Tax Considerations in Structuring Private Investment Funds

Presenting a live 110 minute teleconference with interactive Q&A Tax Considerations in Structuring Private Investment Funds Balancing the Competing Interests of Fund Investors When Structuring Investment Funds THURSDAY, MAY 2, 2013 1pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Christian M. McBurney, Partner, Nixon Peabody, Washington, D.C. Jeremy Naylor, Partner, White & Case, New York Elizabeth Norman, Attorney, Goulston & Storrs, Boston Attendees seeking CPE credit must listen to the audio over the telephone. Please refer to the instructions emailed to registrants for dial-in information. Attendees can still view the presentation slides online. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.

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May 2, 2013 Tax Considerations in Structuring Private Equity Funds Balancing the Competing Interests of Fund Investors When Structuring Investment Funds Christian McBurney, Nixon Peabody LLP, Washington, D.C. office Jeremy Naylor, White & Case LLP, New York office Elizabeth Norman, Goulston & Storrs, Boston office 5

Fund Characteristics Types of Funds Private Equity Venture Capital Hedge Distressed Debt Real Estate LBO Fund of funds 6

Fund Characteristics (cont d) Other important fund characteristics U.S.-based or based outside U.S.? Focus investing in U.S. or outside U.S., or both? Is fund an investor or conducting a trade or business? Investor: possible disallowance of fund manager fees for U.S. investors under Section 212 Trade or business: fees deductible under Section 162; but UBTI, ECI and CAI concerns 7

Type of Fund Investors U.S. Taxable Individual or Corporation U.S. State and Local Government Pension Funds US U.S. TaxExempt Tax-Exempt Investors Corporate Pension Plans University and College Endowment Funds Private Foundations Charity Endowment Funds Individual Retirement Accounts (IRAs) 8

Type of Fund Investors (cont d) Non-U.S. Investors Individuals Non-U.S. entities treated as corporations for U.S. income tax purposes p Pension Funds (not taxed in home country) Non-U.S. Government Investors (Section 892) Sovereign Wealth Funds Pension Funds 9

U. S. Taxable Individuals and Corporations U.S. Taxable Individual - 20% c.g. - 39.6% o.i. - 3.8% nii - Gain on stock sale - Dividends - Interest - Gain on debt sale Portfolio Corp. Fund L.P. U.S. Taxable C Corp. 35% c.g. and o.i. - Gain on interest sale - Gain on asset sale - Interest - Gain on debt sale Portfolio LLC No Fund Blocker desired d Unblocked investor can also claim tax credits and treaty benefits 10

U. S. State and Local Government U. S. State and Local Government 0% U.S. tax rate Fund L.P. Gain/income Portfolio Corp. Gain/income Portfolio LLC No Fund Blocker desired d Unblocked can also claim treaty benefits 11

U. S. Tax Exempt Investors U.S. Tax-Exempt 0% U.S. tax rate - Gain on stock sale - Dividends - Interest - Gain on debt sale Portfolio Corp. Fund L.P. - Gain on interest sale (c.g.) - Interest - Gain on debt sale (c.g.) Portfolio LLC - Gain on sale of noninventory property No Fund Blocker desired d Unblocked investor can also claim treaty benefits 12

U. S. Tax Exempt Investors (cont d) U.S. Tax-Exempt 35% U.S. tax rate Fund L.P. Portfolio LLC Fees earned by L.P. -Operating income - Gain on sale of inventory Fund Blocker often desired d Unrelated business taxable income (UBTI) 13

U. S. Tax Exempt Investors (cont d) U.S. Tax-Exempt 35% U.S. tax rate Debt-Financed: - Gain on stock sale - Dividends - Interest - Gain on debt sale Fund L.P. Debt-Financed: - Gain on interest sale - Interest - Gain on debt sale Portfolio Corp. Portfolio LLC Debt-Financed: - Gain on sale of any property -Operating Income Debt-financed income is UBTI Fund Blocker often desired 14

U. S. Tax Exempt Investors (cont d) Parallel Fund Structure U.S. Tax-Exempt Non-U.S. or U.S. Feeder Fund Non-U.S. Investments (No UBTI) U.S. Investments (No UBTI) U.S. Corp. Blocker Investments (UBTI) 15

Non U.S. Investors U.S. tax goals Avoid having to file a U.S. income tax return Limit U.S. tax on Effectively Connected Income (ECI). If ECI: Must file U.S. federal, state, and local returns Must pay income tax at regular, federal, state and local rates Non-U.S. corp must also pay U.S. 30% branch profits tax Limit U.S. tax on FDAP income 30% U.S. withholding tax rate unless U.S. tax treaty applies Claim U.S. treaty benefits where possible 16

