Lisa B. Petkun

Transcription

1 TaxUpdate Vol. 2014, Issue 4 Berwyn Boston Detroit Harrisburg Los Angeles New York Orange County Philadelphia Pittsburgh Princeton Silicon Valley Washington, D.C. Wilmington Follow Us on Twitter Speakers Corner Joan C. Arnold presented on M&A: Cross-Border Corporate Migrations A New Trend? on June 24, Joan C. Arnold will be speaking at the NYU Summer Institute on July 24, 2014 on the topic of International Tax Issues for PE Funds. Quotable Todd B. Reinstein was quoted in CCH s May 15, 2014 Federal Tax Weekly regarding new proposed regulations on the carryover of attributes in tax-free reorganizations. Published Todd B. Reinstein s article Rev. Proc Provides Taxpayers Relief When Missing Form 1122 on Joining a Consolidated Group was published in the April 2014 issue of Bloomberg BNA Tax Management Insights. The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please send address corrections to phinfo@pepperlaw.com Pepper Hamilton LLP. All Rights Reserved. In Frank Aragona Trust, Tax Court Holds that Trustees Activities as Employees Count for Purposes of Material Participation Under Code Section 469 W. Roderick Gagné gagner@pepperlaw.com Lisa B. Petkun petkunl@pepperlaw.com The issue of whether a trust has passive or non-passive income from its investment in a pass-through entity has taken on increased importance in light of the tax imposed on net investment income under Code Section 1411 of the Internal Revenue Code of 1986, as amended (the Code ). The increased scrutiny of the distinction between passive and non-passive income arises because income derived from a passive activity is subject to the net investment income tax, whereas income from an active trade or business is not subject to the new tax. In the case of Frank Aragona Trust, et al. v. Commissioner, 142 T.C. No. 9, (3/27/14), the United States Tax Court determined that a trust engaged in rental real estate activities, both directly and indirectly through other entities, qualified for the Code Section 469(c)(7) real estate professional exception to the passive loss rules for rental real estate activities. The court found against the IRS s position that the Trust was barred from qualifying for the real estate professional exception because a Trust could not perform personal services and could not materially participate. The court held that a Trust is capable of performing personal services by and through its individual trustees. It further held that the trustees activities as employees of a limited liability company (LLC) wholly owned by the Trust enabled the Trust to materially participate. This publication may contain attorney advertising. in this issue... 1 In Frank Aragona Trust, Tax Court Holds that Trustees Activities as Employees Count for Purposes of Material Participation Under Code Section Podcast: Thomson Reuters Session 2: Investment Management, Hedge Funds and Registered Mutual Funds -What s Happening Now? 4 Foreign Tax-Exempt Organizations Exempt from Withholding Tax 7 Final Noncompensatory Partnership Options Regulations Could Affect the Tax Treatment of Penny Warrants and Other Arrangements

2 The Trust was a residuary trust with six trustees, five of whom were the deceased grantor s children and one was an independent trustee. One of the children, Paul Aragona, was designated as the executive trustee to facilitate the Trust s daily business operations. The trustees acted as a management board for the Trust by making all major decisions. The board met every few months to discuss the Trust s business. Each of the trustees received a trustee fee. Three of the trustees, including Paul Aragona, worked full-time for Holiday Enterprise, LLC (Holiday), which was wholly owned by the Trust. Holiday managed most of the Trust s rental real estate properties, and paid wages to the three trustee employees. The Trust also owned interests in a number of entities engaged in owning and holding real estate for investment and development. The Trust conducted its real estate rental activities through direct real estate ownership, through wholly owned entities, and through entities in which it owned majority interests. Two of the trustees owned minority interests in the entities in which the trust owned majority interests. The Trust also conducted real estate holding and real estate development operations through entities in which it owned majority or minority interests and in which two of the trustees owned minority interests. The Trust classified the losses from the rental real estate activities in 2005 and 2006 as losses from non-passive activities. The Trust carried back the losses to 2003 and The Trust claimed that it met the Code Section 469(c)(7) exception to the general rule that rental real estate activities are passive. This exception applies to remove a real estate activity from passive activity loss characterization if (i) more than one-half of the personal services performed in trades or businesses by the taxpayer during the taxable year are performed in real property trades or businesses in which the taxpayer materially participated, and (ii) the taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participated. The IRS claimed that the rental real estate losses were passive activity losses that could not be deducted and carried back as an NOL. The IRS s position was that a trust is incapable of satisfying the Code Section 469(c)(7)(B)(i) exception because it requires the performance of personal services by the taxpayer. The IRS supported its position by citing the regulations, which provide that personal services mean work performed by an individual in connection with a trade or business. Consequently, in the IRS s view, only an individual can perform personal services; because a trust is not an individual, a trust cannot not perform personal services and, thus, cannot use the exception. The court rejected the IRS s argument, noting that a trust is an arrangement in which trustees manage assets for the trust s beneficiaries. The