NEW September 2016 Edition of Mergers, Acquisitions, and Buyouts by Martin D. Ginsburg, Jack S. Levin, and Donald E. Rocap

Transcription

1 NEW September 2016 Editio of Mergers, Acquisitios, ad Buyouts by Marti D. Gisburg, Jack S. Levi, ad Doald E. Rocap We are proud to eclose the September 2016 editio of Gisburg Levi ad Rocap Mergers, Acquisitios, ad Buyouts. Here is a summary of major developmets reflected i the ew editio, writte by co-authors Jack S. Levi ad Doald E. Rocap, seior parters i the iteratioal law firm of Kirklad & Ellis LLP. Highlights of the New Editio l Charitable doatio of T stock immediately before P s taxable acquisitio of T. If A, a T shareholder (either miority or eve majority cotrollig shareholder), cotributes T stock to charity at approximately the same time as P is acquirig T i a taxable trasactio, (1) is A etitled to a charitable deductio for the FV of the doated T stock without also recogizig the gai iheret i her T stock or (2) is A taxed o her iheret gai i the T stock ad treated as cotributig to charity the proceeds from the stock sale to P? Uder log-stadig precedet, icludig a reveue rulig, A is ot taxed o her iheret gai i the T stock, uless at the time the stock is doated to charity A (the door) is uder, ad thus the doee charity takes the T stock subject to, a bidig legal obligatio (the P-T acquisitio agreemet) to sell, redeem, or otherwise dispose of the T stock. However, if at doatio time A s stock is already subject to such a bidig legal obligatio, A is taxed o the iheret gai i the stock (eve if P has the right to call off the acquisitio should T suffer a material adverse chage before cosummatio). Thus, if at the time of the doatio A has ot yet etered ito a bidig legal obligatio, the tax law does ot recharacterize the trasactio merely because A Copyright 2016 CCH Icorporated. All Rights Reserved. 1 MORE

2 iteds (ad expects) the doee charity to, ad i fact the doee charity does, promptly avail itself of the opportuity to covert the doated stock to cash. The same priciple applies (i.e., A is ot taxed o the appreciatio i her T stock) if the taxable sale of T to P is ot structured as a simple sale of T s stock to P (as discussed above) but utilizes aother trasactioal format: T is beig sold to P via a taxable cash merger betwee P ad T (forward or reverse), ad A s charitable cotributio of T stock occurs before T s shareholders have voted o the T-P merger, T is beig sold to P via a cash teder offer (i.e., P is makig a teder offer for T s stock to be followed by a squeeze-out cash merger of P ad T [forward or reverse]), ad A s charitable cotributio of T stock occurs before a majority of T s shares have bee tedered ito P s teder offer, or T is sellig its assets to P ad distributig the proceeds to its shareholders i a taxable liquidatio ad A s charitable cotributio of T stock occurs before a majority of T s shareholders have ratified the liquidatio pla. See discussio at l Tax-free spi-offs. Uwid of high-vote/low-vote structure. Code 355 dealig with tax-free spi-offs (or split-ups) requires that a distributig corporatio ( D ) ow ad distribute a amout of stock of its cotrolled subsidiary ( C ) represetig C s cotrol, which is defied to mea (a) stock represetig 80% or more of the votig power of all C s outstadig stock ad (b) 80% or more of each class of C s o-votig stock. Where D ows (a) less tha 80% of C s total votig power or (b) less tha 80% of a class of C o-votig stock, IRS ruligs have log permitted D to gai cotrol of C before the spi-off by (a) recapitalizig a class of C votig stock ito a higher votig class so that D i the aggregate holds more tha 80% of C s votig power ad/or (b) recapitalizig a class of C o-votig stock i which D holds less tha 80% ito a class that holds a low amout of votig power. IRS issued several private letter ruligs permittig C, followig the spi-off, to uwid the high-vote/low-vote structure that had bee created to meet the cotrol defiitio as described above. However, i 2013, IRS aouced that it would o loger issue letter ruligs o such high vote/low vote structures while it studied issues associated with such ruligs. I 7/16 IRS published a reveue procedure reportig o the results of that study ad providig a safe harbor with respect to the potetial uwid of these 2

3 structures. Specifically, the reveue procedure applies to a series of trasactios i which: (1) D ows a amout of C stock ot satisfyig the cotrol requiremet, (2) C recapitalizes its shares, as a result of which D acquires cotrol of C through the creatio of high-vote ad low-vote classes of stock (the Recapitalizatio ), (3) D distributes C stock i a proposed Code 355 distributio, ad (4) thereafter C desires to effectively uwid the dual class structure created i the Recapitalizatio. I these cases, IRS will ot assert that the Recapitalizatio lacks substace such that D failed to satisfy the cotrol test so log as either: 5 o actio is take by C (or its directors, officers, or cotrollig shareholders) to uwid the Recapitalizatio at ay time prior to 24 moths after the distributio or 5 the Recapitalizatio uwid occurs pursuat to a trasactio with a third party ad there was o agreemet, uderstadig, arragemet, or substatial egotiatios or discussios regardig the third-party trasactio or a similar trasactio durig the 24 moths edig o the distributio date. This guidace provides welcome certaity to D cosiderig a dual class Code 355 distributio of C with respect to future ability to ratioalize C s capital structure if warrated by market ad busiess cosideratios. The 7/16 Rev. Proc., by its terms, does ot appear to apply where D ows historic cotrol of C ad recapitalizes C s shares ito a high-vote/low-vote structure i order to (i) retai more tha 20% (by value) of C s stock for dispositio subsequet to a Code 355 distributio or (ii) issue more tha 20% (by value) of C s stock i a IPO prior to a Code 355 distributio while maitaiig such cotrol. IRS officials have, however, stated i public forums that the 7/16 Rev. Proc. does exted to such situatios. The authors hope IRS will supplemet the Rev. Proc. to cofirm this poit ad, i doig so, cosider allowig a less-tha-2-year uwid period where D s cotrol of C is historic. See discussio at Active trade or busiess test. A 2/15 reveue procedure expressed cocer regardig spi-offs with small active trades or busiesses, statig that they may preset evidece of device, lack a adequate busiess purpose, or violate other Code 355 requiremets ad/or circumvet the repeal of the Geeral Utilities doctrie. 3 MORE