Non U.S. Investors (cont d) Effectively Connected Income (ECI) is income recognized by a non-u.s. person that is effectively connected with a business carried on in the U.S. Does fund have a loan origination business? Securities trading safe harbor protects offshore funds ECI includes share of operating income from a passthrough entity conducting business in the U.S. Non-U.S. partners are deemed engaged in a U.S. business Sale of partnership interest in partnership that generates ECI: IRS takes the position that gain is ECI FIRPTA income treated like ECI 17

Non U. S. Investors (cont d) Non-U.S. Investor 0% U.S. tax rate U.S. Source: - Gain on stock sale Portfolio Corp. Fund L.P. US U.S. Source: - Portfolio interest - Gain on debt sale Non-U.S. Source: -Gain/income Portfolio Portfolio LLC Corp. No Fund Blocker desired 18

Non U. S. Investors (cont d) Non-U.S. Investor 30% U.S. tax rate (unless treaty applies) Fund L.P. U.S. Source: - Dividends - Non-portfolio interest Portfolio Corp. 19 Treaty benefits can be claimed Non-U.S. pension fund from a treaty country 0% U.S. tax rate No Fund Blocker desired

Non U. S. Investors (cont d) Non-U.S. Investor 35%/39.6% U.S. tax rate Fund L.P. Portfolio LLC Gain on interest sale (ECI) U.S. Source: - Gain on sale of operating assests (ECI) - Operating income (ECI) Fund Blocker usually desired 20

Non U. S. Investors (cont d) Parallel Fund Structure Non-U.S. Investor Non-U.S. or U.S. Feeder Fund Non-U.S. Investments (No ECI) U.S. Investments (No ECI) U.S. Corp. Blocker U. S. Investments (ECI) 21

U.S. Tax Exempt Investor (cont d) Parallel Fund Structure Why use non-u.s. Feeder? Not have to report non-u.s. investments Can avoid "controlled foreign corporation" (CFC) treatment where substantial investors are non-u.s. investors and fund owns 50% or more of the non-u.s. portfolio company Why use U.S. Feeder? Easier to claim U.S. treaty benefits only need to issue W-8BEN to U.S. Feeder Will relevant non-u.s. tax treaties "flow-through" a non- U.S. Feeder? See also Section 894(c). 22

UBTI and ECI Not Exactly the Same Some investments may generate UBTI, but not ECI Debt-financed income (including stock sales, dividends, and interest) Some investments may generate ECI, but not UBTI Sale of partnership interests where partnership conducts a U.S. trade or business Investments in U.S. real property holding corporations (holding 50% or more of gross assets in U.S. real property) Loan commitment fees not UBTI, but may be ECI Accordingly, a blocker that avoids all ECI may be too broad for a U.S. tax-exempt investor; and a blocker that avoids all UBTI may be too broad for a non-u.s. Investor 23

Non U.S. Governmental Investors 24 Non-U.S. Governments (including their controlled entities) are generally exempt from U.S. tax under IRC Section 892 on income from investments from securities, except income from the conduct of a "commercial activity" (CAI) If a controlled entity has CAI (either US or non-us), it could lose its Section 892 exemption (but recent relief in proposed regulations inadvertent and de minimis standards; interest in non-controlled LP) Investments in operating partnerships generate CAI Non-US Government owning U.S. real property or 50% or more of the stock of a United States Real Property Holding Corporation (USRPHC) can generate CAI

Non U. S. Governmental Investors (cont d) Non-U.S. Government 0% U.S. tax rate U.S. Source: - Gain on stock sale - Interest - Dividends Portfolio Corp. Fund L.P. Portfolio Corp. Non-U.S. Source: -Gain/income U.S. Source: - Interest - Gain on debt sale Portfolio LLC No Fund Blocker desired 25

Non U. S. Governmental Investors (cont d) Non-U.S. Government 35% U.S. tax rate Fund L.P. Portfolio LLC Gain on interest sale (CAI) U.S. Source: - Operating income (CAI) - Gain on sale of operating assets (CAI) Fund Blocker desired 26

Non U. S. Governmental Investors (cont d) Non-U.S. Government Non-U.S. or U.S. Feeder Fund Non-U.S. Investments (No CAI) U.S. Investments (No CAI) U.S. Corp. Blocker U. S. Investments (CAI) 27