court found that if individual trustees work in a trade or business as part of their trustee duties, their work can be considered work performed by an individual in connection with the trade or business of the trust. On that basis, a trust is capable of performing personal services through its trustees and therefore can satisfy the exception. After examining the legislative history to Code Section 469(c)(7), the court concluded that if Congress had wanted to exclude trusts from this exception it could have done so explicitly by limiting the exception to a natural person, but that the use of the term taxpayer in this section suggests that Congress did not intend to exclude trusts from the exception. Having lost on the question about whether a trust can satisfy the personal services exception, the IRS s fallback position was the Trust did not qualify for the exception because it did not materially participate in real property trades or businesses. The IRS argued that in determining whether a trust materially participates in an activity, only the activities of trustees can be considered and the activities of the Trust s non-trustee employees must be disregarded. The IRS further argued that the trustees who were employees of Holiday could not include, in the determination of whether the Trust satisfied the passive activity rules, any of the hours performed by them as employees. This position was based on the legislative history, which provides that a trust is treated as materially participating if an executor or fiduciary, in its capacity as such, is so participating. The legislative history further provides that the activities of employees are not attributed to the taxpayer. On the basis of these legal principles, the IRS contended that the activities of the three trustees who were employees of Holiday should be ignored, because such activities should be considered the activities of employees and not fiduciaries. The IRS reasoned that the trustees performed their activities as employees of Holiday, and that it was impossible to disaggregate the activities they performed as Holiday employees from the activities that they performed as trustees. The court found that the activities of the trustee/employees should be considered in determining whether the Trust materially participated in its real estate operations. The court 2

3 TaxUpdate based this conclusion on Michigan law, under which trustees are obligated to administer a trust solely in the interest of the beneficiary (which is the general rule and not limited to Michigan). As a consequence, the trustees activities as Holiday employees were considered by the court in determining whether the Trust materially participated. However, the court did not delineate how to parse the trustee/employee s time spent on the Trust s business. It merely noted that the Trust s real estate operations were substantial and that the three trustees/employees worked full-time in the real estate businesses. The court observed that the Trust had practically no other types of operations and the trustees handled practically no other business on behalf of the Trust. The IRS made a further argument based on the fact that two of the trustees/employees had minority interests in all of the entities in which the Trust operated its real estate holdings and real estate development projects, and they had had minority interests in some of the entities through which the Trust operated its rental real estate business. On account of these ownership interests, the IRS contended that some of their efforts in managing the joint entities should be attributed to their personal portions of the business and not the Trust s portions. The court rejected that contention as well, by pointing out that trustees/employees combined ownership interest did not exceed 50 percent, was not greater than the Trust s ownership interest, and that their interests as owners were generally compatible with the Trust s goals. Even considering their personal ownership, the court held that the two trustees/employees activities were sufficient for the Trust to materially participate in the real property trades or businesses. Having determined that a trust can provide personal services and that the Trust materially participated, the next inquiry would have been whether the personal services provided by the Trust were sufficient to meet the remainder of the Code Section 469(c)(7) test namely, were more than one-half of the personal services performed in real property trades or businesses, and did the Trust perform more than 750 hours of services during the year in the real-property trades or businesses? However, the IRS had limited its arguments to the two specific issues of whether a trust is categorically barred from qualifying under the exception and whether the Trust materially participated. Because both of these issues were resolved in favor of the Trust, the court found that the Trust satisfied the Code Section 469(c)(7) exception for the years at issue. The court at no time gave any significance to the fact that Holiday was wholly owned by the Trust. Therefore, the court left open the issue of whether the activities of trustees would count if the trustees had been employees of an entity in which the Trust owned less than all of the interests. If a lesser ownership level would permit attribution of the trustees activities, what level of ownership would count? Only more than 85 percent? Anything more than a majority? Less than a majority? The court also did not address how to measure the extent of trustees activities necessary to cause a trust to materially participate. Are the activities of each of the trustees aggregated? Are they aggregated using an hours test? Must the aggregate time reach 500 hours or can a trust satisfy the facts and circumstances test with less aggregate time? Does it matter if the trustees are Podcast: Thomson Reuters Session 2: Investment Management, Hedge Funds and Registered Mutual Funds -What s Happening Now? Kevin M. Johnson and Gregory J. Nowak participated in Thomson Reuters Session 2: Investment Management, Hedge Funds and Registered Mutual Funds - What s Happening Now? The podcast is available at 3