4 While it studied these issues, IRS aouced that it would ot ormally issue private letter ruligs where the active trade or busiess of D or C represeted less tha 5% of the corporatio's total gross assets. I 7/16, IRS issued proposed regulatios, which, if fialized i proposed form, would require that the FV of active trade or busiess gross assets of each of D ad C must represet at least 5% of the FV of that etity s total gross assets, calculated by dividig the FV of a etity s Five-Year-Active-Busiess Assets by the FV of the etity s Total Assets. A etity s Five-Year-Active-Busiess Assets would be its gross assets used i oe or more busiesses. This rule would put a premium o havig a certai level of good 5-year active trade or busiess assets. If D or C is egaged i a substatial active trade or busiess that does ot meet the 5-year requiremet, such active trade or busiess assets would fall o the bad side of this calculatio. The test for each of D ad C would be measured at the D separate affiliated group ad C separate affiliated group level, ad although iterests i parterships geerally would ot cout as busiess assets, a look-through rule would apply for parterships through which D or C is cosidered to be egaged i oe or more 5-year active trades or busiesses. Active trade or busiess assets would iclude reasoable amouts of cash ad cash equivalets held as workig capital or required to be held (x) for regulatory purposes, (y) by cotract, or (z) as prudet reserves. Total Assets would be the Five-Year-Active-Busiess Assets plus all of the corporatio s other assets. A corporatio s Five-Year-Active-Busiess Assets ad other assets would be determied ad categorized as of immediately after the distributio. The asset FV could, however, be measured (i) immediately before the distributio, (ii) o ay date withi the 60-day period before the distributio, (iii) o the date that a agreemet bidig o D at all times thereafter regardig the distributio is etered ito, or (iv) o the date of a public aoucemet or filig with SEC with respect to the distributio. If D ad C do ot calculate ad report these values cosistetly, IRS would determie the values as of immediately prior to the distributio (uless IRS determies that the use of such date is icosistet with 355 s purposes). For purposes of Code 355 geerally, a five-year active trade or busiess ca iclude assets acquired less tha five years before a distributio where the assets costitute a expasio of a pre-existig busiess. However, the proposed regulatios iclude a broad ati-abuse rule which would disregard ay trasactio or series of trasactios (e.g., a expasio of a existig busiess) udertake with a pricipal purpose of avoidig the 5%-active-trade-or-busiess requiremet. I additio, the rules would apply separately to each spi-off, with o exceptio 4

5 for a iteral spi-off, where these rules could be problematic eve i a otherwise o-abusive situatio. These 7/16 proposed regulatios would geerally apply to a trasactio occurrig o or after the date fial regulatios are issued, but would ot apply to a distributio (i) pursuat to a bidig agreemet, resolutio, or other corporate actio occurrig prior to the date fial regulatios are issued, (ii) described i a rulig request submitted o or before 7/15/16, or (iii) publicly aouced or described i a SEC filig o or before the date fial regulatios are issued. Importatly, the preamble to the proposed regulatios states that Cogress did ited that a greater tha de miimis active trade or busiess is required i order to accomplish a tax-free spi-off. Despite failig to discer that itet over decades of its previous Code 355 iterpretatios of Cogressioal itet, IRS appears to be takig the positio that a certai level of active trade or busiess assets has always bee required. Give this positio, from ad after 7/15/16 practitioers should be wary of attemptig a Code 355 distributio with a active trade or busiess that does ot meet the 7/16 proposed regulatios miimum active busiess threshold requiremets. See discussio at Device test. To qualify as a tax-free spi-off, D s distributio of C s stock must ot be a device for the distributio of D s or C s E&P. The device test was desiged to prevet shareholders from extractig earigs from D i a CG trasactio without sigificatly reducig their percetage equity iterest i D. IRS regulatios state that the determiatio of whether a corporate separatio costitutes a device is based o all the facts ad circumstaces, icludig the presece of certai eumerated device ad o-device factors. 7/16 proposed regulatios would impose ew device tests where D or C holds substatial o-busiess assets. The preamble to the proposed regulatios expresses IRS belief that, where D is publicly traded, taxpayers have bee givig udue weight to this fact as a o-device factor ad over-emphasizig what IRS views as weak busiess purposes to offset evidece of device resultig from the separatio of o-busiess assets from busiess assets, eve whe pressure from public shareholders was a catalyst for the trasactio. I additio IRS believes that a trasactio is geerally a device where either D or C has a large percetage of o-busiess assets or D s ad C s respective percetages of such assets differ substatially. To address these cocers, the 7/16 proposed regulatios would add two ew device factors : (1) Owership of o-busiess assets by D or C represetig 20% or more of total assets ad 5 MORE