ECI, FDAP and CAI Not Exactly the Same Some investments may generate ECI but not CAI Investments in U.S. real property holding corporations (USRPHC) (holding 50% or more of gross assets in U.S. real property) Only CAI if Non-U.S. Government holds 50% of more of USRPHC Some investments may generate CAI but not ECI Sale at gain of non-u.s. corporate entity controlled by Non-U.S. Government, which would be a USRPHC if formed in the U.S., is taxable CAI, but would not be ECI Some investments may generate FDAP withholding for non-u U.S. Investors, but not for Non-U U.S. Governmental Investors 28

Parallel Fund Structure Most tax efficient fund structure generally is to use separate parallel funds for each type of investor Administrative costs Should each investment have a newly-formed separate blocker? This can avoid U.S. dividend withholding tax on exit But if a single blocker is used for multiple investments, income and gain from one investment can be offset by losses from another Risk of aggregation of different fund entities used in parallel/aiv structure due to applying carried interest across all funds 29

Simplified Parallel Fund Other Investors GP Electing U.S. Tax Exempt, Non U.S. and Non U.S. Governmental Investors Parallel Fund Carry Carry Blocker Corp. Main Fund Intermediate Partnership Portfolio LLC Portfolio Corp. 30

Alternative Investment Fund All Investors Other Investors Electing U.S. Tax Exempt, Non U.S. and Non U.S. Governmental Investors Carry GP AIF B Main Fund AIF A Blocker Corp. Carry Intermediate Partnership Portfolio Corp. Portfolio LLC 31

Feeder Fund No Flexibility Other Investors GP Electing U.S. Tax Exempt, Non U.S. and Non U.S. Governmental Investors Feeder Fund (Offshore) Main Fund L.P. Portfolio LLC Portfolio Corp. 32

Qualified Small Business ( QSB ) Stock U.S. Individuals U.S. Tax-Exempt Investors Non-U.S. Investors Fund L.P. US Portfolio Corp. QSB Stock 33 Section 1202: 0% tax rate for noncorporate taxpayers on sale of QSB stock held for more than five years Some businesses excluded Corporation s total gross assets may not exceed $50m at issuance; Fund must acquire stock at original issue Exclusion limited to greater of $10m or 10x aggregate tax basis of QSB stock

Subsidiary Blocker Structures Taxable Investors Non-U.S./U.S. Tax-Exempt Investors Fund Sensitive investor capital Taxable investor capital U.S. Corp. Blocker Portfolio LLC 34

Subsidiary Blocker Structures Some funds use subsidiary blocker corporations for ECI and UBTI investments Capital of tax sensitive investors channeled through blockers Special allocations at the Fund level substantiality concerns? Risk to Non-U.S. Investors of U.S. tax return filing obligation GP Carry pre- or post-tax? tax? Take out GP carry below the blocker Exit from investment Sale of assets and liquidation of blocker Sale of blocker shares? Allocation of discount? 35

Other Types of US Funds Hedge Funds Distressed Debt Real Estate (including oil and gas) 36

Other Types of US Funds Hedge Funds Onshore/offshore structure Typically Cayman master fund taxed as a partnership Onshore feeder Delaware LP or LLC Taxable investors invest here Simplifies reporting for U.S. taxable investors Offshore feeder Cayman company (or LP that box checks to be treated t as a corp) Tax-Exempts and Non-U.S. investors invest here Offshore feeder may make sense for taxable investors given Section 212 limitations on deductibility of management and other fees and NII Medicare tax 37

Other Types of US Funds Hedge Funds (cont d) Issues for taxable investors Is the fund a trader for tax purposes? deductibility of management fees and expenses GP s performance compensation o structured as a partnership allocation of profits If paid as fee and fund is not trader Section 212 deductibility limitations Management fees and other expenses should be paid at the master fund level Risk that under logic of Rev. Rul. 2008-39, if paid at the feeder level may not be deductible. Investment in offshore feeder may offer tax advantages 38 Deferral if 3.8% Medicare tax on NII until distribution Effective deduction of management fees in non-trader fund

Other Types of US Funds Hedge Funds (cont d) Issues for Non-U.S./U.S. Tax-Exempt investors Trading in stocks and securities safe harbor for feeder Offshore feeder is effective blocker for UBTI and ECI But corporate income tax and branch profits tax on any ECI Non-U.S. government investors cannot access 892 benefits through offshore feeder Allocation of FATCA risk Stop Tax Haven Abuse Act? 39