4 employees of several different entities in which a trust has an ownership interest? Would it matter if a trust owned a minority interest and the trustee owned a majority interest? If a trustee has an ownership interest, can the trustee s time count both for satisfying the trustee s material participation for the trustee s personal tax return and for satisfying the material participation test for the trust? Furthermore, the court did not decide whether the activities of non-trustee employees should be counted in determining that the trust materially participated. Allowing the activities of those persons to count would greatly expand the class of persons whose activities could be used to enhance the ability of a trust to be found to have materially participated. Pepper Perspective Aragona is a significant taxpayer victory in its conclusion that a trust can satisfy the real estate professional exception, and that the activities of trustees who are employees of an entity owned by a trust can satisfy the material participation standard. However, the conclusion about material participation was based on the particular facts of Aragona, and many trusts will have facts that are not as favorable as the Aragona facts. The failure of Aragona to explain whether the trustees activities are aggregated, need to reach 500 hours in the aggregate, and would count if the trust owned less than 100 percent of the interests in the entity in which the trustees were employed are tantalizing questions that will need to be resolved in subsequent cases. Foreign Tax-Exempt Organizations Exempt from Withholding Tax Steven D. Bortnick bortnicks@pepperlaw.com Lisa B. Petkun petkunl@pepperlaw.com Brian Allen allenbr@pepperlaw.com Investment funds, including private equity funds, often receive capital contributions from tax-exempt organizations. These tax-exempt institutions may include U.S. and foreign pension funds, as well as U.S. and foreign charities and college and university endowment funds. This article addresses some of the U.S. withholding tax exemptions and obligations as they relate to foreign tax-exempt organizations invested in investment funds. Taxation of Foreign Investors on U.S.-Source Investment Income Private equity, venture capital and domestic hedge funds typically are formed as partnerships for U.S. federal tax purposes so that (1) the entity is not itself subject to tax, and (2) the nature of the income (such as capital gain or qualified dividends) flows through to the investors in the fund. These funds generally derive investment income, such as interest, dividends and capital gains. Foreign investors that derive such investment income generally are subject to tax in the United States only on their U.S.-source fixed or determinable, annual or periodical (FDAP) income, such as interest and dividends. U.S.-source FDAP income derived by foreign investors generally is taxed at a flat 30 percent on gross (i.e., with no deductions) basis, though this rate may be reduced by applicable tax treaties between the recipient s country of tax residence and the United States. Moreover, the tax generally is collected by way of withholding at the source. Thus, withholding is done by the investment fund, if it is a U.S. partnership or withholding foreign partnership, or the portfolio company itself, if the fund is a foreign fund that is not a withholding foreign partnership. The United States generally does not tax foreign entities on capital gains or portfolio interest derived by foreign entities

5 TaxUpdate Withholding Exemption for Foreign Tax-Exempt Organizations Treasury Regulation Section (a) provides that no withholding is required on amounts paid to a foreign organization that is described in Section 501(c) of the Internal Revenue Code of 1986, as amended (the Code ). 2 In order to be exempt from withholding tax, the amount paid must not constitute unrelated business taxable income. Further, Treasury Regulation Section (b)(2) provides that the withholding agent may rely on a claim of exemption from withholding if it receives IRS Form W-8 to which is attached an opinion of a U.S. counsel acceptable to the withholding agent that concludes that the organization is described in Section 501(c)(3). Form W-8EXP is used for this purpose. Organizations Are Described in Section 501(c) In order to qualify as an exempt organization under Section 501(c)(3), the organization must be both organized and operated exclusively for one or more exempt purposes. The organizational test relates to the purpose of the organization as described in its organizational charter, articles of incorporation, or other governing instrument. The operational test relates to the actual activities conducted by the organization. The organizational test contains requirements pertaining to three subjects: (1) the organization s purposes and activities; (2) legislative and political activities; and (3) distribution of assets upon dissolution. Each must be satisfied for an organization to qualify under Section 501(c)(3). The governing documents of an organization qualified under Section 501(c)(3) must limit its activities to one or more exempt purposes and cannot empower the organization to engage in activities that do not further this purpose. Exempt purposes include religious, charitable, scientific, literary and education, although other purposes also have been recognized as exempt purposes. As to dissolution, to qualify under Section 501(c)(3), the governing documents of the organization must provide that, upon dissolution, the assets of the organization will be distributed exclusively for Section 501(c) (3) purposes. If the organization s governing documents expressly authorize the organization to devote more than an insubstantial portion of its activities to attempting to influence