6 (2) A differece i the percetage of total assets represeted by o-busiess assets betwee D ad C (uless the differece is below 10% or, i a split-off sceario, is attributable to the eed to equalize C s ad D s values). Uder the proposed regulatios, the term busiess assets would mea gross assets used i oe or more active trades or busiesses. Helpfully, IRS clarified that busiess assets would iclude reasoable amouts of cash ad cash equivalets held as workig capital or required to be held (a) for regulatory purposes, (b) by cotract, or (c) as prudet reserves. I additio, the percetage of busiess assets geerally would be measured at the separate affiliated group level. Although partership iterests ad corporate stock would geerally be treated as o-busiess assets, a look-through rule would apply for (i) a partership coductig a active trade or busiess i which D or C is deemed to egage uder Code 355(b) ad the regulatios ad (ii) stock of a corporatio i which either the C separate affiliated group or D separate affiliated group ows a 50%-or-greater iterest. A etity s busiess ad o-busiess assets would be idetified ad classified as of immediately after the distributio. The asset FV could, however, be measured (i) immediately before the distributio, (ii) o ay date withi the 60-day period before the distributio, (iii) o the date that a agreemet bidig o D at all times thereafter regardig the distributio is etered ito, or (iv) o the date of a public aoucemet or SEC filig with respect to the distributio. If D ad C do ot calculate ad report these values cosistetly, IRS would determie the values as of immediately prior to the distributio (uless IRS determies that the use of such date is icosistet with Code 355 s purposes). Fially, although a strog busiess purpose would remai a o-device factor, the 7/16 proposed regulatios would require that, for a busiess purpose to overcome evidece of device related to differeces betwee D s ad C s busiess/ o-busiess asset ratios, there must be a strog busiess purpose relatig directly to such differece. Uder the 7/16 proposed regulatios, certai purported Code 355 distributios would be a per se device, o matter the stregth of the busiess purpose or other o-device factors. This largely mechaical per se device rule (a) would apply if the o-busiess assets of either D or C equal or exceed two-thirds of its total assets ad (b) the would compare the o-busiess asset percetages of each of D ad C. The test would be measured by referece to three bads or rages of o-busiess asset percetages of the corporatio (D or C) that has the higher percetage of o-busiess assets. If the o-busiess asset percetage of the other corporatio is less tha the specified miimum o-busiess asset percetage for the applicable bad, the the trasactio would be a per se device. 6

7 Bad 1 Bad 2 Bad 3 No-busiess asset percetage of D/C Miimum permitted o-busiess asset percetage of other corporatio Equal to or greater tha %, but less tha 80% = Equal to or greater tha 80%, but less tha 90% Equal to or greater tha 90% 30% 40% 50% The rules for determiig the requisite percetages of busiess ad o-busiess assets would be the same as those that apply for purposes of the proposed ew device factors, described above. Proposed adoptio of this per se device rule would make applicatio of the device test more rigid ad may ot take ito accout all circumstaces or good busiess reasos for certai asset divisios. However, IRS appears to be of the view that the burdes resultig from, ad the rigidity of, these mechaical tests are warrated whe two-thirds or more of D s or C s assets cosist of o-busiess assets. The proposed regulatios provide two importat exceptios to this per se device rule that should appropriately free most cash-rich split-offs to corporate shareholders (that pass muster uder Code 355(g)) from applicatio of such rule. First, the per se device rule would ot apply if the distributees i the trasactio are domestic (U.S.) corporatios that would be eligible for the 80% dividedsreceived deductio uder Code 243(a) or 245(b). Secod, the per se device rule ordiarily would ot apply to certai trasactios with importat o-device idicia, described uder Reg (d)(5), such as a trasactio i which D ad C lack E&P or a split-off trasactio i which it is clear that the distributio if taxable would otherwise qualify as a o-pro rata redemptio to all D shareholders uder Code 302(a). See discussio at ad l LossCo (troubled compay) debt restructurig tax ramificatios from trasferrig property to creditor i paymet of full-recourse or o-recourse debt. If LossCo is uable to pay its creditors (or is i bakruptcy), some or all of its debts are typically modified, restructured, or satisfied i a maer that alleviates LossCo s fiacial burde, geerally ivolvig compromises by LossCo s creditors ad possibly by LossCo s shareholders. Full-recourse debt. Where, as a part of such a debt restructurig, LossCo trasfers assets (e.g., real estate) to a creditor i exchage for cacellatio of LossCo full recourse idebtedess which exceeds i amout the trasferred assets FV, the 7 MORE

8 geeral rule is that LossCo is treated, for tax purposes, as sellig the property for a amout equal to the property s FV (ot for the larger amout of idebtedess beig cacelled). Thus, LossCo recogizes Code 1001 gai (or loss) o dispositio of the property equal to the property s FV mius LossCo s tax basis i the property. I additio, LossCo also recogizes debt cacellatio ( DC ) which i tur becomes either cacellatio of debt icome ( CODI ) or attribute reductio ( AR ) equal to the amout of debt cacelled mius the property s FV. No-recourse debt. Where, however, LossCo s debt is o-recourse (i.e., the creditor s claim is limited to the property securig the debt), LossCo is viewed for tax purposes as sellig the asset to the creditor for a amout equal to the debt s adjusted issue price (i.e., face amout, with adjustmets for uamortized OID, uamortized OIP, ad upaid accrued iterest), ad LossCo does ot recogize ay DC. Ofte LossCo would prefer DC rather tha Code 1001 taxable gai because LossCo ca ofte treat DC as AR (which does ot costitute immediate taxable icome), rather tha as gai o dispositio of the asset (which does costitute immediate taxable icome). No-recourse debt created through orgaizatioal structure. The o-recourse ature of debt typically results from limitatios i the applicable loa agreemet, for example, a provisio that, i the evet of a default, the creditor s claim agaist LossCo is limited to LossCo s iterest i the asset (e.g., real estate) securig the loa. However, o-recourse debt ca also be created through orgaizatioal structure. If LossCo has a subsidiary etity that is disregarded for federal icome tax purposes (e.g., a LLC 100% of the equity iterests of which are owed by LossCo), the disregarded etity s debt which is ot guarateed by LossCo is geerally treated as o-recourse LossCo debt for federal icome tax purposes sice (1) the subsidiary is disregarded, (2) the debt is viewed for federal tax purposes as LossCo s debt, ad (3) LossCo does ot have full recourse liability for the debt. This is true eve if the debt is full recourse to the disregarded LLC. Thus, LossCo recogizes Code 1001 gai (or loss) o dispositio of the property equal to the differece betwee disregarded-llc s tax basis i the property ad the full amout of LLC s adjusted issue price for the debt (i.e., the property s FV is ot relevat). Hece oe of LossCo s gai costitutes DC ad oe qualifies for the AR rules. See discussio at ad (2). 8