Other Types of US Funds Hedge Funds (cont d) Issues for Investment Manager Treatment of incentive compensation Allocation allows for potential for capital gains Generally not a large portion of hedge fund s revenues Not available for funds that mark-to-market Incentive fees Section 457A/409A issues if paid by offshore feeder Potentially avoid self-employment tax and new 3.8% Medicare tax on NII 40

Other Types of US Funds Distressed Debt Typically structured similar to hedge funds with same general issues Distressed debt-specific issues Portfolio ol o Interest est Market Discount; OID Recovery of basis treatment for deeply discounted debt? Loan origination activities Workouts/loan modifications resulting in reissuances/deemed new originations Season and Sell other strategies to avoid being considered in loan origination/active financing business Impact of 2009 GLAM (Chief Counsel Mem. AM2009010) 41

Foreign Investment in Real Property Tax Act (FIRPTA) In general, non-us persons generally do not pay U.S. tax on disposals of stock or securities of U.S. issuers FIRPTA is an exception to this general treatment FIRPTA imposes a tax on gains realized from the disposition of a U.S. real property interest, which includes direct real estate holdings and: Partnership/flow-throughs that hold U.S. real estate Interests in a U.S. real property holding corporation (USRPHCs) Direct or indirect rights to share in proceeds, appreciation or profit of U.S. real estate 42

FIRPTA (cont d) USRPHCs FIRPTA also applies to companies where at least half of the fair market value of the company s trade or business assets is attributable to U.S. real property assets Five-year lookback Carve-out for investments in publicly traded stocks where the investor does not hold more than 5% of the class of stock being traded FIRPTA Traps Distressed companies Publicly traded stock de-listed 43

FIRPTA (cont d) Tax imposed at U.S. tax rates Collected partially through withholding Gains treated as ECI Non-U.S. US person with FIRPTA gain also incurs a US U.S. federal income tax filing obligation Branch profits tax may also apply 44

FIRPTA (cont d) U.S. blockers frequently used to hold U.S. real estate assets, which blocks application of FIRPTA tax and filing obligations Note, however, that the U.S. blocker itself may be a USRPHC which would trigger FIRPTA gain if sold (unlikely exit) Trap for unwary: Section 1445(e) withholding on nondividend distributions from a USRPHC 45

FIRPTA (cont d) Non-U.S. Fund Non-U.S. Investments (No FIRPTA) U.S. Non-Real Estate Investments (No FIRPTA) U.S. Corp. Blocker U. S. Real Estate Investments t 46

FIRPTA (cont d) Non-U.S. Fund Financing the U.S. Blocker: Potential Complications (Withholding Tax, Earnings Stripping, AHYDO, Section 267) Offshore Blocker Non-U.S. Investments (No FIRPTA) U.S. Non-Real Estate Investments (No FIRPTA) U.S. Corp. Blocker U. S. Real Estate Investments Loan Interest 47

U. S. Tax Exempt Investors: 514(c)(9) Certain tax-exempt investors ( Qualified Organizations, or QOs) are eligible for an exception to debt-financed UBTI in certain circumstances Most common QOs are pension funds and educational organizations Provided certain requirements are met, Section 514(c)(9) provides that t debt incurred to acquire or improve real property won t give rise to UBTI for QOs Definition of real property unclear Compliance with 514(c)(9) poses challenges, particularly for funds 48

U. S. Tax Exempt Investors (cont d): 514(c)(9) Section 514(c)(9): General Requirements for Debt- Financed Acquisition of Real Estate Purchase Agreements Borrowing Agreements General rule Eligible lenders Multi-property loans Leasing Agreements 49

U. S. Tax Exempt Investors (cont d) : 514(c)(9) Requirements for a 514(c)(9)-Compliant Fund Fund must comply with general requirements AND All of the partners must be QOs, or Each allocation to a QO Partner must be a Qualified Allocation, or The partnership s allocation provisions for tax purposes: Satisfy the Fractions Rule, and Have Substantial Economic Effect Pt Potential til Legal and Economic Consequences of complying with the Fractions Rule and the Substantial Economic Effect Rules 50

Non U.S. Funds with U.S. Investments Same general structural considerations as above Non-U.S. Investors will be focused on ECI If fund holds real estate assets, FIRPTA may also apply Special structuring requirements for non-u.s. investors Treaty planning and additional documentation requirements Non-U.S. corporation in structure (including offshore blocker entity)? Potential branch profits tax US U.S. source income = FATCA implications for fund and its investors 51

