FINANCIAL RESEARCH ASSOCIATES PRIVATE INVESTMENT FUND TAX MASTER CLASS

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1 FINANCIAL RESEARCH ASSOCIATES PRIVATE INVESTMENT FUND TAX MASTER CLASS EFFECTIVELY MANAGING TAX IMPLICATIONS OF FOREIGN INVESTMENTS Steven D. Bortnick May 24, 2017 Princeton Club, New York City # v2

2 AGENDA Outbound transfers of Goodwill Passive Foreign Investment Companies Withholding and Foreign Tax Credit Transfers to Partnerships with Related Foreign Partners 2

3 Outbound Transfers of Goodwill 3

4 Typical Tax-Free Transfers US US 100% Tax free 351 transfer (transfer to controlled corporation) US Assets Foreign Assets Foreign Country Outbound US person transfer to foreign corporation Foreign Assets US gives up primary taxing jurisdiction US Assets 4

5 Transfers to Active Foreign Business 367(a) Generally Foreign corporation not treated as corporation for purposes of determining gain recognition (turns off tax-free liquidation, 351 and reorg rules). Trade or Business Exception: Property transferred to foreign corporation for use by such corporation in active conduct of trade or business outside U.S. Exceptions: Inventory Installation obligations, A/R Foreign currency or property denominated in foreign currency Property leased by transferor to party other than transferee Intangibles described in 936(h)(3)(B) 5

6 936(h)(3)(B) Intangibles Patent, invention, formula, process, design, pattern, know how Copyright, literary, musical or artistic composition Trademark, tradename, brand name Structure, license, contract Method, system, program, procedure, campaign, survey, study, forcast, estimate, customer list, technical data Similar (if substantial value independent of services of any individual) 6

7 Special Rules for Intangibles 367(d) Super Royalty Outbound transfer normal gain recognition rule does not apply Otherwise tax-free transfer treated as sale for payments contingent on productivity, use or disposition Treated as receiving amounts annually over useful life of property Amounts must be commensurate with income attributable to intangible Source as royalty for FTC purposes (old rule source always US) 7

8 Goodwill and Going Concern Valve Not covered by 367(d) Not specifically listed in 367(a) exceptions Prior to September 14, 2015, not covered by 367(a) or (d) 8

9 Retroactive Effective Date Transfers on or after September 14, 2015 Transfers resulting from CTB election if filed on or after September 14,

10 Change in Treatment Goodwill and going concern valve no longer eligible property qualifying for active trade on business exception Generally immediate given recognition May elect to apply 367(d) 10

11 Why the Change? Section 197 permits 15 year amortization of purchased goodwill Section 367(d) income sourced as royalty permits FTC CTB rules and Subpart F look through rules allow CFC to deploy cash to affiliates without U.S. income recognition Increase in market value attributable to intangibles % of S&P % of S&P

12 Private Investment Funds Example US Funds US Securities US LLC US Branch Foreign Funds UK Subsidiary Transfers of US branch to UK subsidiary raises 367 conscious Treatment of contract termination and new contract in US Potential for inversion concerns Other foreign subsidiaries 12

13 Withholding and Foreign Tax Credit Planning 13

14 Withholding Tax Gross basis tax on interest, dividends, royalties and (in certain countries) capital gains on income from sources within country Collected at source via withholding Treaties may reduce rate or eliminate Within Europe, a directive eliminates withholding tax 14

15 The Issue Carry Partner Tax-Exempts Dividends Treaty Resident PE Fund Country Y Portfolio Co. sale-capital gain Non-Treaty Resident PE Fund is a partnership cannot rely on treaty To claim treaty benefits with country Y, must provide proof of residence in treaty country for all investors Some investors not residents in treaty countries Treaty may reduce or eliminate tax. If reduced, tax-exempts are subject to tax 15