legislation by propaganda or otherwise, or to participate in any political campaign, the organization fails the organizational test. In order to qualify under Section 501(c)(3), an organization must be operated exclusively for one or more exempt purposes. In addition, no part of its net earnings may inure in whole or in part to the benefit of any private individual. The law firm providing the opinion to be attached to Form W-8EXP will consider each of these requirements as they relate to the organization claiming the exemption. In addition, it likely will be necessary to consider the impact of local law. For example, if the organization is formed for charitable purposes, within the meaning of the applicable not-for-profit law, are those charitable purposes consistent with those for which an exemption is available under Section 501(c)(3)? Unrelated Business Taxable Income (UBTI) U.S. entities that otherwise are exempt from U.S. taxation under Section 501 are subject to tax on their share of UBTI. UBTI includes income from unrelated trades or businesses (including certain fee income). Interest, dividends, capital gains and foreign currency gain or loss generally are excluded from the definition of UBTI, unless they are derived from debt-financed property. Any such income recognized during a tax year in which there is outstanding acquisition indebtedness will be, at least in part, UBTI. In addition, capital gains recognized from a sale of debt-financed securities within 12 months of the repayment of acquisition indebtedness will be, at least in part, UBTI. Just as U.S. tax-exempt organizations are subject to tax on their UBTI, foreign tax-exempt organizations are not exempt from tax on their UBTI. Unlike U.S. tax-exempt organizations, Foreign private foundations are generally subject to a 4 percent withholding tax on gross investment income 5

6 foreign tax-exempt organizations may claim exemptions or reductions in tax that other, non-exempt, foreign entities may claim. For example, even if it otherwise would be UBTI, portfolio interest and capital gains generally would be exempt from tax. To the extent that a foreign tax-exempt organization receives income that is not UBTI, the Form W-8EXP provided to a withholding agent should indicate that the income in question does not constitute UBTI. Excise Tax on Foreign Private Foundations Tax-exempt organizations come in two varieties: public charities and private foundations. Public charities generally receive their funding from a wide group of contributors and from government grants. Private foundations, on the other hand, generally receive their funding from a smaller group of substantial contributors. Private foundations are subject to additional rules, and potential excise taxes. Foreign private foundations are subject to a 4 percent tax on their gross investment income derived from U.S. sources, excluding income that constitutes UBTI. This tax also is collected by way of withholding. Additionally, although it is counter-intuitive, this tax applies to U.S.-source income not otherwise subject to tax in the hands of foreign persons, such as portfolio interest and capital gains. (Note that capital gains from the sale of stock and securities generally are sourced based on the residence of the recipient. Thus, capital gain recognized by an investment fund on the sale of stock of a portfolio company and allocable to a foreign private foundation typically would be considered foreign source.) If the tax-exempt organization is question is not a private foundation, the Form W-8EXP provided to the withholding agent should indicate this, in order to avoid withholding of the 4 percent tax. Impact of Treaties on UBTI and Excise Tax The United States has entered into income tax treaties with many countries. These treaties are designed to avoid double taxation, and, where a resident of one jurisdiction derives income from the other, generally dictate which country may tax the income, and to what extent. For example, a resident of the United Kingdom which receives U.S.-source interest, and otherwise is eligible to claim the benefits of the treaty between the United States and the United Kingdom generally will be exempt from U.S. withholding tax on such income. The applicable regulations addressing the tax on UBTI derived by foreign tax-exempt organizations and the 4 percent tax on U.S.-source gross investment income of foreign private foundations provide that a foreign tax-exempt organization may claim the benefits of an income tax treaty to reduce or eliminate the tax on UBTI and the tax on gross investment income. In the case of the tax on gross investment income, certain treaties specifically exempt all items of income while other treaties, although covering the 4 percent tax, do not provide for a specific exemption. If the applicable treaty does not provide for a specific exemption, the IRS has tentatively concluded in a Chief Counsel Memorandum 3 that the foreign private foundation will only be entitled to a reduction or elimination of the 4 percent tax to the extent that the applicable treaty rate is less than 4 percent. Of course, determinations must be made that (1) the tax-exempt organization is covered by the treaty, and (2) the treaty covers the tax in question. For example, assume that a United Kingdom tax-exempt organization that would be treated as a private foundation receives $250,000 of U.S.-source dividend income and $750,000 of U.S.