Non U.S. Funds with U.S. Investors: Investing Overseas Some considerations: PFIC/CFC issues (want non-u.s. fund to be pass-through) Tax filing obligations in non-u.s. jurisdictions Non-U.S. withholding tax Treaty analysis U.S. tax-exempt investors will still be concerned about UBTI, and may wish to invest through a blocker if there will be debt-financing or investments in operating pass-throughs Certain countries (India, China) have begun imposing tax on indirect gains, which has led to an increase in the use of filing blockers 52

US Funds Investing Overseas Same general structural considerations as have been illustrated, with some additions UBTI on debt-financed investments/pass-through income Treaty benefits PFIC/CFC Foreign tax credit flow-through Commercial activities income still a concern for controlled commercial entities (but 892 benefits generally irrelevant) Some of these are incompatible E.g., flow-through structures for taxable investors, but UBTI issues for tax-exempts 53

US Funds Investing Overseas Parallel Funds US U.S. Taxable/U.S. /US Non-U.S./U.S. S/ S Government Investors Tax-Exempt Investors Fund (taxed as Fund partnership) (taxed as corporation) Non-U.S. Investments 54

US Funds Investing Overseas Master/Feeder US U.S. Taxable/U.S. Taxable/US Government Investors Non-U.S./U.S. US/US Tax-Exempt Investors Feeder Fund (taxed as corporation) Master Fund (taxed as partnership) Non-U.S. Investments 55

US Funds Investing Overseas (cont d) PFIC/CFC issues for US taxable investors Anti-deferral regimes PFIC - 50% passive assets or 75% passive income Look-through 25% owned subsidiaries Recharacterization of distributions, gain as ordinary income + penalty interest charge No chance for qualified dividend income 56

US Funds Investing Overseas (cont d) Make check the box election to treat as a pass-through Can be difficult to persuade local owners to make US tax election QEF Election modified look-through Losses and FTCs generally don t flow through Often covenants to make election and obtain information to make US tax filings Can be burdensome for funds to gather required information, including from 25% owned subsidiaries 57

US Funds Investing Overseas (cont d) CFC more than 50% of a foreign corporation owned by U.S. Shareholders U.S. persons with 10% or more voting power U.S. partnership p = 1 U.S. person Structure Fund and management entities as Cayman vehicles to apply 10% voting power test on look-through basis Or elect to treat foreign portfolio corporation as a passthrough 58

Luxembourg Investment Structure into Europe U.S. Investors Luxco set up with minimal capital Cash U.S. Main Fund LP Luxco PECs CPECs PECs yield 8% per year CPECs can be redeemed for FMV of shares into which CPECs are convertible 59 Cash German Portfolio Company CTB to be Taxed as a Disregarded d Entity PECs and CPECs Debt for Luxemburg tax purposes Equity for U.S. tax purposes (99/1 debt -equity ratio)

Luxembourg Investment Structure into Europe (cont d) CTB to be Taxed as a Disregarded Entity U.S. Investors U.S. Fund LP Luxco German Portfolio Company Dividends Capital Gains Dividends Capital Gains Little or no Lux withholding tax Luxco benefits from EU tax treaties Luxco disregarded for U.S. tax purposes Some US tax issues: debtequity (including debt maturity); Section 305 60

Issue for Canadian Investors in U.S. Fund US Canadian Canadian Investors Corporation Pension Fund (Taxable) (Non Taxable) U.S. Fund Main LP U.S. Portfolio U.S. Blocker LP Distribution Distribution CTB to be Taxed as a Corporation Canada treats U.S. Blocker LP as a partnership Under U.S.-Canada tax treaty, U.S. 30% withholding tax applies (hybrid entity) Avoided if U.S. Portfolio LP is instead an LLC 61

Another Issue for Canadian Investors Canadian Corporation (Taxable) Canadian Pension Fund (Non Taxable) US Investors U.S. Main Fund LP U.S. Portfolio LLC U.S. Corporation Canada treats t LLC as a corporation Dividendsid d CTB to be Taxed as a Corporation Under U.S.-Canada tax treaty, U.S. 30% withholding tax applies (hybrid entity) Avoided if U.S. Portfolio LLC is instead U.S. Portfolio LP 62

Structuring Fund Manager Entities Funds generally have separate General Partners and Investment Managers GP (or special LP owned by principals) receives carried interest Generally special purpose entity for each fund Investment Manager receives management fees Generally single Management Company across all funds Employees, contracts Franchise value 63

