meetings.abanet.org

TAX ISSUES IN PRIVATE EQUITY TAX ISSUES IN PRIVATE EQUITY

& VENTURE CAPITAL& VENTURE CAPITAL

TAX ISSUES IN PRIVATE EQUITY TAX ISSUES IN PRIVATE EQUITY

& VENTURE CAPITAL& VENTURE CAPITAL

ABA Section of Business LawABA Section of Business LawAugust 12, 2007August 12, 2007

Julie Divola Jonathan Axelrad Julie Divola Jonathan Axelrad Pillsbury Winthrop Shaw Pittman LLP Wilson Sonsini Goodrich & RosatiPillsbury Winthrop Shaw Pittman LLP Wilson Sonsini Goodrich & Rosati

John Lorito John Simon John Lorito John Simon Stikeman Elliott LLP Stikeman Elliott LLP KPMG LLP KPMG LLP

Introduction to VC/PE Introduction to VC/PE Fund StructuresFund Structures

plusplusUpdate on Proposed Update on Proposed

Changes to Taxation of Changes to Taxation of Carried InterestCarried Interest

3

IntroductionIntroduction

Venture Capital and Private Equity (VC/PE) firms traditionally have used partnership structures for the “Funds” that they use to raise capital and make investments

These structures vary significantly and have evolved over time

Key considerations are tax, securities law, alignment of interests, difficulty of valuing private securities, and liability compartmentalization

This presentation briefly provides an overview of certain “typical” fund structures, primarily from a VC perspective

Special Bonus! A brief update on proposed changes to the taxation of carried interest

4

Traditional Fund StructureTraditional Fund Structure

Portfolio Securities

ROIManagement FeeCarry

Investors (LP)

$99%

ROI

VCs

MM/MD

$1%

Key:L.L.C. = Limited Liability CompanyLP = Limited PartnerL.P. = Limited PartnershipMM/MD = Managing Member or Managing DirectorROI = Return on Invested CapitalAll entities are organized under Delaware law.

Fund, L.P.

General Partner, L.L.C.

5

Traditional with Back-Office/Management Co.Traditional with Back-Office/Management Co.

VCs


$99%ROIManagement FeeCarry

ROI

MM/MD

$1%

Key:L.L.C. = Limited Liability CompanyLP = Limited PartnerL.P. = Limited PartnershipMM/MD = Managing Member or Managing DirectorROI = Return on Invested Capital

All entities are organized under Delaware law.Management Co. has perpetual life and may provide services to multiple General Partner entities. All other entities are single-purpose and limited-term.

ManagementCo., L.L.C.

Venture Firm NameOffice Equipment/Lease

Payroll SystemStaff Relationships

Assign Management Fee

Back-Office Services


MM/MD

Fund, L.P.

Investors (LP)

6

Structure Often Includes Many Parallel EntitiesStructure Often Includes Many Parallel Entities

Notes:

1. Qualified Purchaser funds admit only investors that are “qualified purchasers” under the Investment Company Act of 1940 typically, individuals holding >$5 million, and entities holding >$25 million, in investment assets).

2. Affiliates funds have reduced/zero fees/carry.3. Non-MFO fund does not have an offset against management fees for directors fees, etc. received by

VCs from portfolio companies.4. Principals fund allows VCs and their family/estate planning vehicles to co-invest on a tax-efficient,

pro rata basis. It actually holds title as a mere nominee on behalf of its partners.

VCs


QualifiedPurchaser Fund, L.P.

Investors Investors

Non-QualifiedPurchaser Fund, L.P.

Investors

Qualified PurchaserAffiliates Fund, L.P.

Investors

Non-Qual. Purchaser Affiliates Fund, L.P.

Non-MFO Fund, L.P.


Principals Fund, L.P.


Investors (Non-U.S.)

7

Alternative Structure For Principals FundAlternative Structure For Principals Fund


Investors


Principals Fund, L.L.C.

Series 1 Series 2

Main Fund, L.P.

AC = Additional Capital

ACAC

Fund Manager 2Fund Manager 1

8

Sample Alternative For International Investing -- IndiaSample Alternative For International Investing -- India

FVCI Sub Mauritius Co.

FII Sub Mauritius Co.

Private Indian Investments Public Indian Investments

AdvisoryAgreement

Limited Partners

Fund Cayman Islands LP

Advisory Co Indian Co.

General Partner

9

Proposed Changes to Taxation of Carried InterestProposed Changes to Taxation of Carried Interest

S. 1624S. 1624

Would amend IRC Sec. 7704(c) to eliminate corporate Would amend IRC Sec. 7704(c) to eliminate corporate tax exemption for publicly traded partnerships with 90% tax exemption for publicly traded partnerships with 90% passive incomepassive incomeCovers partnerships “providing certain investment Covers partnerships “providing certain investment adviser and related asset management services”adviser and related asset management services”Often called the “Blackstone Bill” because thought to Often called the “Blackstone Bill” because thought to have been triggered by recent/proposed IPOs of large have been triggered by recent/proposed IPOs of large PE firmsPE firmsNot expected to have a huge impact on VC/PE industry Not expected to have a huge impact on VC/PE industry because so few firms in a position to go publicbecause so few firms in a position to go public

10


H.R. 2834H.R. 2834

Would add new IRC Sec. 710 to treat carried interest “distributive share” as Would add new IRC Sec. 710 to treat carried interest “distributive share” as ordinary income for the performance of services, regardless of character of ordinary income for the performance of services, regardless of character of partnership’s underlying incomepartnership’s underlying incomeEssentially based on a profit share that is disproportionately large relative Essentially based on a profit share that is disproportionately large relative to capital contributionto capital contributionApplies if there is provision of investment services in the active conduct of Applies if there is provision of investment services in the active conduct of a trade or businessa trade or business

Not clear how this would apply to a traditional fund structure, under Not clear how this would apply to a traditional fund structure, under which neither Fund nor General Partner typically would be engaged in which neither Fund nor General Partner typically would be engaged in a “trade or business”a “trade or business”

Per statements from Congress, intended to cover nearly all private Per statements from Congress, intended to cover nearly all private investment partnerships, including VC/PE, real estate, oil and gas, etc.investment partnerships, including VC/PE, real estate, oil and gas, etc.This bill is really just a first draft This bill is really just a first draft

Many technical issues/glitchesMany technical issues/glitchesHearings in processHearings in process

11


H.R. 2834 (cont)H.R. 2834 (cont)

Extremely controversialExtremely controversialApparent loophole closer – rich fund managers paying capital Apparent loophole closer – rich fund managers paying capital gains taxes on income from their advisory servicesgains taxes on income from their advisory servicesLeading Democrats voicing support (Clinton, Obama, Edwards)Leading Democrats voicing support (Clinton, Obama, Edwards)Republicans generally oppose (Treasury Dept., etc.)Republicans generally oppose (Treasury Dept., etc.)Lobbyists heavily engaged, with focus on Lobbyists heavily engaged, with focus on

International competitiveness (fund managers moving International competitiveness (fund managers moving offshore; foreign investors outbidding for US investments)offshore; foreign investors outbidding for US investments)Impairment of innovation and capital formationImpairment of innovation and capital formationComparison with “founders stock” (if entrepreneurs can get Comparison with “founders stock” (if entrepreneurs can get capital gains treatment when their companies appreciate, capital gains treatment when their companies appreciate, why not VC/PE managers who also work hard for the why not VC/PE managers who also work hard for the companies’ success?)companies’ success?)

