Tax Update. 1 Does H.R Signal the End of Ubti Blockers? speakers corner. in this issue. September 2007

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1 September 2007 Does H.R Signal the End of Ubti Blockers? The taxation of private equity funds and their managers has become the object of much publicity and scrutiny in the popular and tax press lately. Information gathered at the September Congressional hearings relating to the taxation of carried interests (the managers interest in profits of a private equity or hedge fund with respect to investors capital), spurred another bill designed to alleviate the risk of generating unrelated business taxable income (UBTI) with respect to partnership borrowings. Overview Tax-exempt organizations, such as charities and pension plans, are subject to income tax on their UBTI. This includes their share of UBTI generated by a partnership in which they invest. UBTI includes income from a business regularly carried on which unrelated to the exempt purpose of the organization. It also includes income and gain from debt financed investments. Case law further provides that if a partnership in which an exempt organization invests incurs indebtedness, the tax-exempt partner can recognize UBTI from debt financed property of the partnership, even if the tax-exempt organization, as a limited partner, never would be liable for the indebtedness. Accordingly, if a tax-exempt organization is a partner in a hedge fund or in this issue 1 Does H.R Signal the End of Ubti Blockers? 2 Speakers Corner speakers corner On October 10, Charles L. Potter, Jr. will speak at Penn State, Beaver Campus on Pennsylvania State and Local Tax Update. Charles L. Potter, Jr. will speak on Pennsylvania State and Local Tax Update at the Allegheny Tax Society on October 15. Pepper lawyers Leonard Schneidman, Julia D. Corelli and Steven D. Bortnick will speak at the Institute for International Research s 6th Annual West Coast Program for Venture Capital and Private Equity Tax Practices at the Crowne Plaza Cabana in Palo Alto, California on October 22-24, Steven D. Bortnick will speak at the Wharton Private Equity Club on Tax Planning for Cross Border Private Equity Transactions at noon on October 30. On November 6, Charles L. Potter, Jr. will speak on Oil and Gas Taxation at Penn State, Beaver Campus. Todd B. Reinstein will be speaking at the PICPA Central Chapter Annual Tax Conference on Basics of Foreign Tax Credits in Altoona, Pennsylvania on November 15. Pepper Hamilton is a sponsor of the Institute for International Research s 2nd Annual Private Equity Fund-of-Funds Summit at the Hyatt Regency in Boston on November 27-28, Julia D. Corelli, Michael B. Staebler and Steven D. Bortnick will be speakers. 3 Had A Section 382 Ownership Change? Maybe the IRS Can Help 6 Private Letter Ruling , A Cautionary Tale

2 private equity fund that borrows to make investments, the organization may recognize UBTI. Investors tolerance for UBTI varies significantly, as do the level of commitments of investment funds to avoid or minimize the recognition of UBTI. Those funds that commit to avoid or minimize UBTI may form blocker entities through which to make leveraged investments or investments in portfolio companies formed as partnerships or limited liability corporations. Generally, these are offshore vehicles formed as corporations (or partnerships which elect to be treated as corporations for US tax purposes). Indebtedness incurred by a corporation would not be treated as indebtedness of the fund or its partners. Alternatively, where the fund is not required to avoid UBTI, tax-exempt limited partners may form their own UBTI offshore blocker corporations. It also is common practice for hedge funds that use leverage to form a company in a tax haven jurisdiction through which taxexempt and foreign investors invest. Proposed Legislative Changes H.R (the Proposed Legislation) was introduced on September 7, 2007 to attempt to alleviate the need to use such offshore blocker corporations. Generally, it provides that acquisition indebtedness does not include indebtedness incurred or continued by a partnership in purchasing or carrying any qualified security or commodity. Property is only considered debt financed if there is acquisition indebtedness with respect to such investment. Accordingly, the intent here is that income or gain with respect to debt-financed qualified securities not be treated as UBTI. For this purpose, a qualified security includes stock in a corporation, partnership or beneficial interests in widely-held or publicly-traded partnerships or trusts, notes, bonds, indentures or other evidences of indebtedness, certain notional principal contracts, evidences of interests in, or derivative financial instruments in, the above securities or any currency, including any option, forward contract, short position and similar financial instruments, and certain identified hedges. A qualified commodity includes any actively traded commodity, notional principal contracts with respect thereto and certain identified hedges thereto. Options and derivative contracts with respect to such securities and commodities also are qualified securities or commodities Even under H.R. 3501, debt financed property of a partnership may give rise to UBTI unless the partnership incurring the indebtedness satisfies certain