the provision of services to or for the benefit of the partnership in a partner capacity or in anticipation of becoming a partner Service provider has effectively disposed of the partnership interest (via constructive transfer to related party) within two years of receipt 25

26 Proposed Regulations: Fee Waivers Modification of Rev. Proc The preamble to the proposed regulations indicates that the IRS intends to modify the safe harbor conditions set forth in Rev. Proc so that the safe harbor will not apply to a profits interest issued in conjunction with a partner forgoing payment of an amount that is substantially fixed (including by formula) for the performance of services. Thus, even if a profits interest that is granted in connection with a fee waiver is found not to be a disguised payment for services under the proposed regulations (as in Example 6), the receipt of such interest would not be eligible for the safe harbor under Rev. Proc Consequently, the recipient may have current ordinary income under Section 83 in an amount equal to the FMV of such profits interest at the time it is issued. This change by itself could end the practice of fee waivers, rendering the proposed regulations somewhat moot with respect to fee waiver arrangements. 26

27 Proposed Regulations: Effects on PTPs Preamble to proposed regulations states that changes to existing regulations under Section 707(c) are needed. Example 2 in Reg (c) currently provides: Partner C in the CD partnership is to receive 30% of partnership income as determined before taking into account any guaranteed payments but not less than $10,000. The income of the partnership is $60,000, and C is entitled to $18,000 (30% of $60,000) as its distributive share. No part of this amount is a guaranteed payment. However, if the partnership had income of $20,000 instead of $60,000, then $6,000 (30% of $20,000) would be partner C s distributive share, and the remaining $4,000 payable to C would be a guaranteed payment. Current version of Example 2 concludes the payment is a guaranteed payment only to the extent the partner s distributive share of income is insufficient. 27

28 Proposed Regulations: Effects on PTPs Preamble states that current Example 2 is inconsistent with the notion that an allocation must be subject to significant entrepreneurial risk. Proposed revision to Example 2 in Reg (c): Partner C in the CD partnership is to receive 30% of partnership income, but not less than $10,000. The income of the partnership is $60,000, and C is entitled to $18,000 (30% of $60,000). Of this amount, $10,000 is a guaranteed payment to C. The $10,000 guaranteed payment reduces the partnership's net income to $50,000 of which C receives $8,000 as C s distributive share. Proposed Example 2 would provide that the entire minimum payment (i.e., $10,0000) is treated as a guaranteed payment. 28

29 Proposed Regulations: Effects on PTPs Is the change to Example 2 also applicable to guaranteed payments for the use of capital? PTPs own interests in lower-tier partnerships PTPs rely on the current version of Example 2 to support payments as distributive shares and thus qualifying income under Section 7704(d). Under revised Example 2, payments received by PTPs from lower-tier partnerships for use of capital may not be qualifying income. Proposed solutions Limit the change in Example 2 to payments for services (NYSBA Comments) Treat as distributive share (MLPA Comments) Characterize by reference to type of income replaced (MLPA Comments) 29

30 Proposed Regulations: Effects on PTPs PTPs commonly grant incentive distribution rights ( IDRs ) to a general partner or managing member. IDR holder has right to increasing percentage of cash flow as the perunit distribution on common interests increases. PTPs allocate gross income to the IDR holder equal to the cash flow distribution on the IDR. They do this because Net Section 704(b) income is often less than distributions to IDR holders Net Section 704(b) allocation is administratively burdensome, because remaining depreciation/amortization would not be allocated pro rata to common unitholders Are IDRs disguised payments for services? 30

31 Proposed Regulations: Additional Considerations Disguised payment determination is made at the time the arrangement is entered into. A disguised payment for services is treated as a payment for services for all purposes of the Code. Service income to recipient (e.g., Section 61, Section 409A, Section 457A) Payment for services by the partnership; must be capitalized where appropriate Proposed regulations apply even if their application results in the service provider failing to be treated as a partner for tax purposes. Must determine status of service provider as an independent contractor or an employee. 31

32 Proposed Regulations: Selected Commentary 1 Factors considered and lack of significant entrepreneurial risk presumptions should be clarified and/or modified. Permit gross income allocations if not reasonably certain (e.g., from asset sales) Clarify meaning of predominantly fixed in amount Allow for allocations based on specific time periods and/or performance of specific assets if specified in advance and have business reason Neither a clawback provision nor liquidating in accordance with capital account balances should be required. Provide safe harbors or additional examples of permissible arrangements. 1 Proposed Regulations on Disguised Payments for Services, 2015 NYSBA Tax Sec. Rep (2015 TNT ); Comments on Proposed Regulations Relating to Disguised Payments for Services in the Partnership Context under Section 707 of the Code, 2015 CT Bar Ass n Rep. (2015 TNT ). 32

33 Effective Date and Grandfathering The proposed regulations will be effective on the date that final regulations are published and will apply to any arrangement entered into or modified on or after that date. Rev. Proc would be modified on the same date. Consequently, pre-existing arrangements would be grandfathered so long as they are not modified on or after the effective date. However, any arrangement that permits a service provider to waive fees will be deemed to be modified for this purposes (and thus not grandfathered) if the fee is waived on or after the effective date. So, as a practical matter, existing fee waiver arrangements will not be grandfathered. Despite the prospective effective date, it is the stated position of the Treasury and the IRS that the proposed regulations reflect Congressional intent regarding the treatment of disguised payments for services under current law. 33

34 Questions 34