12


H.R. 2834 (cont)H.R. 2834 (cont)

It will be difficult for Congress to craft a statute that It will be difficult for Congress to craft a statute that can’t be structured aroundcan’t be structured around

At least without vast changes to the IRCAt least without vast changes to the IRCSee lack of success in shutting down See lack of success in shutting down swap/exchange funds, despite several targeted swap/exchange funds, despite several targeted IRC amendments IRC amendments

Lack of definitive statutory text (assuming current Lack of definitive statutory text (assuming current bill really is just a first draft) makes it difficult to bill really is just a first draft) makes it difficult to estimate what structures will be helpfulestimate what structures will be helpful

Nevertheless . . .Nevertheless . . .

13


H.R. 2834 (cont)H.R. 2834 (cont)

Potential gold mine for tax lawyersPotential gold mine for tax lawyersThe stakes are high enough to pay for almost any The stakes are high enough to pay for almost any degree of complex structuringdegree of complex structuringExample: Assume $1 billion fund, which yields a 3x Example: Assume $1 billion fund, which yields a 3x returnreturn

20% carry to GP: $400 million20% carry to GP: $400 millionOrdinary income vs. LTCG tax differential: $80 Ordinary income vs. LTCG tax differential: $80 millionmillion» Employment taxes and timing differences would Employment taxes and timing differences would

make spread even largermake spread even largerIf the bill (or anything like it) passes . . .If the bill (or anything like it) passes . . .

14

Expect This: Expect This:

VCs


QualifiedPurchaser Fund, L.P.

Investors Investors

Non-QualifiedPurchaser Fund, L.P.

Investors

Qualified PurchaserAffiliates Fund, L.P.

Investors

Non-Qual. Purchaser Affiliates Fund, L.P.

Non-MFO Fund, L.P.


Principals Fund, L.P.


Investors (Non-U.S.)

15

To Be Replaced By This:To Be Replaced By This:

Tax Issues in Private Tax Issues in Private Equity and Venture Equity and Venture Capital: Capital:

Blocker CorporationsBlocker Corporations

Taxation of Pass-Through Taxation of Pass-Through Entities vs. CorporationsEntities vs. CorporationsTaxation of Pass-Through Taxation of Pass-Through Entities vs. CorporationsEntities vs. Corporations

18

Pass-Through EntitiesPass-Through Entities

What is a Pass-Through Entity?What is a Pass-Through Entity?An entity in which, for Federal income tax purposes, all An entity in which, for Federal income tax purposes, all of the income and losses of the entity flow through and of the income and losses of the entity flow through and are taxed to the owners of the entityare taxed to the owners of the entityOwners are taxed directly on the entity-level income, Owners are taxed directly on the entity-level income, regardless of whether cash is distributedregardless of whether cash is distributedIncome maintains same character (e.g. capital gain)Income maintains same character (e.g. capital gain)

Examples of Pass-Through Entities:Examples of Pass-Through Entities:

PartnershipsPartnershipsS CorporationsS CorporationsLimited Liability CompaniesLimited Liability Companies

19

CorporationsCorporations

C corporations are subject to “double taxation”C corporations are subject to “double taxation”

Income of a corporation is taxed first at the corporate level Income of a corporation is taxed first at the corporate level Shareholders of a corporation are not directly taxable on this Shareholders of a corporation are not directly taxable on this income income

Second level of tax is at the shareholder level - when a Second level of tax is at the shareholder level - when a corporation distributes the income in the form of dividends, the corporation distributes the income in the form of dividends, the shareholders pay tax shareholders pay tax

Not a direct share of entity incomeNot a direct share of entity income

Dividends, return of capital, capital gainDividends, return of capital, capital gain

Private Equity FundsPrivate Equity FundsPrivate Equity FundsPrivate Equity Funds

21

Private Equity FundsPrivate Equity Funds

Private equity funds (“Funds”) are organized frequently as Private equity funds (“Funds”) are organized frequently as entities classified as partnerships (pass-through entities) entities classified as partnerships (pass-through entities) for Federal tax purposes for Federal tax purposes

LLCsLLCsLimited PartnershipsLimited Partnerships

Typical Fund investors include:Typical Fund investors include:State pension plansState pension plansOther tax-exempt organizations Other tax-exempt organizations Corporate sponsored retirement plans Corporate sponsored retirement plans Foreign investors Foreign investors Other U.S. investors Other U.S. investors

22

Significance of Types of Fund InvestorsSignificance of Types of Fund Investors

Tax-exempt and foreign investors generally qualify for Tax-exempt and foreign investors generally qualify for certain exemptions from U.S. federal income taxcertain exemptions from U.S. federal income tax

However:However:Tax-exempt investors are taxed on Tax-exempt investors are taxed on Unrelated Unrelated Business Taxable IncomeBusiness Taxable Income (“UBTI”) (“UBTI”)Foreign investors are taxed on Foreign investors are taxed on Effectively Connected Effectively Connected IncomeIncome (“ECI”) (“ECI”)

23

Significance of Types of Fund InvestorsSignificance of Types of Fund Investors

If a Fund that is classified as a pass-through entity has UBTI or ECI, its tax-exempt or foreign owners may be required to pay U.S federal income tax on such income because the income flows through to them

Requires filing US tax return

What is UBTI?What is UBTI?What is UBTI?What is UBTI?

25

Unrelated Business Income TaxUnrelated Business Income Tax

Overview and General RulesOverview and General Rules

Internal Revenue Code (“IRC”) Section 501 grants tax Internal Revenue Code (“IRC”) Section 501 grants tax exempt status to a variety of tax-exempt and mutually exempt status to a variety of tax-exempt and mutually beneficial organizationsbeneficial organizations

IRC Section 511 may tax otherwise tax-exempt IRC Section 511 may tax otherwise tax-exempt organizations on their unrelated business income (the organizations on their unrelated business income (the “Unrelated Business Income Tax,” or “UBIT”) “Unrelated Business Income Tax,” or “UBIT”)

Unrelated Business Taxable Income (“UBTI”) is income Unrelated Business Taxable Income (“UBTI”) is income from a trade or business regularly carried on by an exempt from a trade or business regularly carried on by an exempt organization that is not substantially related to the organization that is not substantially related to the organization’s exempt purposeorganization’s exempt purpose

26

Unrelated Business Taxable Income Unrelated Business Taxable Income

The following are excluded from UBTI unless The following are excluded from UBTI unless they are derived from debt-financed property, they are derived from debt-financed property, or, in the case of interest, from controlled or, in the case of interest, from controlled organizations:organizations:

Gains from the sale of stockGains from the sale of stockInterest Interest DividendsDividends

