tax strategies for limited partner investors in private...

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Tax Strategies for Limited Partner

Investors in Private Investment Funds Avoiding Tax Traps Through Side Letters and Other "Hidden" Agreements

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, APRIL 13, 2016

Presenting a live 90-minute webinar with interactive Q&A

Kathleen (Kat) Saunders Gregor, Partner, Ropes & Gray, Boston

Elizabeth M. Norman, Partner, Nutter McClennen & Fish, Boston

Cara Howe Santoro, Nutter McClennen & Fish, Boston

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FOR LIVE EVENT ONLY

Tax Strategies for Limited Partner Investors in Private Investment Funds Kat Gregor, Elizabeth Norman & Cara Howe Santoro April 13, 2016

Agenda

Hot Topics

Initial Questions to Ask

Key Tax Issues

Investor-specific Tax Issues

Overview of Common Fund Structures

Key Aspects of Different Fund Types

Economics and Tips for Negotiating Documents

5

Hot Topics: Partnership Audit Reform

6

Partnership Audit Reform: Bipartisan Budget Act of 2015

New law to take effect in 2018 will create potential exposure to non-profits for tax otherwise born by its for profit partners

Entirely new method of auditing and collecting tax from partnerships

Risk of economic distortion: will current partners be left paying tax for former partners?

Limited ability to elect out of new rules: Not applicable if any partner is itself a partnership for tax purposes, but some joint ventures may be eligible

Currently awaiting proposed regulations on actual implementation of new audit and collection procedures

Hot Topics: Other Issues

Fee Waivers

Proposed Regulations

IRS Audits

Carried Interest Legislation

Recent State Initiative

New York

Massachusetts and other states

Update on Federal Proposals

7

Agenda

Hot Topics


Key Tax Issues





8

What is the Investment?

What kind of fund is it?

Hedge Fund

Fund of Funds

Private Equity or Leveraged Buyout Fund

Real Estate Fund

Venture Fund

Mezzanine Debt Fund

How is the fund structured?

What are the tax consequences to the structure?

9

Other Fund Characteristics

Other important fund characteristics to consider:

U.S.-based or not?

Focus on U.S. investments (or otherwise)?

Is the fund an investor or conducting a trade or business?

Investor: possible disallowance of fund manager fees for US investors (Section 212)

Trade or business: fees may be deductible under Section 162, but UBTI, ECI and CAI concerns

10

What type of investor are you?

U.S. Taxable Individual or Corporation

U.S. State or Local Government

Pension Funds

U.S. Tax-Exempt Investors

Corporate Pension Plans

University and College Endowment Funds

Private Foundations

Charity Endowment Funds

IRAs

11

What type of investor are you? (cont’d)

Non-U.S. Investors Individuals

Non-US entities treated as corporations for US income tax purposes

Pension funds (not taxed in home country)

Non-US Government Investors (Section 892) Sovereign Wealth Funds

Pension Funds

12

Agenda

Hot Topics


Key Tax Issues





13

Key Tax Issue: To Block or Not to Block? 14

What is a blocker corporation?

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

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

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

U.S. Tax Consequences of a Blocker 15

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

Specifically: Whether the blocker is domestic or foreign Whether the blocker holds all or only a subset of the fund

investments Whether the blocker resides above, below, or parallel to the

Fund The types of investments (such as real estate) held by the

blocker Whether the blocker makes any special elections, such as REIT

status

16

Structures Using Blocker Corporations

There are various types of blocker structures, for example:

Feeder, in which the blocker is positioned “above the Fund” as a direct investor in the Fund

Subsidiary Blocker, in which the blocker is positioned “below the Fund” as a wholly-owned subsidiary of the Fund to invest in one or more portfolio entities

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

Alternative Investment Vehicle, in which the blocker invests alongside the fund, and certain investors (such as exempts or non-U.S. investors), invest through the AIV, rather than through the Fund

16

Key Tax Issues: Tax Payment and Filing

Foreign withholding, tax payment and filing obligations Will the GP provide any comfort that the LP will not be

subjected to tax payment or filing obligations in a non-U.S. jurisdiction?

Will the GP undertake to minimize foreign withholding taxes and/or assist the LP in obtaining refunds of amounts erroneously withheld (or amounts that can be reclaimed by law)?

Blockers can also be used to block direct payment or filing obligations

FATCA Increased need for information from investors Risk of withholding and indemnification issues

17

Other Key Tax Issues

Tax Information Reporting Will the GP agree to provide K-1s or other informational reporting by a

specific time that is acceptable to the LP? Will the GP provide enough information to the LP?

U.S. Tax Withholding Depending on the LP, you may want to request that the GP notify the LP prior

to withholding any U.S. tax with respect to that LP’s interest. You should confirm that the Fund will comply with FATCA requirements,

including ensuring that non-U.S. Funds (and any non-U.S. AIVs and SPVs) will take steps to avoid additional withholding as a result of its status as a “Foreign Financial Institution.”

How is Withholding treated? As a distribution? If more than the LP’s distribution for a set period, does it

convert to a loan?

Do the tax matters partner/partnership representative provisions appear to give the GP too much power or require too much of the LP in the event of an audit?