Structuring Fund Manager Entities (cont d) Reasons for separation? Ensure proper tax treatment of separate income streams Carried interest capital gains Management fees ordinary income State/local tax reasons NYC unincorporated business tax Often separate ownership stakes Carried interest more widely distributed than ownership of Management Company Deal-by-deal; fund-by-fund 64

Structuring Fund Management Entities (cont d) Limited it Partners Pi Principalsi Carried interest General Partner Management Company Fund Management Fees Investments 65

Structuring Fund Manager Entities (cont d) Considerations? Management Company Choice of Entity S corp limited flexibility; state tax issues; perhaps avoid self-employment taxes on dividends LLC flexibility; self-employment taxes on distributive share of fee income? LP flexibility; requires separate GP entity; avoid self- employment taxes on distributive share of fee income Statutory exception from SECA for distributive share of a limited partner Impact of Renkemeyer? 66

Structuring Fund Manager Entities (cont d) Considerations? General Partner Choice of Entity Less of an issue than Management Company as all distributions should avoid self-employment taxes Use of LP arguably avoids new Medicare tax on NII General Partner Issuances of Interests; Vesting Issuance of profits interest; no interest in current value 83(b) election Catch-up allocations Vesting/forfeiture/allocations to other partners 67

Foreign Account Tax Compliance Act (FATCA) Foreign Account Tax Compliance Act or FATCA, is generally effective as of January 28, 2013 Intended to ensure that U.S. persons holding assets through offshore entities and accounts pay U.S. taxes on related income Compels non-u.s. financial entities to either (1) document and report information about their U.S. accountholders/investors or (2) face a withholding tax of 30% on most U.S. source gross income or gross proceeds 68

FATCA (cont d) FATCA does not replace the current withholding and reporting regime for non-u.s. US persons FATCA is intended to be coordinated with the current regime in order to prevent double withholding While FATCA is generally effective as of January 28, 2013, a phased implementation timeline applies FATCA has a global reach It imposes new documentation, withholding and reporting requirements not only on non-u.s. entities, but also on certain U.S. financial entities 69

FATCA (cont d) Categories Under Regulations U.S. Withholding Agents U.S. hedge and private equity funds may be required to act as withholding agents under FATCA Foreign Financial Institutions (FFIs) Non-U.S. funds likely FFIs Multiple categories: Participating FFI, Deemed Compliant FFI, and Non-Participating FFI Non-Financial Foreign Entities (NFFEs) Exempt Beneficial Owners Generally not subject to FATCA withholding as long as necessary documentation is provided to withholding agent 70

FATCA (cont d) Withholding Under FATCA FFIs: 30% of any withholdable payment paid to nonparticipating FFIs and recalcitrant account holders Tiered implementation of withholdable payments 2014: U.S. source FDAP income 2017: U.S. source gross proceeds on sale of stock or securities 2017: foreign pass-through payments Other withholding agents: Non-FFI withholding agents must withhold 30% of any withholdable payment paid to non-participating FFIs and passive NFFEs that fail to report on their significant U.S. owners Withholding agent broadly construed under FATCA 71

FATCA (cont d) Two-pronged approach to FATCA compliance IRS Regulations Intergovernmental Agreements (IGAs) Important Guidance to Come FFI Model Agreement, Registration Portal, Tax Certificates, FATCA Reporting Form, Withholding Reports Coordinating guidance, plus guidance on foreign pass-through payments IGAs 72

FATCA (cont d) U.S. Funds: U.S. Withholding Agents Withholding ihhldi by U.S. Fund: If an investor fails to provide necessary information to U.S. Fund, 30% FATCA withholding may be deducted from investor s share of withholdable payments Tax withheld under FATCA is paid by U.S. Fund to IRS 73

FATCA (cont d) Non-U.S. Funds (and non-us blockers): Are they FFIs? Definition of FFI in the final regulations includes (among others) foreign investment entities 74 Broad definition of investment entities Most non-u.s. funds will be FFIs, with the exception of certain real estate funds No credit or refund of 30% withholding tax if fund or blocker is treated as corporation for U.S. tax purposes and treaty does not change result Does every FFI need to comply with FATCA? Material U.S. source income? Legal and practical considerations Various classifications for compliant FFIs

FATCA (cont d) Special Considerations for Funds Organized as Partnerships for U.S. Tax Purposes FATCA withholding applies not just to withholdable payments, but also to allocations of income Timing of FATCA withholding on a partnership s receipt of gross proceeds is unclear Regulations don t address how the sale of a partnership interest will be treated under FATCA 75