27

Sources of UBTISources of UBTI

For private investment funds the principal For private investment funds the principal areas of concern are:areas of concern are:

Fund investments in portfolio pass-Fund investments in portfolio pass-through entitiesthrough entitiesUnrelated debt-financed incomeUnrelated debt-financed incomeFees earned by the FundFees earned by the Fund

28

Sources of UBTI – Operating PartnershipsSources of UBTI – Operating Partnerships

Unrelated trade or business of a partnership is Unrelated trade or business of a partnership is imputed to the tax-exempt partnersimputed to the tax-exempt partners

The tax-exempt partner’s share of the income The tax-exempt partner’s share of the income for the trade or business is UBTI for the trade or business is UBTI

Trade or business can be attributed up through Trade or business can be attributed up through partnershipspartnerships

If a Fund invests in a pass-through entity that If a Fund invests in a pass-through entity that is engaged in a trade or business, a tax-is engaged in a trade or business, a tax-exempt partner’s share of the entity’s income exempt partner’s share of the entity’s income would be UBTI would be UBTI

29

Portfolio Investments in Partnerships?Portfolio Investments in Partnerships?

Why would a Fund invest in a partnership?Why would a Fund invest in a partnership?

Existing target is a partnership (e.g. an LLC)Existing target is a partnership (e.g. an LLC)

Single level of tax on target earningsSingle level of tax on target earningsStepped up basis from earned incomeStepped up basis from earned income

Exit strategy: sale of partnership can give buyer stepped-Exit strategy: sale of partnership can give buyer stepped-up basis in target assetsup basis in target assets

May result in higher sale priceMay result in higher sale price

Tax DistributionsTax Distributions

30

Partnership acquisition structurePartnership acquisition structure

Fund can get basis step up through 754 election

Maintains single level of tax

May avoid potential anti-churning problem

Next buyer can get basis step up on sale of New Portfolio LLC

Target

NewPortfolio

Sellers

Fund

Investors

Target Assets

31

Unrelated debt-financed incomeUnrelated debt-financed income

Capital gain, interest and dividends normally Capital gain, interest and dividends normally excluded from UBTI are treated as UBTI to the excluded from UBTI are treated as UBTI to the extent the property generating the income is extent the property generating the income is financed by debtfinanced by debt

Includes both direct debt of the investor and Includes both direct debt of the investor and investor’s allocable share of Fund or portfolio investor’s allocable share of Fund or portfolio company (if a pass-through) debtcompany (if a pass-through) debt

32

Sources of UBTI – FeesSources of UBTI – Fees

Fees may constitute UBTIFees may constitute UBTI

May result from dealings with a portfolio companyMay result from dealings with a portfolio company

Examples include:Examples include:

Management and monitoring feesManagement and monitoring fees

Origination and commitment feesOrigination and commitment fees

Break-up and finder’s feesBreak-up and finder’s fees

Underwriting commissions Underwriting commissions

Other transaction-related paymentsOther transaction-related payments

What is ECI?What is ECI?What is ECI?What is ECI?

34

Effectively Connected IncomeEffectively Connected Income

Overview and General RulesOverview and General Rules

Section 871(b) subjects foreign persons to U.S. federal Section 871(b) subjects foreign persons to U.S. federal income tax on income effectively connected with the income tax on income effectively connected with the conduct of a trade or business within the U.S. conduct of a trade or business within the U.S.

Section 875 treats a foreign person that is a partner in a Section 875 treats a foreign person that is a partner in a partnership as being engaged in any trade or business in partnership as being engaged in any trade or business in which the partnership is engaged which the partnership is engaged

Both the Fund and the foreign investors are deemed to be Both the Fund and the foreign investors are deemed to be engaged in the U.S. trade or business in which any of the engaged in the U.S. trade or business in which any of the portfolio companies taxed as pass-through entities are portfolio companies taxed as pass-through entities are engaged engaged

35

Consequences of ECIConsequences of ECI

ECI generated by the portfolio company is taxed ECI generated by the portfolio company is taxed on a net basis in the same manner and at the on a net basis in the same manner and at the same rates as income of a U.S. personsame rates as income of a U.S. person

The foreign investor must file a U.S. tax return, The foreign investor must file a U.S. tax return, regardless of whether it actually recognizes regardless of whether it actually recognizes income in any given yearincome in any given year

36

Sources of ECISources of ECI

In private investment funds, the principal In private investment funds, the principal areas of concern are:areas of concern are:

Fund investments in portfolio pass-through Fund investments in portfolio pass-through entitiesentities

Investments in U.S. real property interestsInvestments in U.S. real property interests

Fees earned by the FundFees earned by the Fund

37

Sources of ECI – Fund Investments in Portfolio Pass-Through EntitiesSources of ECI – Fund Investments in Portfolio Pass-Through Entities

If a Fund invests in a pass-through entity that is engaged in a trade or business, a foreign partner’s share of the entity’s income would be ECI

A portion of any gain realized by the foreign investor upon the sale of its interest in a Fund that directly or indirectly conducts a US trade or business would be ECI to the extent of the foreign investor’s share of gain or loss on sale of Fund assets would be ECI.

Sale by Fund of investment in pass through entity can create ECI if assets used in US trade or business

38

Sources of ECI – U.S. Real Property InterestsSources of ECI – U.S. Real Property Interests Investments in U.S. Real Property Interests are always Investments in U.S. Real Property Interests are always

treated as ECItreated as ECI

U.S. Real Property Interests include:U.S. Real Property Interests include:Real property located in the U.S.Real property located in the U.S.Fixtures on such real propertyFixtures on such real propertyStock in a U.S. Real Property Holding Company Stock in a U.S. Real Property Holding Company (“USRPHC”)(“USRPHC”)

A USRPHC is any domestic corporation if more than A USRPHC is any domestic corporation if more than 50% of the fair market value of such corporation’s 50% of the fair market value of such corporation’s assets is attributable to U.S. real property interestsassets is attributable to U.S. real property interests

A blocker corporation structure is NOT effective to avoid A blocker corporation structure is NOT effective to avoid the recognition of ECI from U.S. real property intereststhe recognition of ECI from U.S. real property interests

39

Sources of ECI – Income from FeesSources of ECI – Income from Fees

Fees may be considered ECI, including:Fees may be considered ECI, including:Management, consulting and monitoring feesManagement, consulting and monitoring feesOrigination and commitment feesOrigination and commitment feesBreak-up and finder’s feesBreak-up and finder’s feesClosing feesClosing feesEquity commitment feesEquity commitment feesGuarantee feesGuarantee fees

More inclusive then UBTIMore inclusive then UBTI

40

Branch Profits TaxesBranch Profits Taxes

Foreign investors that are corporations, or that invest Foreign investors that are corporations, or that invest through a foreign corporation, may be subject to an through a foreign corporation, may be subject to an additional tax (the “branch profits tax”)additional tax (the “branch profits tax”)

Branch profits tax is equal to 30% of the “dividend Branch profits tax is equal to 30% of the “dividend equivalent amount,” which is the earnings and profits of a equivalent amount,” which is the earnings and profits of a U.S. branch of a foreign corporation attributable to its ECI U.S. branch of a foreign corporation attributable to its ECI

Triggered by changes in US net equityTriggered by changes in US net equity

Avoided by complete termination of US trade or businessAvoided by complete termination of US trade or business

May be modified by treatyMay be modified by treaty

What is a Blocker What is a Blocker Corporation?Corporation?