9 l 2016 proposed Code 385 debt-equity regulatios. 4/16 complex proposed regulatios would madate equity characterizatio for certai related party debt istrumets, without regard to traditioal subjective debt-equity factors (e.g., DER, overlap, projected ability to service the debt, reasoable debt terms, act like creditor). These regulatios would apply oly i limited circumstaces: to debt istrumets issued betwee corporatios bearig a 80%-or-greater paret-subsidiary or brother-sister relatioship (but ot part of a sigle group filig a U.S. cosolidated federal icome tax retur), referred to as a expaded group. These rules would apply where, for example, a U.S. corporatio issues a debt istrumet to its 80%-or-greater foreig paret corporatio or where a partership ows 80% or more of the stock of two U.S. corporatios, oe of which issues a debt istrumet to its sister corporatio. The proposed regulatios would, with limited exceptios (icludig a exceptio for debt istrumets ot exceedig $50 millio i the aggregate), automatically treat a debt istrumet as equity if issued by oe expaded group member to aother: (a) as a divided or redemptio distributio, (b) i exchage for stock of aother group member, or (c) i exchage for property of aother group member i certai types of asset reorgaizatios. The same treatmet would apply if a debt istrumet is issued by oe expaded group member to aother member for cash or other property, with a pricipal purpose of fudig a distributio or acquisitio described i (a) through (c). The proposed regulatios would treat debt as issued with a pricipal purpose of fudig such a distributio or acquisitio if the debt is issued durig the period begiig 36 moths before, ad edig 36 moths after, the applicable distributio or acquisitio, with a arrow exceptio for certai debt issued for property i the ordiary course of busiess. This portio of the regulatios would apply to debt istrumets issued after 4/3/16. To facilitate IRS audits, the proposed regulatios would also impose ew recordkeepig requiremets for a debt istrumet issued betwee members of a expaded group (as defied above) if (regardless of the type of trasactio beig fiaced): (1) the stock of ay group member is publicly traded, (2) a group fiacial statemet shows total assets exceedig $100 millio, or (3) a group fiacial statemet shows total aual reveue exceedig $50 millio. 9 MORE

10 Such a debt istrumet would automatically be treated as equity uless: (a) documetatio is prepared withi 30 days of the debt istrumet s issuace evidecig a bidig obligatio to repay the fuds, the creditor s rights to eforce the terms of the istrumet, ad a reasoable expectatio of the borrower s ability to repay the istrumet o its terms ad (b) ogoig documetatio is prepared ad maitaied evidecig a cotiuig ad geuie debtor/creditor relatioship, icludig paymets of iterest ad pricipal ad, if applicable, eforcemet actios upo default. This documetatio portio of the regulatios would apply to a debt istrumet issued after the regulatios are fialized. See discussio at l Reductios i compay s GAAP earigs because of stock grats, sales, or optios to executives. Stock sale or award. Whe a compay makes a stock sale or award to a executive, (1) the compay s accoutig et icome is reduced (over the executive s service period, geerally the vestig period) by the compesatio expese, which i tur is equal to the stock s FV at the time of sale or award less the price (if ay) paid by the executive ad (2) the compay s accoutig et icome is icreased by its expected tax savig from ay tax deductio created by the stock sale or award, so that the compay s accoutig et icome is reduced by such compesatio expese et of the tax beefit. Stock optio. Whe a compay grats a stock optio to a executive, (1) the compay s accoutig et icome is reduced (over the executive s service period, geerally the vestig period) by the compesatio expese, which i tur is equal to the optio s FV at the grat date, takig ito accout both (a) the spread (if ay) at grat betwee the stock s FV ad the optio price ad (b) the FV of the optio privilege, i.e., the value to a executive from deferrig the stock purchase decisio ad paymet of the optio price (geerally 20% to 40% of the optio stock s grat date FV for a optio that is ot sigificatly i-the-moey at grat), ad (2) the compay s accoutig et icome is icreased by its expected tax savig from ay tax deductio created by the optio grat ad exercise, so that the compay s accoutig et icome is reduced by such compesatio expese et of the tax beefit. Tax savig calculatio. Uder pre-3/16 GAAP rules, the tax savigs from ay tax deductios i excess of the compay s accoutig expese ( excess tax beefits ) have geerally bee credited directly to et worth as paid i capital ad do ot flow through the compay s icome statemet. However, GAAP rules adopted i 3/16 elimiate the cocept of excess tax beefits, effective 1/17 for a public 10