-source interest income that qualifies as portfolio interest. Assume further that the dividend income related to debt-financed stock and, thus, would be UBTI. In this case, the $250,000 dividend income would not qualify for the withholding tax exemption for tax-exempt organizations, because it constitutes UBTI. However, the tax treaty between the United States and United Kingdom specifically provides that the United Kingdom tax-exempt organization may be treated as a tax resident of the United Kingdom for treaty purposes. Thus, the organization can qualify for the 15 percent withholding tax rate (rather than the normal 30 percent) on the dividend income. The interest income is not UBTI, and, thus, would be exempt from 30 percent withholding tax, both because the entity qualifies as a foreign tax-exempt organization and because the interest qualifies as portfolio interest. In addition, the tax treaty between the United States and United Kingdom covers the 4 percent tax; however, it does not specifically exempt all items of income from the 4 percent tax. Therefore, based on the IRS s conclusion, withholding will be required at the lesser of (i) the applicable treaty rate that the organization qualifies for and (ii) 4 percent. The tax treaty between the United States and United Kingdom exempts withholding tax on interest income. Thus, the organization can qualify for a complete exemption from the 4 percent tax. Further, as the dividend income constitutes UBTI, it will not be subject 6

7 to withholding on the 4 percent tax. However, if the dividend income did not constitute UBTI (for instance, because it did not relate to debt-finance stock) the dividend income would be subject to withholding tax at a rate of 4 percent (the lesser of the 15 percent applicable treaty rate and 4 percent). It should be noted that the Form W-8EXP is not used to claim treaty benefits. Rather, Form W-8BEN is used for this purpose. A Word about Foreign Pension Funds Qualifying domestic pension funds obtain their tax exemption pursuant to Sections 401(a) and 501(a), and not pursuant to Section 501(c). Accordingly, foreign pension funds are not exempt from withholding pursuant to Treasury Regulation Section However, certain treaties, including the treaty between the United States and United Kingdom, specifically provide exemptions from tax on U.S.-source interest and dividends. Endnotes 1. Foreign investors that are engaged in a trade or business are subject to U.S. taxation in the same manner as U.S. persons on income that is effectively connected to a U.S. trade or business, including effectively connected interest, dividends and capital gains. Moreover, gain on the sale of stock of a United States Real Property Holding Corporation (i.e., generally, a domestic corporation the assets of which are primarily comprised of U.S. real property and cash) is treated as effectively connected capital gain and, thus, foreign investors are subject to tax in the same manner as U.S. residents on such gain. Foreign investors are treated as being engaged in a U.S. trade or business conducted by partnerships in which they are partners. This article generally does not discuss income that is effectively connected to a U.S. trade or business. 2. Unless otherwise stated, Section references are to the Code. 3. IRS CCM (November 30, 2009). Final Noncompensatory Partnership Options Regulations Could Affect the Tax Treatment of Penny Warrants and Other Arrangements Lisa B. Petkun petkunl@pepperlaw.com Brian Allen allenbr@pepperlaw.com Investments in partnerships (and other pass-through entities such as limited liability companies treated as a partnership) often involve the acquisition of warrants, options or other rights to acquire securities. This is often because the investor either (i) does not want to be an actual partner in the partnership for tax purposes or (ii) wants the potential for an equity upside in connection with a debt financing transaction without currently being considered to be a partner for tax purposes. Whether the investment security achieves those goals depends on whether the security is respected as a separate instrument or is treated as exercised for tax purposes. In 2013 the U.S. Treasury Department finalized regulations addressing when noncompensatory options (also called investment warrants 1 ) will be treated as equity for federal tax purposes. Under the regulations, nominally priced investment warrants will be treated as equity for federal tax purposes if both (i) the investment warrant provides for rights that are similar to an owner of the underlying security and (ii) there is a strong likelihood that the failure to treat the investment warrant holder as the owner would result in a substantial reduction in the present value of the aggregate tax liabilities of the investment warrant holder and the owners. Penny warrants raise a significant risk that the warrants will be treated as equity. Equity treatment may cause: foreign investors to be liable for filing U.S. tax returns and paying U.S. taxes; tax-exempt investors to have unrelated business taxable income (UBTI); and taxable U.S. persons to have taxable income without the right to receive a tax distribution. 7

8 TaxUpdate Federal Tax Consequences of Nominally Priced Investment Warrants in Partnerships that Are Treated as Equity If the investment warrant is treated as an equity interest, the holder will be treated as a partner in the issuing partnership for all federal tax purposes. 2 A holder that is treated as a partner in the issuing partnership will be allocated income, gain, loss, deduction or credit of the investment warrant issuer to the extent of its interest in the partnership (taking into account all facts and circumstances). 