What is a Blocker What is a Blocker Corporation?Corporation?

42

What is a Blocker Corporation?What is a Blocker Corporation?

A “blocker corporation” is a corporation that is A “blocker corporation” is a corporation that is placed between the tax-exempt or foreign investors placed between the tax-exempt or foreign investors and the source of UBTI and ECIand the source of UBTI and ECI

The blocker corporation incurs and pays tax on the The blocker corporation incurs and pays tax on the operating income that is allocated to it from the operating income that is allocated to it from the pass-through entity, and thus “blocks” such income pass-through entity, and thus “blocks” such income from reaching the tax-exempt and foreign investors from reaching the tax-exempt and foreign investors

Any net after-tax proceeds distributed by the blocker Any net after-tax proceeds distributed by the blocker corporation to the tax-exempt and foreign investors corporation to the tax-exempt and foreign investors should be non-UBTI, non-ECI distributionsshould be non-UBTI, non-ECI distributions

43

Structures Using Blocker CorporationsStructures Using Blocker Corporations

There are generally three types of blocker structures:There are generally three types of blocker structures:

Parent BlockerParent Blocker, in which the blocker is positioned , in which the blocker is positioned “above the Fund” as a direct investor in the Fund“above the Fund” as a direct investor in the Fund

Subsidiary BlockerSubsidiary Blocker, in which the blocker is positioned , in which the blocker is positioned “below the Fund” as a wholly-owned subsidiary of the “below the Fund” as a wholly-owned subsidiary of the FundFund

Parallel BlockerParallel Blocker, in which the blocker is positioned , in which the blocker is positioned below a parallel Fund that is formed to invest side-by-below a parallel Fund that is formed to invest side-by-side with the main Fundside with the main Fund

44

Tax Consequences of Using a Blocker CorporationTax Consequences of Using a Blocker Corporation

The U.S. tax consequences of holding a pass-through The U.S. tax consequences of holding a pass-through investment through a blocker corporation depends on investment through a blocker corporation depends on the chosen structure the chosen structure

Specifically, the tax consequences depend on:Specifically, the tax consequences depend on:Whether the blocker is domestic or foreignWhether the blocker is domestic or foreignWhether the blocker holds all or only a subset of the Whether the blocker holds all or only a subset of the fund investments fund investments Whether the blocker resides above, below, or parallel Whether the blocker resides above, below, or parallel to the Fundto the Fund

Threshold question is whether the blocker will be Threshold question is whether the blocker will be respected as the tax owner of the investmentrespected as the tax owner of the investment

Blocker Structuring ExamplesBlocker Structuring ExamplesBlocker Structuring ExamplesBlocker Structuring Examples

46

Fund Invests in CorporationFund Invests in Corporation

Investors contribute capital to FundInvestors contribute capital to Fund

Fund invests in portfolio corporationFund invests in portfolio corporation

GP

Fund

ForeignInvestor

Exempt Investor

Corp

OtherInvestors

47

Fund Invests in LLC Fund Invests in LLC

Investors contribute capital to FundInvestors contribute capital to Fund

Fund invests in portfolio LLCFund invests in portfolio LLC

GP

Fund

ForeignInvestor

Exempt Investor

LLC

OtherInvestors

48

No BlockerNo Blocker

ProsProsStructural simplicityStructural simplicityNot all gain on sale of LLC interest will necessarily be Not all gain on sale of LLC interest will necessarily be UBTI or ECIUBTI or ECI

ConsConsExempt Investor and Foreign Investor probably have Exempt Investor and Foreign Investor probably have UBTI and ECIUBTI and ECI

Foreign Investor is required to file US tax returnForeign Investor is required to file US tax returnExempt Investor may have to file tax returnExempt Investor may have to file tax return

Sale of one (of multiple) LLC by Fund could trigger Sale of one (of multiple) LLC by Fund could trigger branch profits tax on Foreign Investorbranch profits tax on Foreign Investor

49

Parent BlockerParent Blocker

Mechanics:Mechanics:

Exempt Investor and Foreign Investor contribute Exempt Investor and Foreign Investor contribute capital for investment in LLC to a corporation capital for investment in LLC to a corporation (“Blocker Corp”) in exchange for 100% of the stock(“Blocker Corp”) in exchange for 100% of the stock

Blocker Corp contributes capital to Fund and Blocker Corp contributes capital to Fund and participates in investment in same manner as all participates in investment in same manner as all Other InvestorsOther Investors

New Blocker Corp for each investmentNew Blocker Corp for each investment

Blocker Corp will generally be a foreign corporationBlocker Corp will generally be a foreign corporation

50


GP

Fund

LLC

ForeignInvestor

Blocker Corp

Exempt Investor

OtherInvestors

51


ProsProsExempt Investor and Foreign Investor will not Exempt Investor and Foreign Investor will not have to report UBTI or ECI have to report UBTI or ECI Foreign and Exempt Investors will not have to Foreign and Exempt Investors will not have to file US tax returnfile US tax returnGP’s carried interest is not affected by Blocker GP’s carried interest is not affected by Blocker CorpCorp

ConsConsDifficult to avoid Blocker Corp level tax on Difficult to avoid Blocker Corp level tax on dispositiondispositionPotential Branch Profits Tax issuePotential Branch Profits Tax issueTax rate to Foreign InvestorTax rate to Foreign Investor

52

Subsidiary BlockerSubsidiary Blocker


Fund forms Blocker Corp as wholly-owned subsidiaryFund forms Blocker Corp as wholly-owned subsidiaryFund agreement provides:Fund agreement provides:

Fund contributes capital contributions of Exempt Fund contributes capital contributions of Exempt Investor and Foreign Investor to Blocker Corp, which Investor and Foreign Investor to Blocker Corp, which uses them to acquire pro rata share of portfolio LLCuses them to acquire pro rata share of portfolio LLCExempt Investor and Foreign Investor share in Exempt Investor and Foreign Investor share in distributions and allocations to extent they are derived distributions and allocations to extent they are derived from distributions or sales proceeds attributable to from distributions or sales proceeds attributable to Blocker CorpBlocker CorpDistributable cash of Fund attributable to Blocker Corp Distributable cash of Fund attributable to Blocker Corp is divided between Exempt Investor, Foreign Investor is divided between Exempt Investor, Foreign Investor and GPand GPAll other distributable cash and allocations of income All other distributable cash and allocations of income and losses attributable to LLC are allocated among and losses attributable to LLC are allocated among Other Investors and GP Other Investors and GP