requirements. The Proposed Legislation makes reference to existing UBTI provisions dealing with indebtedness incurred by a partnership to acquire or improve real property. In order to fall within the exception of the proposed legislation, (i) all allocations to tax-exempt entities must have substantial economic effect, and (ii) either (A) each allocation to a tax-exempt organization must be a qualified allocation or (B) partnership allocations must satisfy the so-called fractions rule. Generally, in order for an allocation to be a qualified allocation, it must be consistent with the tax-exempt organization s being allocated the same share of each item of income, gain, loss, deduction, credit and basis. Additionally, this share must remain the same during the entire period the entity is a partner in the partnership. The fractions rule generally requires that a tax-exempt organization not have a share of overall partnership income for any taxable year greater than the partner s share of the overall partnership loss for the taxable year for which the partner s loss share will be the smallest. A complete discussion of the qualified allocation and fractions rules is beyond the scope of this update. However, it is important to note that there will be technical requirements that must be complied with in order for a fund to avail itself of the proposed UBTI exception. The Proposed Legislation also provides that rules similar to those discussed herein shall apply in the case of tiered partnerships and other pass-through entities. Pepper Perspective The Proposed Legislation, if enacted, would be a welcome change for private equity and hedge funds and their investors. However, it cannot be viewed as a cure-all. Though many investments held by such partnerships could be debt financed without giving rise to UBTI, this exception would not apply to all investments. Additionally, qualification for the exception requires that the partnership s allocations meet certain technical requirements. For some partnerships, this may require amending partnership allocations in order to fit within these requirements. Blockers still will be necessary to avoid UBTI from the investment in operating companies formed as flow-through vehicles, such as partnerships or -2-

3 LLCs. Finally, it should be noted that the exception only applies to indebtedness incurred by a partnership that has tax-exempt investors. Indebtedness incurred directly by tax-exempt investors in order to make investments still may give rise to UBTI. Author: Taxpayers are required to use the longterm tax-exempt rate for the month in which the ownership change occurs when calculating their Section 382 limitation for any ownership change. Steven D. Bortnick / bortnicks@pepperlaw.com Had A Section 382 Ownership Change? Maybe the IRS Can Help As many of you know, Section 382 of the Internal Revenue Code (the Code) will generally require a corporation to limit the amount of its income in future years that can be offset by historic losses (NOL carryforwards) once that corporation has undergone an ownership change. While the general mechanics of whether or not an ownership change has occurred is beyond the scope of this article, we do address some important considerations for a corporation to consider when determining the impact of an ownership change, and highlight some potential opportunities to obtain a better, if not great, result under these rules. Calculating the Section 382 Limitation Once a corporation has determined that an ownership change occurred, the corporation is required to calculate the Section 382 limitation resulting from that ownership change. Each time a corporation undergoes an ownership change, a separate Section 382 limitation is calculated. Thus, it is very common for a corporation to have more than one ownership change, each generating its own separate Section 382 limitation. It is critical to know each Section 382 limitation because the rules addressing successive ownership changes require that the lowest limitation on NOL carryforwards that exists on the date of an ownership change will be applied, even if another ownership change results in a higher Section 382 limitation. The Section 382 limitation is a formulaic calculation that is basically equal to the product of the value of the loss corporation and the long-term tax-exempt rate. The long-term tax-exempt rate is published on a monthly basis by the Internal Revenue Service in Revenue Rulings and can be found in IRS publications, including the Internal Revenue Bulletin. Taxpayers are required to use the long-term tax-exempt rate for the month in which the ownership change occurs when calculating their Section 382 limitation for any ownership change. Value of the Loss Corporation The determination of the value of the loss corporation is not as straight forward as it might first appear. Many people assume that the value of the corporation on the change date is the value used for purposes of calculating a Section 382 limitation. But as discussed below, this value is rarely the value used in determining the Section 382 limitation. Differences between the value of the corporation on the change date and the value of the loss corporation used for purposes of calculating a Section 382 limitation can arise because there is a presumption in the Code that any capital contributions made within two years of the change date were made for the purpose of increasing the Section 382 limitation upon an ownership change. For example, assume the loss corporation is a company that has two classes of stock outstanding; common stock --