3 While the rules determining a holder s interest in a partnership are quite complex, certain situations would clearly lead to the allocation of income, gain, loss, deduction or credit to the holder. For example, if the investment warrant is classified as equity under the tests described below and the terms of an investment warrant grant the holder a right not to only share in the future upside of the partnership but also to share in partnership capital in an amount that exceeds the exercise price of the warrant, the holder should be considered to have an interest in the partnership. In this case, income, gain, loss, deductions and credits of the partnership would be allocated to the holder in accordance with its interest in the partnership. Therefore, depending on the holder s interest in the partnership, it is possible that a holder will be allocated taxable income even though the holder may not be entitled to any distributions (including tax distributions) under the issuer s operating agreement. The unexpected receipt of income without the right to receive a corresponding distribution is a possible consequence that should be considered when structuring investments. Pepper Perspective If it is determined that the investment warrant will be treated as an equity interest, the investment warrant agreement and the partnership agreement should state that the investment warrant holder will be treated as a partner for purposes of tax allocations and tax distributions. Further, the possibility of a holder of an investment warrant being treated as a partner in the issuing partnership raises additional concerns for special types of holders. For example: U.S. tax-exempt investors should consider whether the investment warrant would cause them to receive UBTI. Regulated Investment Companies should consider whether the investment warrant would cause them to have income or assets that do not qualify under Section 851(b). Foreign investors should consider whether the investment warrant causes them to be engaged in a trade or business in the United States or to have a permanent establishment in the United States, which could require such foreign investors to file U.S. tax returns and pay U.S. tax. The investment warrant will be treated as an equity interest in the issuer if the two tests set forth under Tests for Whether an Investment Warrant in a Partnership Is Treated as Equity are met. These tests generally will be met when the investment warrant has a nominal exercise price and there is a strong likelihood that the failure to treat the warrant as the owner of the underlying security would result in a substantial tax reduction. Tests for Whether an Investment Warrant in a Partnership Is Treated as Equity An investment warrant to acquire an equity interest in a partnership (or other pass-through entity, including a limited liability company that is treated as a partnership for federal tax purposes) is treated as an equity interest if, on certain measuring dates (discussed further in Measuring Dates on page 11) both of two tests are met: i. the investment warrant provides the holder with rights that are substantially similar to the rights afforded to the owner of an interest into which the investment warrant is exercisable, and ii. there is a strong likelihood that the failure to treat the holder of the investment warrant as the owner of the underlying security would result in a substantial reduction in the present value of the aggregate tax liabilities of the other owners of the interests and holder of the investment warrant (a Substantial Tax Reduction ). If these tests are met, then the investment warrant will be considered to be exercised, and therefore the holder will be considered to be a partner of the partnership for all U.S. tax purposes. Pepper Perspective If a partnership (or other pass-through entity) expects to issue or receive a substantial amount of nominally priced investment warrants, it should consider requiring its partners to provide information regarding the tax attributes of the partner s direct or indirect owners. This may allow the partnership to determine 8

9 whether the investment warrants would not be required to be classified as an equity interest under the regulations because warrant treatment would not result in a Substantial Tax Reduction. Test I - Rights Similar to Owners An investment warrant provides its holder with rights that are substantially similar to the rights afforded to an owner of an equity interest in the issuer if either (i) the investment warrant is reasonably certain to be exercised, or (ii) the investment warrant holder possesses owner attributes. Whether an investment warrant is reasonably certain to be exercised at the time of a measurement event is determined based on all the facts and circumstances. While these facts and circumstances include a variety of factors, if the value of the partnership interest is equal to or higher than the exercise price, an investment warrant with a nominal exercise price would generally be considered reasonably certain to be exercised unless a safe harbor applies. Test I -Safe Harbors The final regulations provide two objective safe harbors. These safe harbors only apply, however, if the holder of the investment warrant does not have as a principal purpose achieving a Substantial Tax Reduction on the measuring date. If the holder of the investment warrant has such a purpose, then the holder of the investment warrant cannot rely on the safe harbors and the determination must be made based on all of the facts and circumstances. An investment warrant will fall into a safe harbor and will therefore not be considered reasonably certain to be exercised, if, as of the measurement event, either of the following is applicable: i. the warrant may be exercised no more than 24 months after the measurement event and the strike price is equal to or greater than 110 percent of the fair market value of the underlying interest in the issuer on the date of the measurement event; or ii. the warrant s terms provide that the strike price is equal to or greater than the fair market value of the underlying interest in the issuer on the warrant s exercise date. While the failure to satisfy either of the safe harbors is not determinative of whether an investment warrant is treated as reasonably certain to be exercised, in the absence of a safe harbor, an investment warrant with a nominal exercise price may have a substantial risk of being treated as reasonably certain to be exercised under the general facts and circumstances test. Therefore, unless there is support that the fair market value of an investment warrant with a nominal strike price is almost worthless (i.e., less than such nominal amount) on the date of issuance or other relevant measuring date, or an investment warrant provides for