16 Third Country SPV PE Fund Lux European Portfolio Company PE Fund Mauritius Indian Portfolio Company No need to establish residence of each investor Covers all investors even if from non-treaty jurisdictions Ability to pick country with favorable tax treaty and favorable internal tax laws Typically need substance in treaty jurisdiction 16

17 Limitation on Benefits US - Detailed objective tests - Ownership and anti-base erosion - Trade on business in jurisdiction Other countries - Substance General Anti-Avoidance Rule (GAAR) OECS Multilateral Instrument - Suggests principal purpose test or LOB - Both countries to treaty must sign on - Unclear what happens if one county picks principal purpose test and one picks LOB - Doesn t impact EU directive 17

18 PFICs 18

19 What is a PFIC? A foreign corporation where, in any taxable year: 75% or more of the gross income of such corporation is passive income, or 50% of more of the gross assets of such corporation are passive assets, meaning assets that produce, or are held for the production of, passive income. For gross basis for asset test, see Notice 88-22, C.B. 489 ( Notice ). As discussed below in detail, always consider the various lookthough rules in making this determination. 19

20 PFIC / CFC Overlap IRC 1297(d) If a foreign corporation is both a PFIC and CFC, 10% U.S. shareholders are taxed under CFC rules, not the PFIC rules. The PFIC rules can still apply to U.S. persons that hold less than 10% of the foreign corporation. 20

21 Income Test What is Passive Income Defined by reference to FPHCI. IRC 954(c). Generally includes: (A) dividends, interest, royalties, rents, and annuities, other than certain active rents and royalties derived from unrelated persons; and (B) gain from the sale of property the give rise to income described in (A). Active banking exception. Lack of clarity with regard to active financing exception in 954(h) (which references 954(c)(1)). 21

22 Asset Test Based upon the average gross assets (value or basis) at the end of each quarter of the corporation's taxable year. Assets valued based either on its FMV (required for public companies) or its adjusted basis (by election for non-public companies, except CFCs). Assets are passive if they have generated, or are reasonably expected to generate in the reasonably foreseeable future, passive income. Depreciable property used in an active business typically active. Intangible assets classified either (i) based upon the nature of the income they produce (e.g., a patent or license) or (ii) in the case of goodwill the nature of the income producing activity it is associated with. Cash, even working capital, is always passive. Subject to the related-party look through rules discussed below, stock and debt are typically passive assets as they produce passive income. No guidance for short years. 22

23 25% Subsidiary Look-Through Rule If a foreign corporation owns (directly or indirectly) 25% (by value) or more of a subsidiary corporation it is treated as owning/receiving its proportionate share of such subsidiary s income/assets. IRC 1297(c). The stock of a look-through subsidiary is ignored for the asset test. There is a lack of clarity applying the rule in a chain of ownership (top-down or bottom-up), though the language of the Code seems to suggest top-down as does Notice Application to partnership interests unclear. 23

24 Related Party Look-Through Rules Interest, dividends, rents, or royalties received or accrued from a related person are not passive income if allocable to active income of such related person. IRC 1297(b)(2)(C). Relatedness tested by control test of IRC 954(d)(3), for example: Two corps are related if same the same person or persons, directly or indirectly, own stock with (a) more than 50% of the total voting power of all classes of stock entitled to vote or (b) more than 50% of the total value of stock of such corporation. Constructive ownership rules apply The asset test treatment of the stock or debt that gives rise to relatedparty interest or dividends follows the treatment of such income. 24

25 Annual Determination of PFIC Status PFIC status must be determined each year. A foreign corporation may be a PFIC one year despite not previously being a PFIC. Once treated as PFIC in one taxable year, interests (whether held directly or indirectly) of the corporation will be treated as interests in a PFIC indefinitely, absent a purging election. IRC 1298(b)(1). i.e., once a PFIC, always a PFIC. 25