11 compay usig the caledar year ad 1/18 for a private compay usig the caledar year, with early adoptio permitted. Uder the ew 3/16 rules, the compay is required to adjust its tax beefits (geerally calculated pursuat to Code 83, 409A, ad 404(a)(5)) from a sale, award, or optio grat ad exercise as estimated at grat to reflect its actual tax beefits (e.g., because of FV fluctuatios betwee sale/grat ad vestig if o 83(b) electio was made for a stock sale/award or betwee grat ad exercise/ vestig for a optio) ad such adjustmets, whether positive (the compay s actual tax beefits are greater tha estimated) or egative (the compay s actual tax beefits are smaller tha estimated), flow through the compay s icome statemet ad affect GAAP et icome. Vestig rules. A executive s stock or optio is frequetly subject to vestig based o a service coditio (requirig the executive to provide services to the compay) or a performace coditio (requirig both (i) the executive to provide services to the compay ad (ii) satisfactio of a performace target relatig to the employer s operatios or activities, either durig or after the requisite service period). Stock or optio FV is ot reduced based o the possibility the executive will ot vest i the award ad hece will forfeit the compesatio; rather, compesatio expese is recogized oly for a award that ultimately vests. Uder GAAP rules adopted i 3/16 (effective 1/17 for a public compay ad 1/18 for a private compay as described above), the compay must either (i) estimate the portio of its awards expected to vest based o the provisio of services ad subsequetly adjust such estimate from time to time i light of vestig expectatios ad ultimately based o actual vestig results or (ii) take ito accout forfeitures based o failure to provide services as they actually occur. Prior to the 3/16 rules effective date a compay must estimate the forfeitures expected to occur based o the failure to provide services ad adjust the estimate from time to time based o vestig expectatios ad actual forfeitures. Payig withholdig tax with ew shares. A award may permit the compay to withhold shares to meet the employer s miimum statutory [tax] withholdig requiremets without causig the award to be treated as a liability for accoutig purposes (which would ivoke harsher accoutig rules). Uder pre-3/16 GAAP rules, if a amout i excess of the miimum statutory requiremets is withheld, or may be withheld at the employee s discretio, the etire award shall be classified... as a liability for accoutig purposes. 11 MORE

12 However, GAAP rules adopted i 3/16 permit shares to be withheld at a rate up to the maximum idividual statutory tax rate i the applicable jurisdictios for federal, state, ad local icome ad payroll taxes, without causig the award to be treated as a liability. Subject to this commo percetage cap applicable to all employees taxed i a give jurisdictio, the ew rules (a) do ot require that the employer actually withhold the same percetage amout from each employee ad (b) allow a employee some discretio i specifyig the amout of withholdig with respect to his award. Thus, uder these 3/16 GAAP rules, the employer may withhold shares i a amout up to the taxes the employee would owe with respect to the award, determied usig the maximum idividual statutory tax rate i the applicable jurisdictios, ad the award could still be treated as a equity istrumet (allowig the more desirable accoutig rules described above to be utilized). However, the ew 3/16 rules apply oly to a employer that has a statutory tax withholdig obligatio (e.g., ot to a partership, for a award issued to a parter). The 3/16 rules are effective 1/17 for a public compay usig the caledar year ad 1/18 for a o-public compay usig the caledar year, with early adoptio permitted. See discussio at , , l Proposed IRS regulatios attack PE/VC fud maagemet fee reductio i exchage for ehaced LTCG allocatio, i.e., waived maagemet fee. Waived maagemet fee cocept. GPs of some PE/VC fuds opt to reduce the maagemet fee payable by the fud to the GP (which is taxable as OI) i exchage for a ehaced allocatio of fud profits taxable at lower rates as LTCG ad/or QDI. This maagemet fee reductio is most commoly structured as a cashless cotributio arragemet, uder which GP ca satisfy a portio of its capital commitmet to the fud by makig deemed (or cashless ) cotributios to the fud equal to the amout by which the maagemet fee was reduced. GP the receives subsequet fud distributios as if it had actually made the cashless cotributios to the fud i cash (i.e., amouts represetig a retur of the cashless cotributio plus or mius the positive or egative ivestmet retur o the cashless cotributio), coditioed o the fud earig sufficiet profits to support characterizatio of these distributios as a iterest i future fud profits (LTCG ad QDI). 1 1 Less ofte, GP receives a capped iterest i future fud allocatios ad distributios equal to oly the fee reductio (i.e., cashless cotributio) amout. 12

13 I some cases the etire GP waiver is made upfrot at the time of fud formatio, while i other cases GP reserves the right to elect periodically to waive i advace a portio of the maagemet fee i exchage for such a ehaced allocatio of fud future appreciatio. As log as there is meaigful ecoomic risk that GP may ot receive sufficiet allocatios of fud profits to make GP whole for the foregoe maagemet fee (e.g., whe the allocatio equal to the foregoe maagemet fee is out of aual et profits ad may ot be take from appreciatio i fud assets existig at the time of the maagemet fee-reductio electio, but rather may be take oly from subsequet [i.e., post-maagemet-fee waiver] appreciatio), this techique should covert maagemet fee icome which would have bee taxed as OI ito a profits iterest i the fud, so that the character of the item of icome allocated to GP geerally LTCG ad QDI flows through to GP. 7/15 IRS proposed regulatios. 7/15 proposed IRS regulatios would treat such a fud maagemet fee reductio arragemet as a disguised paymet for services, resultig i OI characterizatio, uless the arragemet meets a high etrepreeurial risk stadard. The proposed regulatios would create a presumptio of isufficiet etrepreeurial risk where GP s profit allocatio is: (i) capped i amout, (ii) measured by gross icome, rather tha et icome, (iii) reasoably determiable i amout, or (iv) eve if ot reasoably determiable i amout, desiged to assure that sufficiet et profits are highly likely to be available to make the allocatio to GP. Uder traditioal maagemet fee reductio arragemets, GP s right to receive or retai distributios i respect of waived fees has bee coditioed o the fud recogizig sufficiet CG or QDI i oe or more years i which the fud geerates overall et icome (igorig years i which the fud has et losses). Uder the proposed regulatios, profit allocatios would be viewed as highly likely to be available ad hece presumed to be disguised paymets for services (i.e., OI) uless profits allocated to GP uder the arragemet are limited to the fud s et profits over a exteded period (e.g., the fud s cumulative et icome over the fud s etire life). The proposed regulatios would apply to arragemets etered ito or modified (icludig by makig ew fee waivers) after fial regulatios are issued (expected sometime i late 2016). 13 MORE