an exercise price equal to or greater than the fair market value of the interest on the date of exercise, the investment warrant may be treated as an equity interest unless there is not a strong likelihood of a Substantial Tax Reduction. Example 1 100,000 investment warrants in a partnership are granted to Holder with a restriction that the warrants must be exercised within 24 months of their issuance. Using the Discounted Cash Flow method, it is determined that at the time of issuance the underlying partnership interest has a fair market value of $910. Therefore, if the combined exercise price of the warrants is $1,000 (1 cent per warrant), the investment warrant will meet the first safe harbor. If the warrants are exercisable more than 24 months after the issuance, then they would not meet the safe harbor and likely would be considered reasonably certain to be exercised. Example 2 100,000 investment warrants in a partnership are granted to Holder. There is no restriction on the timing of the exercise of the warrants. However, instead of a fixed exercise price, the warrants provide that the exercise price will be equal to the fair market value of the partnership interest granted as of the date of exercise. Using the Discounted Cash Flow method, it is determined that at the time of issuance the underlying partnership interest has a total value of $910. In Year Five, the fair market value of the partnership interest has increased to $100,000. By the terms of the investment warrant, the exercise price of the warrants will be $100,000 in Year Five. Therefore, the warrants will meet the second safe harbor. However, the investment warrant holder does not share in either the initial $910 value or in any of the increase of the value of the partnership interest from $910 to $100,

10 TaxUpdate Test II - Substantial Tax Reduction If the investment warrant does not fall into one of the safe harbors and is considered to provide the holder with rights similar to an owner, then it will be treated as an equity interest if there is also a strong likelihood that the failure to treat the holder of the investment warrant as the owner of the underlying security would result in a Substantial Tax Reduction. Whether there is a strong likelihood that the failure to treat an investment warrant holder as an owner would result in a Substantial Tax Reduction is a facts and circumstances test. It takes into account: i. the interaction of the allocations of the issuer and the tax attributes of the owners and the investment warrant holder (including tax consequences that result from such interaction that is unrelated to the issuer) ii. ii. the absolute amount of the federal tax reduction the amount of the reduction relative to the overall federal tax liability, and iv. the timing of items of income and deductions. In general, if it can be determined that all of the owners (or at least owners that hold a large majority of the existing equity interests) are taxed at the highest marginal tax rate at which the investment warrant holder would be taxed, then treating the investment warrant holder as an owner would not result in a Substantial Tax Reduction. However, the determination of whether a Substantial Tax Reduction would result will depend on the specific tax attributes of the owners. For instance, if the existing owners had net operating losses that would offset any partnership income allocable to them and the investment warrant holder did not, then there may be a Substantial Tax Reduction if in the same situation it was expected that the issuing partnership would generate taxable income. Conversely, if the partnership is expected to generate tax losses, then the allocation of those losses to the holder may not result in a Substantial Tax Reduction, as the holder would receive a present tax deduction while the owner would only receive further net operating losses. Therefore, in practice it may be difficult for an investment warrant holder or issuing partnership to have sufficient information regarding the tax attributes specific to each owner to determine whether there is a strong likelihood that the failure to treat the investment warrant holder as an owner would result in a Substantial Tax Reduction. Example 1 Assume that a partnership has three partners, each of which is a taxexempt entity and that none of the income earned by the partnership would be considered to be UBTI (because, for example, it is all interest and dividends). Therefore, none of the income of the partnership is taxable to those partners. The partnership earns a substantial amount of income and has very few losses. Assume that the partnership issues investment warrants to Holder, and the warrants provide for an exercise price of 110 percent of the current fair market value of the underlying partnership interest and a 24-month limitation on the exercise of the warrants. Holder is a taxable U.S. corporation and does not have any tax attributes, such as net operating losses, which would allow it to offset income of the Partnership. The failure to treat Holder as a partner in the partnership likely will result in a Substantial Tax Reduction, as none of the income will be taxable if the Holder is not treated as a partner, while Holder s allocable share of income would be taxable if it were treated as a partner. Therefore, if a principal purpose of the issuance of the investment warrants was to reduce the aggregate tax liability of the three partners and Holder, then notwithstanding the fact that the investment warrants otherwise meet the safe harbor, the warrants may be treated as an equity interest. Example 2 The facts are the same as Example 1, except the partnership earns a substantial amount of losses and has very little income. The failure to treat the Holder as a partner in the partnership likely will not result in a Substantial Tax Reduction, as the losses would not be able to be used by the tax-exempt entities, but allocating the losses to the Holder may reduce the Holder s taxable income. Example 3 The facts are the same as Example 1, except that the investment warrants do not contain the 24-month limitation. As the warrants do not meet the safe harbor and the failure to treat the warrants as equity interests would result in a strong likelihood of a Substantial Tax Reduction, the warrants likely will be treated as an equity interest. 10