26 Who Owns Interests in a PFIC? Attribution rules apply to treat U.S. persons that do not directly own stock of a PFIC as owning stock of such PFIC. E.g., a person that: owns interests in a foreign partnership is considered to own proportionately any stock owned by the partnership. directly or indirectly owns 50% or more in value of the stock of a non-pfic foreign corp is considered to own a proportionate amount (by value) of any stock owned directly or indirectly by the corp. directly or indirectly owns any stock of a PFIC is considered to own a proportionate amount (by value) of any stock owned directly or indirectly by the PFIC. The attribution rules are applied successively in a chain of ownership. A U.S. person treated as indirectly owning a PFIC under the attribution rules is generally treated as a shareholder of the PFIC for all purposes of the PFIC rules. 26

27 Partial Exit PE Bidco 20% Portfolio Company Public 80% Bidco initially held 100% portfolio company 25% look through rule Bidco was not PFIC In IPO, public acquired 80% of portfolio company Now 100% Bidco assets considered passive Bidco PFIC 27

28 Overfunding PE $100M cash Bidco $10M Co-investor $10M PE funds Bidco with $100M for future investment in JV Cash is a passive asset Majority of Bidco s assets considered passive Bidco is PFIC JV 28

29 Debt Funded Minority Investment PE Bidco is corp. to avoid UBTI Bidco Loan Bank Bidco owns less than 25% of Target so 100% assets produce passive income Bidco is PFIC 20% Target 29

30 Tax Consequences of PFIC Status Subject the ability of stockholders of PFICs to make certain elections triggering the current realization of income (QEF & MTM), U.S. persons treated as owning stock of PFIC are not subject to tax until: Their interest in the PFIC is (directly or indirectly) disposed of, or They receive (directly or indirectly) a distribution from the PFIC. 30

31 PFIC Distributions Excess Distributions If a distribution from a PFIC is characterized as an excess distribution it will be subject to current tax. IRC Generally taxable at ordinary income rates. Need not be supported by current or accumulated E&P. Portion of a distribution that is the excess distribution is excess of total distributions for the current year over 125% of the average distributions for the last three years. The other portion is taxed under ordinary foreign corp. rules. Applies to liquidating distributions as well. PFICs do not pay qualified dividends (even on non-excess distributions) 31

32 Taxation of Excess Distributions IRC 1291 The excess distribution is allocated ratably to each day of the U.S. person s (entire) holding period of the PFIC stock. Portion allocated to (1) current year and (2) pre-pfic years = taxable as current year ordinary income (rates currently 39.6% for individuals, 35% for corps). 3.8% Medicare tax follows general rule (IRC 301) not 1291 Portion allocated to prior years during which the entity was a PFIC are taxed at the highest rate applicable to that year is subject to an interest charge. 32

33 Taxation of Dispositions of PFIC Stock Capital gain treatment is not available. Instead, the gain from the disposition is treated as an excess distribution and is subject to the rules discussed previously. 33

34 Reporting Form 8621 HIRE Act (2010) added new PFIC annual reporting rules. Requires annual filing of Form 8621, which supplies information about the PFIC investment, including: Share information (class, acq. date, number, etc.), Value of the investment, and Type of PFIC (i.e., are QEF or MTM elections made). Also includes information about annual QEF & MTM inclusions as well as elections to defer current QEF inclusions and excess distribution inclusions from the disposition of PFIC stock and distributions from PFICs. 34

35 The QEF Election a Summary The qualified electing fund ( QEF ) election turns a PFIC into a modified flow-through entity for the shareholder. Advantages*: Disadvantages: Avoids interest charge and excess distribution rules Allows recognition of capital gain on sale of PFIC stock Flows through capital gain recognized by the PFIC Current taxation on income, whether or not distributed Corporation and shareholder must comply with information reporting for flow-through (i.e., QEF information statement) *These advantages assume QEF election is made timely with respect to first date of ownership of the PFIC stock. 35