FATCA (cont d) FATCA and Fund Documentation Fund organizational and operational documents Operating agreements Investor subscription documents and account applications Fund offering documents Side letters Service provider agreements (transfer agent, custodian, administrator, withholding agent, adviser, etc) Credit agreements/isdas/repo & securities lending agreements 76

New 3.8% Medicare Contribution Tax Imposed on U.S. individuals taxpayers, and estates and trusts Not imposed on corporations or pass-through entities but net investment income passes through to U.S. individuals, and estates and trusts Not imposed on non-resident individuals Effective date: January 1, 2013 77

New 3.8% Medicare Contribution Tax (cont d) The Medicare contribution tax is 3.8% on the lesser of: Net investment income or The excess of modified adjusted gross income (MAGI) over the applicable threshold amount The threshold amounts are: Married individuals filing jointly - $250,000 Married individuals filing separately - $125,000 Qualifying widow(er) with dependent child - $250,000 Trust and estates - $11,950 for 2013 78

New 3.8% Medicare Contribution Tax (cont d) Three Buckets of Net Investment Income: Gross income from interest, dividends, annuities, royalties, and rents Gross income derived from a business constituting a passive activity to the taxpayer under IRC Section 469 (and gross income derived from a trade or business comprised of trading in financial instruments or commodities) Net gains from the disposition of property, such as the sale of stocks, partnership interests, bonds, and real estate Under proposed regs, the first two buckets can be negative and offset other buckets, but the third bucket cannot 79

New 3.8% Medicare Contribution Tax (cont d) U.S. Taxable Individual (and certain Trust and Estate) Investors 3.8% nii Other Investors - Gain on stock sale - Dividends - Interest - Gain on debt sale Portfolio Corp. Fund L.P. - Gain on interest sale - Gain on asset sale - Interest - Gain on debt sale Portfolio LLC 80

New 3.8% Medicare Tax Impact on Fund Managers and Planning Carried Interest Passive investment income subject to new tax Additional 3.8% tax on top of 20% LTCG (or 39.6% for interest, STCG and nonqualified dividend income) Incentive compensation in hedge fund? If paid as fee, may be subject to 3.8% self-employment employment tax unless qualifying for LP exception or perhaps flowing through as S corp dividends (but see next slide) If paid as allocation, subject to new Medicare tax Even if fund is a trader hedge fund 81

New 3.8% Medicare Tax (cont d) Impact on Fund Managers and Planning Carried Interest Passive investment income subject to new tax Additional 3.8% tax on top of 20% LTCG (or 39.6% for interest, STCG and nonqualified dividend income) Incentive compensation in hedge fund? If paid as fee, may be subject to 3.8% self-employment employment tax (but see next slide) If paid as allocation, subject to new Medicare tax Even if fund is a trader hedge fund 82

New 3.8% Medicare Tax (cont d) Planning Opportunities More incentive for deferral transactions 1031s gain not picked up under NII rules until recognized Restructure carried interests as incentive fees If majority of income is already ordinary (STCG, interest, rent, royalties) If carried interest is taxed as OI, further incentive to convert fees (even if self-employment taxes would apply as the new Medicare tax is nondeductible against recipient s income) Potential bad result for taxable investors in fund due to 212 limitation on deductibility of incentive fee 83

New 3.8% Medicare Tax (cont d) Planning Opportunities Convert LLCs to S Corps or LPs Trade or business income paid as dividends by an S corp to its shareholders that materially participate is not subject to the tax Member in LLC on same facts arguably subject to selfemployment taxes on same income Meaning of Materially participating going to be very important 84

New 3.8% Medicare Tax (cont d) Planning Opportunities Using corporations Corporations pay low tax rates on income up to $50,000. Incentive fees up to such amounts could be paid to a corporation owned by Fund manager Dividend out of corporation subject to 20% top federal tax + 3.8% NII tax Effective federal tax rate of 35.8% as compared with 43.4% State and local taxes to be considered Potential double state tax 85

What is a Carried Interest? Private equity and hedge fund managers structure funds with a 2 & 20 compensation structure Fixed percentage of gains over losses Typically y 20% Often, most income/gain allocated to the 20% carry is taxed at favorable capital gain rates New legislation would apply to the 20% carry 86