11 Example 4 The facts are the same as Example 1, except that (i) the investment warrants do not contain the 24-month limitation and (ii) Holder is a tax-exempt entity that would not be taxable on income attributable to it from the partnership if the warrants were treated as an equity interest. As there is not a strong likelihood of a Substantial Tax Reduction (because Holder is a tax-exempt entity), the investment warrants would likely be respected as investment warrants and would likely not be treated as an equity interest. If the investment warrant holder or owner of the partnership is a pass-through entity, the determination of whether there is a strong likelihood of a Substantial Tax Reduction must take into account the tax attributes of the direct and indirect owners of the pass-through entity. In this case, it may be difficult for either the issuer or the investment warrant holder to determine whether there is a strong likelihood of a Substantial Tax Reduction, as this determination would require tax information from persons who are not a party to the partnership agreement. Example 5 Assume that a partnership has three partners, all of which are themselves partnerships. Each of the three partners has a variety of taxable corporate owners. Holder is a taxable U.S. corporation and does not have any tax attributes, such as net operating losses, which would allow it to offset income of the issuing partnership. Holder is issued investment warrants from the issuing partnership. In order to determine whether the warrants would be able to meet one of the safe harbors or otherwise establish that there is no substantial tax reduction, information would be needed regarding the tax attributes of each of the indirect corporate owners to determine whether there is a strong likelihood of a Substantial Tax Reduction. If, for instance, the indirect corporate owners had substantial net operating losses, which would offset the income attributable to them from the issuing partnership, not treating the investment warrants as an equity interest may result in a Substantial Tax Reduction. If this were the case, the warrants could avoid being treated as an equity interest by meeting one of the safe harbors. Note that the issuing partnership may have difficulty obtaining from its three partnership owners adequate tax information regarding their corporate owners to permit the issuing partnership to make the determination. Measuring Dates The characterization test applies at any of the following times (so-called measurement events): i. issuance of the investment warrant ii. an adjustment of the terms of the investment warrant or of the underlying interest in the partnership (including an adjustment pursuant to the terms of the investment warrant), and iii. transfer of the investment warrant, if either the investment warrant may be exercised (or settled) more than 12 months after issuance, or the transfer is pursuant to a plan in existence at the time of issuance or modification of the investment warrant that has as a principal purpose the substantial reduction of the present value of the aggregate federal tax liabilities of the other owners of the interests in the partnership and the investment warrant holder. Continued Application of General Tax Principles The final regulations clarify that the characterization rules discussed above do not override any general tax principles that would characterize an investment warrant as a partnership interest. Therefore, the IRS may assert that notwithstanding the fact that an investment warrant meets the requirements of the characterization rules to avoid being treated as an equity interest (for instance, treating the holder as a partner would not result in a Substantial Tax Reduction), the investment warrant should nonetheless be treated as an equity interest. Endnotes 1. For the purpose of the regulations, an investment warrant includes any contractual right to acquire an interest in the issuer (or to cash or property having a value equal to the value of such an interest) that is not issued in connection with the performance of services. Warrants, options, convertible debt (debt that is convertible into an interest in the issuer) and convertible equity (an equity interest in an issuer that is convertible into a different equity interest of the issuer) are considered noncompensatory options under this regulation. 2. See Treas. Reg for the rules. 3. See Treas. Reg (b)(4) for the rules determining a partner s interest in a partnership. 11

12 TaxUpdate Pepper Hamilton s Tax Practice Group Federal and International Tax Issues Brian Allen allenbr@pepperlaw.com Joan C. Arnold arnoldj@pepperlaw.com Steven D. Bortnick bortnicks@pepperlaw.com Annika M. Chin china@pepperlaw.com W. Roderick Gagné gagner@pepperlaw.com Howard S. Goldberg goldbergh@pepperlaw.com Kevin M. Johnson johnsonkm@pepperlaw.com Timothy J. Leska leskat@pepperlaw.com Ellen McElroy mcelroye@pepperlaw.com Lisa B. Petkun petkunl@pepperlaw.com Todd B. Reinstein reinsteint@pepperlaw.com Joan M. Roll rollj@pepperlaw.com State and Local Tax Issues Lance S. Jacobs jacobsls@pepperlaw.com Employee Benefits Issues Jonathan A. Clark clarkja@pepperlaw.com David M. Kaplan kapland@pepperlaw.com Sign Up to Receive Your Tax Update Sooner We are encouraging our readers to switch to delivery. delivery means faster delivery of updates to you, reduced printing and postage costs for us, and reduced environmental impact for everyone. Please subscribe online at or send your request, name, company and address to phinfo@pepperlaw.com. Please be assured that we will respect your privacy please see our privacy policy at