14 For arragemets etered ito before issuace of fial regulatios (ad ot thereafter modified), the regulatory preamble asserts that the proposed regulatios geerally reflect Cogressioal itet, although there appears to be little support i pre-existig law for recharacterizig a properly structured cashless cotributio arragemet as a disguised paymet for services. Future modificatio of Rev. Proc The preamble to the 7/15 proposed regulatios also aouced that IRS iteds to modify Rev. Proc (which allows a partership profits iterest issued to a service parter to be valued at its $0 LV, rather tha its speculative FV) so that the Rev. Proc. would ot apply this taxpayer-favorable rule to a profits iterest issued i cojuctio with a parter foregoig paymet of a amout that is substatially fixed. If the Rev. Proc. is so modified, IRS could assert that a fud GP eterig ito a fee reductio arragemet must recogize immediate OI equal to the FV of the profits iterest received by GP eve if this profits iterest satisfies the high etrepreeurial risk stadard of the proposed disguised sale regulatios. See discussio at (6). l 6/16 IRS liberalizatio of Code 409A regulatios. Exceedigly complex ad legthy Code 409A regulatios madate immediate OI recogitio plus a 20% additioal pealty tax (producig a 59.6% maximum tax rate) o may types of OI compesatio to a service provider paid o a deferred basis. 6/16 proposed (pro-taxpayer) regulatory amedmets (which taxpayers may immediately rely upo) liberalize a few of Code 409A s may highly techical (ad ati-taxpayer) rules, icludig: the uforeseeable evet rule, permissible distributio triggers, the ati-abuse rule, severace arragemets, ad service recipiet stock rules. See discussio at l Double-tax pealty o REIT built-i gai exteded to 10 years. A C corp (with appreciated assets) electig to be taxed as a REIT (or a existig REIT acquirig appreciated assets from a C corp with carryover basis [ COB ]), is geerally, by virtue of Code 337(d) ad the regulatios thereuder, subject to Code 1374 s etity-level corporate pealty tax o such built-i gai ( BIG ) to the extet recogized withi a 14

15 specified period (the recogitio period ) followig the C corp s REIT electio (or the REIT s COB asset acquisitio from a C corp). Prior to 2016, the recogitio period for a former C corp (with appreciated assets) electig to be taxed as a REIT (or for a REIT acquirig appreciated COB assets from a C corp) tracked the Code 1374 recogitio period for a C corp electig to be taxed as a S corp (or a S corp acquirig COB appreciated assets from a C corp), i.e., 10 years for such gai recogized before 2009, temporarily reduced to 7 years for such gai recogized i 2009 ad 2010, the temporarily reduced to 5 years for such gai recogized i 2011 through 2014, the permaetly reduced to 5 years for gai recogized i 2015 ad thereafter, as discussed i the S corp cotext at While the legth of the S corp recogitio period (10 years, the 7 years, the 5 years) is established by statute (Code 1374), the legth of the REIT recogitio period has always bee established by regulatios which util 6/16 simply icorporated by referece the S corp 1374 statutory recogitio period. Ideed, the legislative history of the 12/15 legislatio which made permaet the S-corp year recogitio period ackowledged that Uder curret Treasury regulatios, these [Code 1374] rules, icludig the five-year recogitio period, also would apply to REITs (emphasis added). However, i 6/16 IRS surprisigly chaged course, publishig temporary 337 regulatios that, effective for a C corp with appreciated assets which coverted to a REIT after 8/7/16 (or a REIT acquirig appreciated COB assets from a C corp after 8/7/16), de-liked the regulatory REIT recogitio period from the statutory S corp recogitio period, statig i the regulatory preamble that REIT coversios will o loger be affected by [the shorteig of] the legth of the [S corp] recogitio period from 10 years to 5 years with respect to C corporatios that elect to be, or trasfer property to, S corporatios. Istead, these temporary regulatios adopted a 10-year recogitio period for a C corp with appreciated assets which elected to be taxed as a REIT after 8/7/16 (or a REIT which acquired appreciated COB assets from a C corp after 8/7/16). Applicatio of these Code 1374 priciples is madatory abset a electio (made whe the C corp with appreciated assets elects REIT status or the REIT acquires appreciated assets from a C corp) to istead recogize the iheret gai i the appreciated assets at such time. See discussio at l 2016 court decisio expads scope of ERISA group liabilities. If P acquires the requisite percetage of T s stock, ERISA geerally causes P (i.e., T s ew paret) as well as P s other subsidiaries (i.e., T s ew sister etities) to be joit ad severally liable for T s upaid ERISA pesio obligatios, which is very relevat if T should ultimately go bakrupt with uderfuded pesios. 15 MORE

16 Similarly if PE/VC fud acquires the requisite percetage of T s stock (or Newco formed ad owed by PE/VC fud acquires the requisite percetage of T s stock), ERISA may cause PE/VC fud as well as its other portfolio compaies (i.e., T s sister portfolio compaies) to be joit ad severally liable for T s upaid ERISA pesio obligatios. 2 The requisite owership is 80% or more (by vote or value where the lower-tier etity is a corporatio or by capital or profits where the lower-tier etity is a partership or LLC), except that i certai circumstaces where P (or PE/VC fud) ows 50% or more of the lower-tier etity, certai shareholders (e.g., lower-tier etity s employees who ow stock i lower-tier etity subject to restrictios) are disregarded, so that P s (or PE/VC fud s) less-tha-80% owership of the lower-tier etity could costitute requisite owership. I a 2016 district court decisio, bakrupt T (with uderfuded pesio liability) was owed 70%-30% by two PE/VC fuds (the Su fuds) formed several years apart by the same PE/VC sposor group (Su Capital). The two Su fuds did ot geerally ivest i the same portfolio compaies, had miimal commo LPs, ad if the two fuds did occasioally ivest i the same portfolio compay, the ivestmets were ot proportioate to each fud s capital. Actual structure Su GP & mgmt etities LP group #1 LP group #2 Su Fud 3 Su Fud 4 formed % 70% LLC 100% Bakrupt T formed 2005 No flow-through liability to Su fuds: uder state LLC law (which grats limited liability to a LLC s equity owers) or uder ERISA law (because either Su Fud owed requisite percetage) 2 Where the upper-tier etity (P or PE/VC fud) is a partership or LLC (rather tha a corporatio) the ERISA group liability rules apply to such upper-tier partership/llc etity oly if such uppertier etity is egaged i a trade or busiess, but there is less clarity o whether the upper-tier etity s other subsidiaries (i.e., T s sister etities) escape ERISA group liability if the upper-tier etity is ot egaged i a trade or busiess. 16