53


GP

Fund

LLC

OtherInvestors

ForeignInvestor

Blocker Corp

Exempt Investor

54


ProsProsFund can sell Blocker Corp as part of sale of portfolio Fund can sell Blocker Corp as part of sale of portfolio LLCLLCExempt Investor and Foreign Investor not taxable on Exempt Investor and Foreign Investor not taxable on disposition of stockdisposition of stock

ConsConsSubstantial economic effect issuesSubstantial economic effect issuesBuyer will not get a step up on sale of Blocker CorpBuyer will not get a step up on sale of Blocker CorpOther ECI or UBTI at Fund?Other ECI or UBTI at Fund?Effect on GP’s carryEffect on GP’s carry

55

Subsidiary Blocker (alternative)Subsidiary Blocker (alternative)

GP

Fund

LLC

ForeignInvestor

Blocker Corp

Exempt Investor

LLC

OtherInvestors

56

Parallel BlockerParallel Blocker


Parallel investment vehicle (“Parallel Parallel investment vehicle (“Parallel Fund”) is established for Exempt and Fund”) is established for Exempt and Foreign InvestorsForeign InvestorsParallel Fund will incorporate wholly-Parallel Fund will incorporate wholly-owned subsidiary for each pass-through owned subsidiary for each pass-through investmentinvestment

57

Parallel Fund Parallel Fund

OtherInvestors

ParallelFund

LLC

GPForeignInvestor

Blocker Corp

Exempt Investor

Fund

CorporateInvestments

58

Blocker Corp DebtBlocker Corp Debt

Use capital contribution of Exempt Investor and Use capital contribution of Exempt Investor and Foreign Investor to loan capital to Blocker CorpForeign Investor to loan capital to Blocker Corp

Creates deductions at Blocker Corp that offset gain in Creates deductions at Blocker Corp that offset gain in sale of portfolio LLCsale of portfolio LLC

Reduces corp level tax at Blocker CorpReduces corp level tax at Blocker CorpInterest non-taxable to Exempt Investor and maybe Interest non-taxable to Exempt Investor and maybe Foreign InvestorForeign Investor

Earnings stripping (Section 163(j))Earnings stripping (Section 163(j))Portfolio interest limitationsPortfolio interest limitations

59

Blocker Corp DebtBlocker Corp Debt

GP

Fund

LLC

OtherInvestors

ForeignInvestor

Blocker Corp

Exempt Investor

Debt

60

Debt and Warrant StructureDebt and Warrant Structure

Structure portfolio investment as straight debt Structure portfolio investment as straight debt coupled with warrants coupled with warrants

Debt/equity issues Debt/equity issues

Basic tax objective is to avoid status as a "partner" Basic tax objective is to avoid status as a "partner" for tax purposesfor tax purposes

If the investor is not a partner of the portfolio If the investor is not a partner of the portfolio company, it will not be deemed to be engaged company, it will not be deemed to be engaged in the trade or business of the portfolio in the trade or business of the portfolio companycompany

61


Fund

LLC

DebtOther

Investors

Warrant

ForeignInvestor

Exempt Investor

GP

62


UBTI/ECI Risks UBTI/ECI Risks

Debt could be treated as equityDebt could be treated as equity

Warrant could be treated as profits interest in Warrant could be treated as profits interest in operating company, resulting in UBTI and ECIoperating company, resulting in UBTI and ECI

particularly if warrant holders have rights particularly if warrant holders have rights typically held by equity holders (such as typically held by equity holders (such as voting rights)voting rights)

Structuring Investments in or Structuring Investments in or Acquisitions of Portfolio Acquisitions of Portfolio

CompaniesCompanies

Structuring Investments in or Structuring Investments in or Acquisitions of Portfolio Acquisitions of Portfolio

CompaniesCompanies

64

Portfolio InvestmentsPortfolio Investments

Providing for dividend vs. capital gain in a Providing for dividend vs. capital gain in a “partial exit”“partial exit”

Acquisitions utilizing Section 338(h)(10) in Acquisitions utilizing Section 338(h)(10) in transactions involving management rolloverstransactions involving management rollovers

Minimizing taxes on ‘PIK’ preferred stockMinimizing taxes on ‘PIK’ preferred stock

Dividend vs. Capital Gain in a Dividend vs. Capital Gain in a “Partial Exit”“Partial Exit”

Dividend vs. Capital Gain in a Dividend vs. Capital Gain in a “Partial Exit”“Partial Exit”

66

Dividend vs. Capital GainDividend vs. Capital Gain

InvestorCharacter of Income Individual US Corporate Foreign Tax-Exempt

Dividend 15% if QDI/10.5% (after

DRD)Withholding at

30% or Exempt

No Basis Offset Reduced Treaty

Rate

STCG35% + Basis

Offset35% + Basis

Offset Exempt Exempt

LTCG15% + Basis

Offset35% + Basis

Offset Exempt Exempt

67

Leveraged Recap in < One Year(assumes e&p > total distribution)Leveraged Recap in < One Year(assumes e&p > total distribution)

Investor

Individual*

US Corporate*

Foreign

Tax-Exempt

Prefer Dividend or Capital Gain?

Dividend if (15% x (Distribution)) < (35% x (Distribution - Basis))

Dividend if (35% x (Distribution x (1 - 70%)) < (35% x (Distribution - Basis))

Capital Gain

Indifferent

* Assumes full use of "lost basis" to reduce future capital gain

68

Leveraged Recap in > One Year(assumes e&p > total distribution)Leveraged Recap in > One Year(assumes e&p > total distribution)

Investor

Individual*

US Corporate*

Foreign

Tax-Exempt

Prefer Dividend or Capital Gain?

Capital Gain

Dividend if (35% x (Distribution x (1 - 70%)) < (35% x (Distribution - Basis))

Capital Gain

Indifferent

* Assumes full use of "lost basis" to reduce future capital gain

69

Parial Exit: Leveraged RecapParial Exit: Leveraged Recap

TargetTarget

HoldcoHoldco

MidcoMidco

Holdco incurs debt to finance distribution of investors. Newco designed to minimize E&P. (It has no other debt so need for distributions to Newco is eliminated.)

Distributions are taxed: First, as dividends to the extent of earnings and profits; Second, as tax-free return of capital; and Third, as capital gain (once basis is offset).

Query whether result can be changed to “boot dividend” treatment if existing shares are exchanged for new shares. Boot dividend is taxed as a dividend, but only to the extent of any built-in gain.

LoanLoan

Fund Fund Fund

70

Partial ExitPartial Exit

TargetTarget

HoldcoHoldco

MidcoMidco

Alternatively, structure could have Holdco owning all Midco common but with each Fund owning Midco nonvoting preferred in proportion to their common interests in Holdco.

Midco uses loan proceeds to redeem preferred shares. Redemption should be entitled to capital gain treatment under section 302(a). See Trea. regs. § 1.302-2(a) and Rev. Rul. 77-426.

Another alternative in some cases: Convert Midco to an LLC, treatd as a deemed liquidation. Sale or exchange treatment under section 331 should be available as long as preferred stock is not “plain vanilla” preferred under section 1504(a).