36 Electing Shareholders QEF Election is made by any US Person that is a PFIC shareholder. This includes: US taxpayers that own PFIC stock directly US taxpayers that own PFIC stock indirectly through foreign entities, such as foreign partnerships, foreign trusts /estates, or foreign corporations US flow-through entities, such as US partnerships and nongrantor trusts, are themselves considered to be PFIC shareholders for purposes of making the QEF election. 36

37 Transfers to Partnerships with Related Foreign Partners 721(c) 37

38 721(c) Property Defined Property with built-in gain contributed by US transferor Focus on partnership s basis in property not partners change from IRS notice Exceptions Cash equivalents Security (475(c)(2)) Tangible property if built-in gain is more than $20,000 or built-in loss Interest in partnership that holds property of which 90% or more of value consists of above 38

39 Transfer to Partnership Current Law A B A B $100 basis $100 FMV $30 basis $100 FMV AB, LP $100 cash Asset 1 $100 basis $100 FMV $30 basis $100 FMV Cash Asset 1 No gain/loss to A, B or AB, LP A&B take basis in AB, LP equal to basis in property transferred AB, LP takes basis in property equal to A and B s basis in property First $70 of tax gain on sale of Asset 1 allocated to B 39

40 Transfer to Partnership IRS Concern with Current Law A $100 cash AB, LP Asset 1 FMV declined to $90 and is sold for $90 cash. B $90 cash sale $100 basis $90 FMV Asset 1 Book purposes - $10 loss allocated $5 to A and $5 to B Tax purposes - $60 gain all allocated to B A cannot claim loss until A sells interest in AB, LP or AB, LP liquidates. If foreign, doesn t care. If liquidate B would get $95. B s basis is $90 ($30 basis plus $60 tax gain allocated to B) B effectively defers $5 gain until liquidation 40

41 Limitations on Allocations of Pre-Transfer Tax Gain Ceiling rule Total depreciation, depletion, gain or loss that can be allocated to partners is limited to the actual amounts realized for tax purposes by the partnership 41

42 Regulatory Fix Immediate Gain Recognition General non-recognition rule on transfer of property to partnership does not apply if: - Transferee partnership (domestic or foreign) Receives 721(c) property as contribution A related foreign person is direct or indirect partner US transferor and related persons own 80% or more of partnership profits, capital, deductions, or losses Such a partnership referred to as a 721(c) partnership 42

43 Primary Exception Adoption of Gain Deferral Method Adopt remedial method for 721(c) property and apply consistent allocation method - Remedial method creates tax items to help eliminate the book tax difference OR All income and gain with respect to 721(c) property for all direct and indirect partners that are related foreign persons with respect to US transferor subject to tax as ECI with no claim of treaty benefits - From time of contribution until no remaining BIG Accelerate gain upon certain triggering events 43

44 Consistent Allocation Method Must allocate same percentage of each book item of income, gain, deduction and loss with respect to 721(c) property to transferor partner 44

45 Exceptions De Minimis Exception All 721(c) property contributed to a 721(c) partnership during the taxable year does not exceed $1m Transfer resulting from a technical termination Mere change in identify, form or place of organization of a partnership or a recapitalization of a partnership 45

46 Steven D. Bortnick Partner, Tax Steven D. Bortnick is a partner in the Tax Practice Group of Pepper Hamilton LLP, resident in the Princeton and New York offices. Mr. Bortnick focuses his practice on domestic and international tax and private equity matters. Mr. Bortnick handles a broad range of transactions, including asset, stock, cross-border and domestic acquisitions, recapitalizations and reorganizations. He is experienced in, and a significant portion of his practice is devoted to, the structuring of domestic and international private equity transactions. He advises business organizations on a variety of tax issues, and he is involved in the formation of private equity and hedge funds. An active speaker and author, Mr. Bortnick has written materials and spoken for several major private equity tax conferences. Topics of his presentations include private equity, venture capital, crossborder investing, venture capital operating company issues, and merger and acquisition tax issues. Before joining Pepper in 2007, he practiced in the New York office of Dechert LLP. 46

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48 Steven D. Bortnick, Partner 48