17 Because either of the two PE/VC fuds owed the requisite percetage (here 80%) of bakrupt T, the court (i holdig both PE/VC fuds liable for bakrupt T s upaid pesio obligatio) created a differet path, cocludig that both PE/VC fuds were liable because, i the district court s view, they had created a ew etity, a federal partership-i-fact (owed 70/30 by the two PE/VC fuds), to serve as the LLC s 100% ower (so the imagiary partership was [uder the ERISA rules] liable for the ERISA obligatio the LLC had iherited [uder the ERISA rules] from bakrupt T). The court the cocluded (without discussio) that the parters of the imagiary federal partership (the two PE/VC fuds) were liable (i.e., apparetly as the imagiary partership s geeral parters) for the imagiary partership s ERISA obligatio. Court s imagiary structure Su GP & mgmt etities LP group #1 LP group #2 Su Fud 3 formed 2003 Su Fud 4 formed % 70% Imagiary federal p ship 100% Flow-through liability to Su fuds: apparetly because federal p ship law cotais o statutory limited liability for imagiary geeral p ship s equity owers LLC 100% Bakrupt T The court (relyig o the Iteral Reveue Code s broad defiitio of a partership for tax purposes) reasoed that the two PE/VC fuds smooth coordiatio [was] idicative of a partership-i-fact sittig atop the LLC: a site of joiig together ad formig a commuity of iterest. However, if the court believed the two PE/VC fuds eeded a etity i order to egage i such joit activity, it is uclear why the LLC actually formed by the two PE/VC fuds (which uder state law afforded its members protectio from the LLC s upaid obligatios) rather tha a imagiary federal partership-i-fact created by the court would t serve as the repository for such coordiated activity. 17 MORE

18 Because there is i fact o federal partership law (i.e., all parterships are formed uder state, ot federal, law), it is ot surprisig that the court s federal partership-i-fact (ulike the LLC which the two PE/VC fuds actually did create) afforded o explicit equity ower-level protectio agaist upaid partership -level liabilities. Possible extesio of imagiary partership approach to ivestmets made i cocert by several wholly idepedet PE/VC fuds or by PE/VC fud alog with co-ivestors. If this 2016 district court decisio were to stad, there is a possible argumet that ivestmets by multiple ivestors i a bakrupt T (made i cocert) should be amalgamated, i.e., treated as made by a imagiary partership, eve if made: (a) by two or more wholly idepedet PE/VC fuds (or two wholly idepedet Ps) or (b) by a PE/VC fud alog with oe or more co-ivestors (e.g., oe or more of the fud s limited parters ad/or oe or more persos who are ot fud limited parters). I such case, all of the co-ivestors who cooperate i makig the ivestmet (icludig eve a 1% co-ivestor) could be viewed as GPs i a imagiary geeral partership, with full ulimited liability for bakrupt T s etire ERISA liability. See discussio at through l Avoidig T shareholder vote (ad SEC proxy rules) o secod-step squeeze-out merger of T miority shareholders after P first acquires (geerally by teder offer) substatial T stock. Where P (or S) has first acquired a portio of T s stock ad P the desires to squeeze out T s remaiig (miority) shareholders by merger, P geerally prefers to avoid a vote of T s shareholders (e.g., especially where T is a 1934 Act reportig compay ad hece required to comply with SEC s proxy rules). There are two circumstaces where a vote of T s shareholders ca be avoided: First exceptio: Delaware 253(a) ad similar exceptios i other states. Most state laws cotai a log-stadig exemptio allowig a short-form merger without ay T shareholder vote betwee a paret (here P or its subsidiary S, whichever has acquired sufficiet owership of T s stock) ad oe of its corporate subsidiaries (here T), with T s miority shareholders receivig P stock, cash, or other cosideratio as specified i the short-form-merger agreemet. The percetage of owership that P (or S) must have i T i order to utilize the short-form merger procedure (without a T shareholder vote) varies from state to state (90% beig the required percetage i Delaware). Thus, oce P (or S) has acquired the requisite stock owership i T by purchasig T stock (e.g., at least 18