33%33%CommonCommon

Fund Fund Fund

LoanLoan

33%33%CommonCommon

33%33%CommonCommon

33%33% PfdPfd

33%33% PfdPfd

33%33% PfdPfd

Section 338(h)(10) Section 338(h)(10) Transactions Involving Transactions Involving Management RolloversManagement Rollovers

Section 338(h)(10) Section 338(h)(10) Transactions Involving Transactions Involving Management RolloversManagement Rollovers

72

Section 338(h)(10) ElectionSection 338(h)(10) Election

Election to Treat a Stock Sale as an Asset Sale

Can Apply to a Subsidiary in a Consolidated/Affiliated Group or to an S Corporation

Purchaser must be a corporation

Qualified Stock Purchase (QSP)— Acquiring must purchase amount of stock described in section 1504(a)(2) in one or more transactions within a 12-month period. See section 338(d)(3)

73

Section 338(h)(10) ElectionSection 338(h)(10) Election

Section 1504(a)(2): Generally 80% voting power and 80% value (excluding certain plain vanilla preferred)

Purchase under section 338(h)(3) means:The stock basis is not determined, in whole or part, by reference to its basis in the hands of the sellerThe stock is not acquired in an exchange that is subject to section 351 or section 354The stock is not a acquired from a person whose stock would be attributed to the acquiring person under section 318(a) (ignoring option attribution)

74

Section 338(h)(10) Election: Example 1Section 338(h)(10) Election: Example 1

TargetTarget

TargetTargetStockStock(20%) (20%)

NewcoNewco

MgmtMgmt

NewcoNewcoStockStock

MergerMergerSubSub

$150$150

PPX forms Newco to acquire TargetX forms Newco to acquire Target

Target’s FMV is $200.Target’s FMV is $200.

P corp. owns 80% of Target; Mgt. P corp. owns 80% of Target; Mgt. owns 20% of Targetowns 20% of Target

Mgmt. will “rollover” their 20% Mgmt. will “rollover” their 20% interest by contributing their interest by contributing their Target stock to NewcoTarget stock to Newco

X contributes $150 to NewcoX contributes $150 to Newco

Newco forms Merger Sub and Newco forms Merger Sub and contributes the $150 received contributes the $150 received from Xfrom X

Merger Sub borrows $10Merger Sub borrows $10

Merger Sub merges into Target Merger Sub merges into Target with Target surviving; P receives with Target surviving; P receives $160 in the merger$160 in the merger

XX

$150$150

$10$10

LoanLoan

20%20% 80%80%

ReverseReverseMergerMerger


75


TargetTarget


NewcoNewco

MgmtMgmt


$150$150

PP

Are the QSP requirements satisfied?

Newco is treated as acquiring Target stock. Rev Rul. 73-427, Rev. Rul. 78-250 and Rev. Rul. 79-273.

Transfer of P shares is treated as part-sale and part-redemption.

Mgmt. shares acquired tax-free under section 351. Rev. Rul. 84-71.

However, Mgmt. shares represent 21% of total Target shares. P only acquires 79% of Target shares by “purchase.” (Where Section 338(h)(10) election is respected Target recognizes 100% of the gain on the deemed sale of its assets.)

What if the loan is to Newco?

XX

$150$150

$10$10

LoanLoan

$160$160


76


TargetTarget


NewcoNewco

5% 5% NewcoNewcoStockStock& $190& $190

PP

X forms Newco to acquire Target

Target’s FMV is $200.

P receives $190 plus 5% of the Newco stock

Are the QSP requirements satisfied?

P’s shares of Target were acquired in a section 351 transaction with boot

Any difference if all of P’s gain is recognized? See section 338(h)(3)(A)(ii).

XX

$190$190NewcoNewcoStockStock

77


TargetTarget

(S Corp.)(S Corp.)


NewcoNewco

AA

NewcoNewcoStockStock& $40& $40

MergerMerger

SubSub

$140$140

X forms Newco to acquire Target

Target is an S corporation with a FMV of $200.

P owns 70% of Target; A owns 30% of Target

X contributes $180 to Newco

A will “rollover” a third of her shares. A receives 10% of the stock of Newco and $40

Newco forms Merger Sub and contributes $140

Merger Sub merges into Target with Target surviving; P receives $140 in the merger

XX

$180$180

30%30% 70%70%

MergerMerger

PP


78


TargetTarget

(S Corp.)(S Corp.)


NewcoNewco

AA

NewcoNewcoStockStock& $40& $40

$140$140

XX

$180$180

$140$140

PPAre the QSP requirements satisfied?

A’s shares (equal to 30% of Target) were acquired in a section 351 transaction


79


TargetTarget


NewcoNewco


XX$160$160

AA

P and A (Target P and A (Target shareholders) contribute shareholders) contribute Target stock to Newco in Target stock to Newco in exchange for Newco shares exchange for Newco shares in a section 351 transactionin a section 351 transaction

At the same time, P sells its At the same time, P sells its Newco shares to X pursuant Newco shares to X pursuant to a binding written to a binding written agreementagreement

Transaction fails section 351 Transaction fails section 351 “control immediately after” “control immediately after” test. See Rev. Rul. 70-140.test. See Rev. Rul. 70-140.

Can Newco and P make the Can Newco and P make the section 338(h)(10) election?section 338(h)(10) election?

What if A receives a note What if A receives a note convertible into Newco convertible into Newco shares?shares?


PP

(1)(1) (2)(2)



80


TargetTarget


NewcoNewco

AA


$160$160

PP

Facts are the same as in Example 1 Facts are the same as in Example 1 except:except:

Pursuant to a binding written Pursuant to a binding written agreement, X sells Newco agreement, X sells Newco shares to friendly bank.shares to friendly bank.

What if the Newco shares sold What if the Newco shares sold by X are a special class of by X are a special class of nonvoting preferred stock? nonvoting preferred stock? What if there is only one share of What if there is only one share of the special class of preferred?the special class of preferred?

See PLR 8817079 (2/4/88), See PLR 8817079 (2/4/88), supplemented by PLR 8822062 supplemented by PLR 8822062 (3/7/88) (single share of non-(3/7/88) (single share of non-voting preferred stock sold to voting preferred stock sold to affiliate is sufficient to disqualify affiliate is sufficient to disqualify transaction under section 368(a)transaction under section 368(a)(2)(E)).(2)(E)).

XX

$160$160

$160$160

NewcoNewcoStockStock(common(common&&preferred)preferred)

FBFB $$$$

Newco Newco preferred preferred stockstock

(1)(1)(2)(2)

81

Section 338(h)(10) Election:Example 6Section 338(h)(10) Election:Example 6

TargetTarget

TargetTargetPref. Stk. Pref. Stk. & Com. & Com. Stk. Stk. (20%) (20%)

NewcoNewco

AA


$150$150

PP

Facts are the same as in Example 1 Facts are the same as in Example 1 except:except:

A’s interest in Target is A’s interest in Target is recapitalized immediately recapitalized immediately before the incorporation of before the incorporation of Newco. A receives “plain Newco. A receives “plain vanilla” preferred stock.vanilla” preferred stock.