4 that is publicly traded on a stock exchange, and preferred stock that is not publicly traded. Further, assume that one year before an ownership change, the company engaged in a tax free merger and issued its common stock to the target shareholders as consideration in the merger. In this situation, both the common stock and the preferred stock would be counted in determining the value of the corporation. However, this value must be reduced by the value attributable to any capital contributions made within two years of the change date. Because the merger was an acquisition that resulted in an increase in value of the loss corporation during the two year period proceeding the ownership change date, the value of the target company must be subtracted from the value of the outstanding stock to arrive at the value of the loss corporation for purposes of calculating the Section 382 limitation on the change date. This rule is generally referred to as the anti-stuffing rule and is found in Section 382(l)(1). It also is important to note that any cash or other assets coming into the loss corporation on the date of the change are not included in the value of the loss corporation for purposes of calculating the Section 382 limitation. 1 Relief from the Anti-Stuffing Rule Luckily, the Legislative History to Section 382 provides some limited relief from this rule for capital contributions that are made to continue basic operations of the corporation, like paying salaries of employees, lease of equipment or office facilities, etc. 2 But the relief does not apply to amounts used to make investments or increases in value due to acquisitions. While no Treasury Regulations have been issued expanding on relief from Section 382(l)(1), the IRS has expanded (and in some cases, limited) the exceptions found in the Legislative History through private letter rulings and technical advice memoranda issued by the IRS to include, for example, infusions of cash to fund minimum capital requirements of banks, payments of salary and routine operating expenses, and most recently, to maintain minimum capital requirements for rating agencies and state regulators of an insurance company. 3 Other Rules Addressing Value We also note that there are several other provisions in Section 382 that address what to exclude from value in determining the value of the loss corporation, including cash not used in the business, investment assets, corporate contraction events, and others. None of these provisions -have Treasury Regulations that address their application; however, as in the case of the anti-stuffing rule, the IRS has issued private letter rulings over the years applying these provisions to individual taxpayer situations. Practicalities of Calculating Value in a FIN 48 World This brings us to the it s not all bad part of this discussion. As discussed above, the IRS has been willing to assist taxpayers in resolving these issues so taxpayers can obtain certainty with respect to their Section 382 limitation. Indeed, the recent implementation of FIN 48 addressing uncertain tax positions for financial statement reporting purposes has brought the valuation issue to the forefront for companies that are required to provide substantiation for their tax positions. As a result of the increased scrutiny and documentation requirements of FIN 48, external financial auditors are taking a very hard view of a taxpayer s ability use the exceptions to the anti-stuffing rule from the Legislative History, and some have taken the position, that absent an IRS ruling on the issue, the taxpayer cannot include in its value any capital contributions made within the two year period prior to the ownership change. They believe that, because no Treasury Regulations have been issued under these rules, and the Code creates a presumption except as provided in regulations, the capital contribution will be viewed as made for the purpose of increasing the Section 382 limitation. The other major instance where taxpayers are at risk of a strict interpretation of the anti-stuffing rule is in a due diligence situation where the buyer is challenging the Section 382 limitations resulting from earlier ownership changes. In particular, where many successive rounds of funding occurred to get a new company up and running, it is possible for the Section 382 limitation for an earlier ownership change to be zero when all the funding occurred during a short time period prior to the ownership change. As a result, none of the income of the corporation (or its successor) can be offset by the pool of NOL carryforwards that are subject to such Zero limitation, and such NOL carryforwards will most likely expire unused. The possibility of a Zero limitation has given potential acquiring companies and the external auditor of a public company the impetus to require a loss corporation to prove the continued availability of its NOL carryforwards, even if the NOL carryforwards are not currently being used to offset income. Thus, for financial statement purposes, such NOL carryforwards may cease to be reflected on the company s balance sheet.