Carried Interest Tax Proposals In President Obama s 2014 budget Proposed legislation to add new IRC section 710 Proposal would tax as ordinary income a fund manager s share of income from an investment services partnership interest in an investment partnership Or a portion, i.e,. 50% if the investment is held for five years or more Applies to old and new partnerships (no grandfathering) 87

Carried Interest Tax Proposals (cont d) Applies to persons (or related persons) who: Directly or indirectly provide any of the following services with respect to assets held (directly or indirectly) by the partnership: Advising on investing in, purchasing, or selling a specified asset Managing, g, acquiring, or disposing of a specified asset Arranging financing with respect to a specified asset; or Any activity in support of any of the previously described activities 88

Definition of Specified Assets The term specified asset means: Securities (section 475(c)(2)) Real estate held for rental or investment Partnership interests Commodities (section 475(e)(2)) Options or derivative contracts with respect to these assets 89

Some Partnerships Covered Include: Private equity funds Hedge funds Venture capital funds LBO funds Real estate funds and partnerships Marketable securities funds and partnerships Oil and gas funds and partnerships??? 90

Some Partnerships Not Covered: Partnership operates an active business E.g., profits interests are issued to service providers by an LLC that operates a manufacturing business Obama budget: proposal is not intended to affect qualification of a REIT owning a carried interest in a real estate partnership 91

Tax Acceleration Tax on Carried Interest is accelerated if: Carried Interest holder transfers Carried Interest (even transfers to family partnerships or REIT operating partnerships) Carried Interest holder receives property distributions from the partnership Partnership merges into another partnership In limited cases the Carried Interest holder can elect to avoid the gain if the Carried Interest taint is carried over to the new partnership (e.g., a partnership merger, division or termination under section 708(b)(1)(B)) 92

Other Consequences Where an individual is engaged in the trade or business of providing specified services, income taken into account as ordinary income would become subject to self-employment tax This is regardless of whether the partner is a limited partner and regardless of whether the underlying partnership income would be exempt from self- employment tax (e.g., dividends, interest, capital gain) Net income and net loss generally is treated as ordinary The idea is that Carried Interest is compensation income and should not receive tax losses like an investment 93

Qualified Capital Exception Carried Interest holder can exclude Qualified Capital that is acquired for invested capital and intended to be the side-by-side capital such holder puts in with the investors To apply the rule, there must be an unrelated investor who contributes cash in exchange for a capital interest on the same basis as the Carried Interest holder One exception: Carried Interest rule does not apply if all allocations, distributions and capital contributions have been pro rata 94

Qualified Capital Exception Loans Carried Interest holder will not be treated as having a Qualified Capital Interest to the extent that contributed capital is attributable to a loan made or guaranteed, directly or indirectly, by any other partner or the partnership (or a person related to such partner or the partnership) Other loans to Carried Interest holder are not disqualified 95 95

Sale of Interests in Fund Manager Entity A B C A, B and C Sell LLC Interests XYZ Fund Managers Goodwill LLC Investors GP 20 GP 20 % % LP LP Investors Obama budget: committed to working with Congress to develop mechanisms to assure the proper amount of income recharacterization where the business has goodwill or other assets unrelated to services 96

Fund Documents Key Tax Provisions Offering Memorandum Limited Partnership Agreement Subscription Documents Side Letters Tax Opinions 97

Fund Documents Key Tax Provisions Private Placement Memorandum Summary of key tax provisions General overview of tax treatment Limited Partnership Agreement (Operating Agreement) Examples of key tax-related provisions: ECI and UBTI Covenants GP Clawback Management fee waivers Management fee offsets Withholding Allocations Tax Distributions Non-U.S. Taxes and Returns Tax information reporting Tax matters partner 98

Fund Documents Key Tax Provisions (cont d) Subscription Documents Investor tax representations PTP representations Transfer restrictions Electronic K-1 consent Side Letters PFIC/QEF election and CFCs Foundation issues ERISA issues Tax reporting, and much more Tax Opinions Partnership Tax Opinion 514(c)(9) Opinion Prohibited transactions 892 Non-U.S. Governmental Investors Non-U.S. investor-specific issues 99

Today s Speakers Christian McBurney, Partner, Nixon Peabody LLP, Washington, D.C. Office, (202) 585-8358, 8358 cmcburney@nixonpeabody.com Jeremy Naylor, Partner, White & Case, New York City Office, (212) 819-8760, jnaylor@whitecase.com Elizabeth Norman, Associate, Goulston & Storrs, Boston Office, (617) 574-3568, enorman@goulstonstorrs.com 100