Can A get section 351 Can A get section 351 treatment this way without treatment this way without impacting the section 338(h)impacting the section 338(h)(10) election? See Rev. Rul. (10) election? See Rev. Rul. 57-114 (transitory ownership 57-114 (transitory ownership not respected).not respected).

Does it help if A gets plain Does it help if A gets plain vanilla preferred stock of vanilla preferred stock of Newco?Newco?

XX

$150$150

$10$10

LoanLoan

$160$160


Alternatives to Section 338(h)Alternatives to Section 338(h)(10)(10)

Alternatives to Section 338(h)Alternatives to Section 338(h)(10)(10)

83

Asset Sale through Forward Merger Asset Sale through Forward Merger

TargetTarget

NewcoNewco

AANewcoNewcoStockStock

MergerMergerSubSub

$150$150

PP

Same as Example 1 except:

Target merges into Merger Sub in a forward subsidiary merger.

P receives cash and A receives Newco stock.

A does not achieve rollover treatment

XX

$150$150

$10$10

LoanLoan

20%20% 80%80%

MergerMerger


$160$160

84

Asset Sale through LLC ConversionAsset Sale through LLC Conversion

TargetTargetLLCLLC

NewcoNewco

MgmtMgmtNewcoNewcoStockStock

PP

Same as Example 1 except:

Target is converted into an LLC immediately before the transaction. Mgmt. is taxed in connection with the deemed liquidation of Target.

No merger. Instead Mgmt. receives Newco stock and P receives cash in exchange for Target LLC interests.

Target is a disregarded entity in Newco hands; Newco is treated as owning assets for tax purposes.

XX

$150$150

20%20% 80%80%


$160$160Target Target LLC LLC interestsinterests

Target Target LLC LLC interestsinterests

$10$10

LoanLoan

85

Asset Sale through LLC ConversionAsset Sale through LLC Conversion

TargetTargetLLCLLC

MgmtMgmtNewcoNewcoLLC LLC interestsinterests

PP

LLC conversion allows asset sale treatment without the requirement that assets continue to be held by a corporate buyer:

Target is converted into an LLC immediately before the transaction.

Mgmt. and P are taxed on the deemed liquidation of Target, but liquidation is tax-free to P under section 332.

Mgmt. receives Newco LLC interests and P receives cash in exchange for Target LLC interests.

Section 754 election for Target LLC provides stepped-up basis in assets

XX

$150$150

20%20% 80%80%

NewcoNewcoLLC LLC interestsinterests

$160$160Target Target LLC LLC interestsinterests

Target Target LLC LLC interestsinterests$10$10

LoanLoanNewcoNewco

LLCLLC

86

Asset Sale through LLC Conversion (S Corp. Target)Asset Sale through LLC Conversion (S Corp. Target)

TargetTargetLLCLLC

MgmtMgmt

NewcoNewcoLLC LLC interestsinterests& $160& $160

XX

$150$150 20%*20%*80%80%NewNewTargetTargetSharesShares

NewcoNewcoLLC LLC interestsinterests

$160$160

Target Target LLC LLC interestsinterests

$10$10

LoanLoanNewcoNewco

LLCLLC

PP

NewNew TargetTarget

(S Corp.)(S Corp.)

Same facts as prior example except that Target is an S corp.

Target is converted to an LLC as part of an “F reorganization. New Target (holding company) is formed. Old Target is contributed to New Target. Old Target is converted into an LLC.

New Target is treated as the alter ego of Old Target for tax purposes. Target LLC is disregarded.

New Target sells Target LLC (deemed asset sale) for cash and Newco LLC interests. Cash is distributed to P in exchange for P’s shares.

S corporation mechanics mean that only 20% of Mgmt’s gain will be deferred.

Minimizing Dividend Taxes Minimizing Dividend Taxes on ‘PIK’ Preferred Stockon ‘PIK’ Preferred Stock

Minimizing Dividend Taxes Minimizing Dividend Taxes on ‘PIK’ Preferred Stockon ‘PIK’ Preferred Stock

88

Significance to ParticipantsSignificance to Participants

Foreign InvestorsAvoid U.S. withholding taxesAvoid accelerated liability for taxPotential tax exemption

U.S. InvestorsAvoid accelerated liability for taxCapital gain conversion

89

“Pre-Money” Valuation Disputes“Pre-Money” Valuation Disputes

Conversion Price = LP / # of Common SharesConversion Price = LP / # of Common Shares

Conversion Price usually ‘at-the-money’Conversion Price usually ‘at-the-money’

PIK Preferred to bridgePIK Preferred to bridge

90

A Common Valuation DisputeA Common Valuation Dispute

The founders of XYZ Corp need to raise $20 The founders of XYZ Corp need to raise $20 million. They value the business at $30 million. million. They value the business at $30 million. VentureCo proposes to invest $20 million in VentureCo proposes to invest $20 million in exchange for newly-issued convertible preferred exchange for newly-issued convertible preferred stock, but values the business at only $20 million. stock, but values the business at only $20 million. So the founders propose that the preferred be So the founders propose that the preferred be convertible into 40% of the common stock (i.e., convertible into 40% of the common stock (i.e., $20/($20 + $30)), VentureCo proposes that the $20/($20 + $30)), VentureCo proposes that the preferred be convertible into 50% of the common preferred be convertible into 50% of the common stock (i.e., $20/($20 + $20)).stock (i.e., $20/($20 + $20)).

91

The ‘PIK’ SolutionThe ‘PIK’ Solution

XYZ Co issues PIK preferred stock, initially convertible into XYZ Co issues PIK preferred stock, initially convertible into 40% of the underlying common. The PIK dividend rate is 40% of the underlying common. The PIK dividend rate is 8.5%.8.5%.

After 5 years, the preferred stock is now convertible into After 5 years, the preferred stock is now convertible into 50% of the common stock (i.e., ($20M x 1.085)^5 = $30M).50% of the common stock (i.e., ($20M x 1.085)^5 = $30M).

By “PIKing” the dividends, VentureCo receives its desired By “PIKing” the dividends, VentureCo receives its desired conversion price after 5 years, even though it invested at a conversion price after 5 years, even though it invested at a pre-money valuation of $30 million.pre-money valuation of $30 million.

92

§ 305 Issues with PIK Preferred§ 305 Issues with PIK Preferred

PIK dividend is taxed to the extent of E&P:

§ 305 (b)(4): distributions ‘on’ preferred stock.

§ 305 (b)(5): distributions ‘of’ convertible preferred stock

§ 305 (b)(2): cash to some, increase in proportionate interest to others

93

Tax Considerations in Capitalizing Holdcos: Debt vs. Preferred StockTax Considerations in Capitalizing Holdcos: Debt vs. Preferred Stock

Debt provides an immediate deduction for portfolio companies operating as C corporations (and reduce income subject to double taxation)

Funds will be immediately taxable on interest income.

Excess deductions in C corporations are deferred and used only as net operating loss carryovers. In contrast, Funds may use interest deductions generated at the pass-through level.