5 Other Avenues for Increasing the Section 382 Limitation Once the value of the loss corporation is determined under the parameters described above, opportunities still exist for a loss corporation to increase its Section 382 limitation in years following the ownership change. One such opportunity is for a loss corporation that is in a net unrealized built-in gain position on the change date 4 to sell an asset that was considered a built-in gain asset on the ownership change date within the five year period following the change date. In that situation, the Section 382 limitation can be increased by the amount of the recognized built-in gain and thus, more income can be offset against NOL carryforwards subject to the Section 382 limitation. In addition, the IRS permits certain increases in the Section 382 limitation for corporations under the rules set forth in Notice , C.B These rules provide limited relief during the five year period following the change date. A more detailed discussion of when taxpayers might want to consider applying Notice can be found in our April 2006 Tax Update, which can be found on Pepper Hamilton s Web site at Endnotes 1 This rule is not under the anti-stuffing rule, but is a function of when you determine the value of the loss corporation, which is generally the value immediately preceding the event that caused the ownership change. Section 382(e). 2 See, H.R. Rep. No. 841, 99 th Cong. 2d Session 189 (1986) and see also, Joint Committee on Taxation, 99 th Cong., General Explanation of the Tax Reform Act of (1987). 3 See PLR (April 27, 2007), PLR (May 29, 1998), PLR (July 10, 1995), PLR (November 30, 1994), and TAM (April 30, 1993). 4 Section 382(h) has very specific and complex rules that dictate whether or not a loss corporation is in a net unrealized built-in gain or net unrealized built-in loss position on a change date. A discussion of these rules is beyond the scope of this article. Pepper Perspective Thus, the good news is that taxpayers can go to the IRS to resolve questions on what can and cannot be included in the value of the loss corporation on the change date, even if their auditor or merger partner is not willing to apply the logic of the Legislative History in finding exceptions to the anti-stuffing rule. It does take a few weeks (or perhaps months) to obtain such a ruling, assuming the IRS agrees with your interpretation of the issue. However, if a company believes they are within the exceptions of the Legislative History, it may be worth the effort to approach the IRS with such a request if the alternative is to accept a Zero limitation on the loss corporation s NOL carryforwards, either for financial statement purposes or in a deal context. Author: Annette M. Ahlers ahlersa@pepperlaw.com RSS on Subscribe to the latest Pepper articles via RSS feeds. Visit today and click on the RSS button to subscribe to our latest articles in your news reader. --

6 Private Letter Ruling , A Cautionary Tale On June 13, 2007, the IRS denied two taxpayers requests for an extension of time under of the Procedure and Administrative Regulations (Section 9100 relief) to comply with the documentation requirement for success-based fees under Treas. Reg (a)-5(f). Section 9100 relief grants taxpayers additional time to file required information when a deadline has been missed. Here, the taxpayers were subject to the documentation requirement of the Section 263(a) regulations under which any success-based fee paid in a corporate transaction is presumed non-deductible unless a taxpayer secures records supporting the deduction prior to the due date of the company s federal income tax return for the year during which the transaction closes. These taxpayers failed to collect the required documents prior to the filing deadline and sought additional time to gather the required records so that significant deductions would not be lost. The Service refused the taxpayers requests and made clear that such relief would be unlikely granted to any other similarly-situated taxpayers. As a result, this ruling is a cautionary tale to any company going through a corporate transaction, timeliness is critical when a transaction cost deduction is at stake. Both taxpayers were involved in capital transactions subject to Section 263(a). The transactions were complicated, involved multiple entities, with several acquisitions and mergers. In these transactions, the taxpayers engaged investment banking firms and incurred fees for investment banking services, which were success-based. As in most corporate transactions, investment bankers receive multimillion dollar fees that are contingent on the transaction closing. As noted, the Section 263(a) regulations presume that success-based fees are non-deductible, capital expenditures. 1 The regulations provide a significant exception for amounts for which a taxpayer maintains sufficient documentation to rebut this presumption. To take advantage of this exception, the documentation supporting the deduction must be completed prior to the due date of the company s federal income tax return (including extensions) for the year during which the transaction closes. 2 In these cases, each taxpayer relied on an accounting firm to advise them about the treatment of costs and to gather the required documentation supporting that a portion of the success-based fee was allocable to deductible activities in accordance with Reg (a)-5(f). Because a portion of each success-based fee was attributable to deductible services, under the Section 263(a) regulations, each taxpayer should have been otherwise eligible for a deduction. Unfortunately, however, the accounting firm miscalculated the original due dates for the taxpayers tax returns and failed to advise the taxpayers to file for an extension of time to file their returns. As a result, the accounting firm failed to complete the documentation requirement for the success-based fees incurred with regard to the transactions before the due dates of taxpayers timely filed original tax returns (including extensions). Because the taxpayers were not timely in securing the required documentation, they sought 9100 relief from the IRS based on the accounting firm s error. Section 9100 relief is generally available for any application for relief in respect of tax; a request to adopt, change or retain an accounting method or accounting period. Under these relief provisions, the Commissioner has discretion to grant a taxpayer a reasonable extension of time to make a regulatory election to make the requisite accounting method or period filing. So, did the IRS have any sympathy for the taxpayers? Did the IRS exercise its discretion and offer Section 9100 relief? Unfortunately, no. According to the Private Letter Ruling, the IRS does not believe that the timely documentation requirement for success-based fees in 1.263(a)-5(f) constitutes an election to which the provisions of apply. 