19 90% i Delaware) i a teder offer or i oe or more egotiated stock purchases P (or S) ca (if such a short-form merger statute is applicable) merge with T without a T shareholder vote. Where the acquisitio is friedly ad T has adequate authorized but uissued stock, T might also grat P (or S) a top-up optio before P (or S) commeces its teder offer for (or egotiated purchase of) T stock, givig P (or S) the right (ad perhaps the obligatio) to purchase from T (typically for a ote) that umber of ew T shares which, whe combied with the T shares acquired by P (or S) i the teder offer or egotiated purchase, will be sufficiet to meet the state law threshold for a short-form merger (e.g., 90% i Delaware). Secod exceptio: Delaware 251(h). Uder a 2013 additio to Delaware law (as further ameded i 2016), a vote of T s shareholders (ad hece a 1934 Act proxy statemet) o a forward or reverse merger of T ad P (or P s subsidiary S) ca be avoided where: (a) T (orgaized as a corporatio) has more tha 2,000 shareholders or is listed o a atioal securities exchage immediately prior to executig the merger agreemet, (b) P or its corporate subsidiary ( AcquirigCorp ) makes a first-step teder or exchage offer for ay ad all T stock (although it is permissible for such teder offer to be coditioed o T shareholders tederig a miimum umber or percetage of T s shares), (c) Immediately followig the cosummatio of the [first-step teder] offer, the T stock purchased by AcquirigCorp i such [teder] offer...,together with the [T] stock otherwise owed by [AcquirigCorp] ad ay rollover stock (as defied below) is sufficiet to approve the secod-step squeeze-out merger (uder Delaware law ad T s charter), geerally more tha 50%, (d) all o-tedered T stock (other tha rollover stock) is exchaged i the secod-step squeeze-out merger for the same amout ad kid of cosideratio per share as was received by the tederig T shareholders i the teder offer (i.e., cash i the same amout per share as i the teder offer where the teder offer cosideratio was cash), (e) T is icorporated i Delaware, ad (f) the merger agreemet expressly permits or requires this procedure. Rollover stock meas T shares covered by a writte agreemet requirig such [T] shares to be trasferred...to[acquirigcorp]...i exchage for [AcquirigCorp] stock, so log as such T shares have actually bee trasferred 19 MORE

20 to AcquirigCorp o later tha immediately prior to the time the merger becomes effective. The 2016 amedmet made two salutary chages to 251(h): (i) Before the 2016 statutory amedmet, all o-tederig T shareholders were required to receive (i the squeeze-out merger) the same type ad amout of cosideratio per share for their T stock as the tederig T shareholders (i.e., requiremet (d) above but without the parethetical exceptio for rollover stock which was added by the 2016 statutory amedmet). However, after the 2016 statutory amedmet to requiremet (d), AcquirigCorp ca ow acquire T shares owed by oe or more T shareholders (icludig T executives) i exchage for [AcquirigCorp] stock, eve though all of T s other shareholders receive cash for their T shares (both i the teder offer ad i the squeeze-out merger). While the 2016 statutory amedmet allows T stock owed by ay T shareholder (ot merely by a T executive) to be treated as rollover stock, i.e., acquired by AcquirigCorp i exchage for AcquirigCorp stock, the provisio is most likely to be used i practice oly to roll oe or more key T executives T stock ito AcquirigCorp stock. (ii) After the 2016 statutory amedmet, rollover stock is geerally couted (alog with tedered T stock) toward requiremet (c) s sufficiet-t-stock-toapprove-the-merger test. Especially where P is a ew etity (formed by a PE fud to acquire T i a LBO), ew P may (after the 2016 amedmet) offer T executives (who will post-merger become key P executives) a opportuity to exchage their T shares for P shares tax-free (as part of P s Code 351 formatio ad buyout of T), thus allowig such T executives to exchage their low tax basis T stock without CG recogitio for higher FV P stock (which takes a post-merger low carryover tax basis from their old T stock). Complexity of schedulig 251(h) trasactio steps i compliace with state law fiduciary duty ad federal teder offer rules. After the 2016 Delaware amedmet became effective o 8/1/16, there is complexity i schedulig P s 251(h)-compliat two-step acquisitio of T with (x) T executives receivig P stock ad (y) other T shareholders receivig cash, i both cases i exchage for their T stock. For the reasos explaied below, the best schedule would geerally be as follows: (1) P aouces ad the (after a 20-busiess-day wait, as required by the federal teder-offer rules) closes its cash teder offer for ay ad all T stock, but T executives to whom P is plaig to offer P stock do ot teder their T shares for cash. 20

21 (2) Immediately after teder offer closig P ad such T executives eter ito a writte (rollover) agreemet obligatig P to issue P stock i exchage for such executives T rollover shares, callig for a immediate closig (e.g.) oe miute or so after sigig the rollover agreemet. (3) P ad such T executives the (oe miute or so after sigig the rollover agreemet) complete the exchage of P stock for T rollover stock (thus satisfyig Delaware 251(h) s requiremet that the T rollover stock is actually trasferred to AcquirigCorp o later tha immediately prior to the time the merger becomes effective ). (4) The merger is the cosummated immediately thereafter. This tightly scripted time schedule is ecessary i order to satisfy all the requiremets of Delaware 251(h), state law fiduciary duty, ad the federal teder offer rules: (A) P caot acquire or cotract to acquire T executives T stock before aoucig the teder offer, or ideed probably util after teder offer completio. T s executives have a state law fiduciary duty to (i) maximize the cosideratio for T s shareholders ad to (ii) treat all bidders for T equally, which would certaily appear to be breached if oe or more T executives were to joi forces with P (by cotractig to sell their T stock to P i exchage for P stock) before P s teder offer for T had bee aouced, or ideed at ay time before teder offer completio, sice other bidders competig (or plaig to compete) with P to acquire T may still be i the game ad may still top P s bid ad egage i a biddig war to acquire T. I additio, a T executive probably would ot wat to trasfer or commit to trasfer his T shares to P at P s forthcomig teder offer valuatio whe aother higher bidder for T may yet arise. Ad P may well ot wat to acquire (or commit to acquire) the T executives T stock util P is certai P s teder offer will be successful, so that P ca complete its acquisitio of 100% of T s stock. (B) P caot acquire or cotract to acquire executives T stock while the teder offer is pedig. The federal teder offer rules prohibit P (after public aoucemet of the teder offer) from acquirig or eterig ito a agreemet to acquire the executives T stock (or ideed ayoe s T stock) outside the teder offer util after the teder offer has expired. (C) P caot make two simultaeous teder offers: a stock-for-stock teder offer for the executives T stock ad a cash teder offer for the other T shareholders stock. The federal teder offer rules prohibit P from offerig disparate 21 MORE