Certain tax rules that eliminate, reduce or defer interest deductions must be considered:

Basic debt vs. equity rulesSection 163(e) (AHYDO Rules). Applies to debt instruments held more than 5 years, if interest rate is greater than AFR + 5% and there is significant OID.Section 279: Acquisition indebtedness that is convertible (or issued with options and warrants) and subordinated.Section 163(j): Interest paid to related party that is not subject to tax on the income (or where debt is guaranteed by tax-exempt party) if debt-equity ration is greater than 1.5 to 1.

94

Tax Considerations in Capitalizing Holdcos: Debt vs. Preferred StockTax Considerations in Capitalizing Holdcos: Debt vs. Preferred Stock

Dividends on preferred stock generally are not taxed until actual or constructive receipt. See Treas. reg. § 1.301-1(b).

Preferred “original issue discount” may be created if preferred stock is issued at a discount (i.e., redemption price exceeds issue price).

Arises where preferred stock is issued as part of an investment unit (with common stock or warrants) unless the value of the preferred stock is equal to its face amount.

Only applies if stock is preferred for tax purposes (i.e., stock that does not participate in corporate growth to a significant extent).

Dividend arrearages are generally taxed at capital gain rates upon a sale or redemption of preferred (unless dividends have been previously declared).

Dividend arrearages may be taxes as dividends (to the extent of E&P) if preferred stock is converted to common stock in a recapitalization. See Treas. Reg. § 1.305-7(c).

Tax ConsiderationsTax Considerations in Making Private Equity in Making Private Equity

InvestmentsInvestments in Canada in Canada

Tax ConsiderationsTax Considerations in Making Private Equity in Making Private Equity

InvestmentsInvestments in Canada in Canada

96

Tax Considerations in Making Private Equity Investments in CanadaTax Considerations in Making Private Equity Investments in Canada

General Canadian tax rules applicable to General Canadian tax rules applicable to non-resident investorsnon-resident investors

Treaty considerationsTreaty considerations

Using alternative investment vehiclesUsing alternative investment vehicles

Maximizing tax shelter in the targetMaximizing tax shelter in the target

97

General Canadian Tax Rules Applicable to Non-Resident InvestorsGeneral Canadian Tax Rules Applicable to Non-Resident Investors

Interest and dividends subject to 25% withholding tax

Gains on “taxable Canadian Property” subject to capital gains tax

Rollovers available for conversion of securities

Clearance certificate requirements

98

“Taxable Canadian Property”“Taxable Canadian Property”Shares of Canadian resident corporations not listed on a Shares of Canadian resident corporations not listed on a

prescribed stock exchangeprescribed stock exchange

Shares of non-resident corporations not listed on a Shares of non-resident corporations not listed on a prescribed stock exchange if more than 50% of property prescribed stock exchange if more than 50% of property is taxable Canadian property or Canadian resource is taxable Canadian property or Canadian resource property property andand more than 50% of property is Canadian real more than 50% of property is Canadian real property or resource propertyproperty or resource property

Listed shares of corporations described above if seller Listed shares of corporations described above if seller held 25% or more of shares of held 25% or more of shares of anyany class in 60 months class in 60 months preceding salepreceding sale

Also includes certain partnership and trust interestsAlso includes certain partnership and trust interests

Includes rights to acquire above property, therefore Includes rights to acquire above property, therefore includes debt convertible into any of the foregoingincludes debt convertible into any of the foregoing

99

Convertible SecuritiesConvertible Securities

Rollovers available for debt for share and share Rollovers available for debt for share and share for share exchangesfor share exchanges

Property acquired deemed to be taxable Canadian Property acquired deemed to be taxable Canadian property if converted property was taxable property if converted property was taxable Canadian propertyCanadian property

100

Clearance CertificatesClearance Certificates

Section 116 clearance certificate required when Section 116 clearance certificate required when non-resident sells taxable Canadian property that non-resident sells taxable Canadian property that is not “excluded property”is not “excluded property”

Excluded property includes shares listed on a Excluded property includes shares listed on a prescribed stock exchange, debt obligations and prescribed stock exchange, debt obligations and “deemed” taxable Canadian property“deemed” taxable Canadian property

Information required for all vendors including Information required for all vendors including partners of partnershipspartners of partnerships

Could be administratively burdensome procedureCould be administratively burdensome procedure

101

Treaty ConsiderationsTreaty Considerations

Treaties lower withholding rate on interest and dividendsTreaties lower withholding rate on interest and dividends

Generally exempt gains from Canadian tax unless value Generally exempt gains from Canadian tax unless value of property sold derived primarily from Canadian real of property sold derived primarily from Canadian real property or resource propertyproperty or resource property

Some treaties provide better protection on gains by Some treaties provide better protection on gains by excluding real property used in business from definition excluding real property used in business from definition of real propertyof real property

Additional exemptions available for tax-exemptsAdditional exemptions available for tax-exempts

LLC issues – resolved?LLC issues – resolved?

102

Alternative Investment VehiclesAlternative Investment Vehicles

Canadian investments may be made through Canadian investments may be made through intermediary entities in offshore jurisdictions such intermediary entities in offshore jurisdictions such as Barbados, Luxembourgas Barbados, Luxembourg

Advantages:Advantages:

added treaty protectionadded treaty protection

simplified clearance certificate proceduressimplified clearance certificate procedures

Disadvantages:Disadvantages:

maintenance costs, inconveniencemaintenance costs, inconvenience

assessment riskassessment risk

103

Maximizing Tax Shelter in the TargetMaximizing Tax Shelter in the Target

Maximize shelter for US tax purposes by structuring Maximize shelter for US tax purposes by structuring acquisition as asset acquisition for US tax purposesacquisition as asset acquisition for US tax purposes

Achieved by converting target to unlimited liability Achieved by converting target to unlimited liability company before or after acquisition or by making company before or after acquisition or by making s.338 elections.338 election

Generally no step-up in asset basis for Canadian Generally no step-up in asset basis for Canadian tax purposes on share acquisitiontax purposes on share acquisition

Shelter created for Canadian tax purposes through Shelter created for Canadian tax purposes through leverageleverage

104

Leveraged EquityLeveraged Equity

Equity to be used for acquisition can be structured Equity to be used for acquisition can be structured as two-thirds debt for Canadian tax purposesas two-thirds debt for Canadian tax purposes

2:1 debt to equity ratio required to comply with 2:1 debt to equity ratio required to comply with Canadian thin capitalization rulesCanadian thin capitalization rules

Possible to structure so no immediate income Possible to structure so no immediate income inclusion for interest on debt by using “blocker” inclusion for interest on debt by using “blocker” entityentity

35% tax savings achieved in exchange for 10% 35% tax savings achieved in exchange for 10% withholding taxwithholding tax

105

Leveraged Equity – Typical StructureLeveraged Equity – Typical Structure

Fund

Luxco

Acquisition Co

Finance LP

Target

Loan $200

$100 Equity

$200

QUESTIONS & ANSWERSQUESTIONS & ANSWERSQUESTIONS & ANSWERSQUESTIONS & ANSWERS

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mmmd fund

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