3 In other words, there is no relief for failure to timely document success-based fees, no matter what the circumstances. More importantly, although Section 9100 relief is discretionary, the ruling seems to suggest that Section 9100 relief would not be available to any taxpayer in similar circumstances. Pepper Perspective The IRS gave several reasons for denying relief. First, they found that these filings did not require a separate notice or formal filing with IRS for which Section 9100 relief might be available, e.g., filing a document with a tax return as with a start-up election as required in Treas. Reg

7 1(b). The IRS noted that the timely documentation requirement of 1.263(a)-5(f) does not require any filing with the Service; instead, a taxpayer must complete the appropriate documentation by the due date of the return to establish that certain amounts are exempt from capitalization. Second, the IRS found that the explicit language of Treas. Reg (a)-5(f) indicates that it was not intended to be treated as an election covered by The Section 263(a) regulations require that taxpayers complete detailed documentation in close proximity to the taxable year in which the acquisition transaction closes. According to the ruling, allowing relief would undermine the regulations emphasis on maintaining contemporaneous and accurate records that clearly demonstrate that a portion of the success-based fee is allocable to activities that do not facilitate the acquisition. 4 Third, the IRS concluded that the documentation requirement for success-based fees in Treas. Reg (a)- 5(f) is not (i) a request to adopt an accounting method; (ii) a request to change an accounting method; or (iii) a request to retain an accounting method. As the ruling explains, the method of accounting is the timing principle: success-based fees are capitalized, except to the extent they are timely documented as non-facilitative. The existence (or absence) of timely prepared documentation is an objective and verifiable fact external to the accounting method that determines the application of the accounting method. The method of deducting non-facilitative successbased fees does not apply to fees that are not timely documented any more than it applies to fees that are not in fact success-based or facilitative. 5 Interestingly, the ruling seems to indicate that the method is established not through the taxpayer s treatment of an item on a return but by gathering documentation. 6 This seems to be a unique definition of the establishment of a method of accounting. What is more disappointing is that even though the IRS has defined a broad policy of methods of accounting in this area, 7 this final conclusion suggests that the failure to gather timely documentation eliminates deductions entirely. That is, if these deductions are not taken on an initial return, such mistakes cannot be remedied with an accounting method change. For companies with what may be once-in-a lifetime corporate transaction costs, this result can be extremely detrimental. Under Treas. Reg (a)-5, it is not uncommon for success-based fees to constitute a significant portion of transaction fees. Often, investment bankers spend a considerable amount of time rendering due diligence services that the regulations deem not to facilitate the transaction and allow taxpayers to currently deduct the expenses. In addition, in certain transactions, such as stock transactions, capitalized acquisition costs are not recoverable until the business ceases, which may not occur for decades. This Private Letter Rule serves as an important reminder of two important considerations. First, double check all filing deadlines. It would be incredibly disappointing to miss major deductions because of a foot fault. Second, and more importantly, timely documentation of success-based fees are critical to maximize deduction of corporate transaction costs. Authors: Ellen McElroy* mcelroye@pepperlaw.com Christian T. Wood woodc@pepperlaw.com * Admitted in Colorado only; supervision by principals of Pepper Hamilton llp who are members of the DC Bar. Endnotes 1 See Treas. Reg (a)-5(f), which provides that an amount paid a capital transaction described in Treas. Reg (a)-5(a), which is contingent on the successful closing of the transaction, is presumed facilitative of the transaction and may not be deducted. 2 Treas. Reg (a)-5(f) provides that the rebuttable presumption may be overcome if documentation supporting the deduction is completed prior to the due date of the company s federal income tax return (including extensions) for the year during which the transaction closes. 3 Priv. Ltr. Rul Id. 5 Id. 6 Rev. Rul , CB57. 7 Treas. Reg (a)-5(n). -7-

8 Pepper Hamilton llp Tax Practice Group Federal and International Tax Issues Annette M. Ahlers Joan C. Arnold James W. Barson Steven D. Bortnick Gordon R. Downing W. Roderick Gagné Howard S. Goldberg Benjamin M. Hussa Bryan D. Keith* Ellen McElroy** Marc D. Nickel Lisa B. Petkun Todd B. Reinstein Joan M. Roll Leonard Schneidman James H. Stevralia Laura D. Warren Christian T. Wood R. D. David Young State and Local Tax Issues Philip E. Cook, Jr Lance S. Jacobs Charles L. Potter, Jr Employee Benefits Issues Jonathan A. Clark David M. Kaplan Andrew J. Rudolph Eric R. Stern *Project manager, not admitted to practice **Admitted in Colorado only; supervision by principals of Pepper Hamilton llp who are members of the DC Bar. For more information about any of our tax professionals listed, please visit our Web site, The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. Berwyn Boston Detroit Harrisburg New York Orange County Philadelphia Pittsburgh Princeton Washington, D.C. Wilmington 2007 Pepper Hamilton llp. All Rights Reserved. This publication may contain attorney advertising. -8-