18

Agenda

Hot Topics


Key Tax Issues





19

U.S.

Taxable

C Corp.

35% c.g. and o.i.

Fund L.P.

Portfolio

Corp.

Portfolio

LLC

- Gain on interest sale

- Gain on asset sale

- Interest

- Gain on debt sale

U.S. Taxable

Individual

- 20% c.g.

- 39.6% o.i.

- 3.8% nii

- Gain on stock sale

- Dividends

- Interest

- Gain on debt sale

No Fund Blocker desired

Unblocked investor can also claim tax credits

and treaty benefits

U. S. Taxable Individuals and Corporations 20

U. S. State and

Local Government

0% U.S. tax rate

Fund L.P.

Portfolio

Corp.

Portfolio

LLC

Gain/income


Unblocked can also claim treaty benefits

Gain/income

U. S. State and Local Government

21

U.S. Tax-Exempt

0% U.S. tax rate

Fund L.P.

Portfolio

Corp.

Portfolio

LLC

- Gain on interest sale (c.g.)

- Interest

- Gain on debt sale (c.g.)


- Dividends

- Interest

- Gain on debt sale


Unblocked investor can also claim treaty benefits

- Gain on sale of

noninventory property

U. S. Tax-Exempt Investors 22

U.S. Tax-Exempt

35% U.S. tax rate

Fund L.P.

Portfolio

LLC

Fees earned by L.P.

Fund Blocker often desired

Unrelated business taxable income (UBTI)

- Operating income

- Gain on sale of inventory

U. S. Tax-Exempt Investors (cont’d) 23

U.S. Tax-Exempt

35% U.S. tax rate

Fund L.P.

Portfolio

Corp.

Portfolio

LLC

Debt-Financed:

- Gain on interest sale

- Interest

- Gain on debt sale

Debt-Financed:


- Dividends

- Interest

- Gain on debt sale

Debt-financed income is UBTI

Fund Blocker often desired

Debt-Financed:

- Gain on sale

of any property

- Operating Income

U. S. Tax-Exempt Investors (cont’d) 24

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)

U. S. Tax-Exempt Investors (cont’d) Parallel Fund Structure

25

U.S. Tax-Exempt Investor 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

Minimize risk that Fund interest will be treated as part of non-U.S. individual investor’s estate for U.S. estate tax purposes

26

U.S. Tax-Exempt Investor (cont’d) Parallel Fund Structure

Why use U.S. Feeder?

Easier to claim U.S. treaty benefits—only need to issue W-8BEN to U.S. Feeder

Will treaty benefits "flow-through" a non-U.S. Feeder to a non-U.S. investor? Generally, non-U.S. entity must be fiscally transparent for non-U.S. as well as U.S. purposes

See also Section 894(c).

27

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

28

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 pass-through 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

29

Non-U.S. Investor

0% U.S. tax rate

Fund L.P.

Portfolio

Corp.

Portfolio

LLC

U.S. Source:

- Portfolio interest

- Gain on debt sale


Portfolio

Corp.

Non-U.S.

Source:

- Gain/income

U.S. Source:


Non-U. S. Investors (cont’d) 30

Non-U.S. Investor

30% U.S. tax rate (unless treaty applies)

Fund L.P.

Treaty benefits can be

claimed

Non-U.S. pension fund from

a treaty country – 0% U.S.

tax rate

No Fund Blocker desired Portfolio

Corp.

U.S. Source:

- Dividends

- Non-portfolio interest


Non-U.S. Investor

35%/39.6% U.S. tax rate

Fund L.P. Fund Blocker usually

desired

Gain on interest sale (ECI)

Portfolio

LLC

U.S. Source:

- Gain on sale of operating assests (ECI)

- Operating income (ECI)


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)

Non-U. S. Investors (cont’d) Parallel Fund Structure

33

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

34

Non-U.S. Governmental Investors

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 U.S. or non-U.S.), 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

35

Non-U.S. Government

0% U.S. tax rate

Fund L.P.

Portfolio

Corp.

Portfolio

LLC

U.S. Source:

- Interest

- Gain on debt sale


Portfolio

Corp.

Non-U.S.

Source:

- Gain/income

U.S. Source:


- Interest

- Dividends

Non-U. S. Governmental Investors (cont’d) 36

Non-U.S. Government

35% U.S. tax rate

Fund L.P.

Fund Blocker desired

Gain on interest sale (CAI)

Portfolio

LLC

U.S. Source:

- Operating income (CAI)

- Gain on sale of operating assets (CAI)


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)


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.S. Investors, but not for Non-U.S. Governmental Investors

39

Agenda

Hot Topics


Key Tax Issues





40

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 Sun Capital decision

41

Main Fund

Other Investors

Parallel Fund

Portfolio

LLC

Intermediate

Partnership

GP

Electing U.S. Tax-Exempt, Non-U.S. and Non-U.S.

Governmental Investors

Blocker Corp.

Portfolio Corp.

Carry Carry

Simplified Parallel Fund 42

AIV “A”

Other Investors

AIV “B”

Portfolio

LLC

Intermediate

Partnership

GP

Main Fund

All Investors

Blocker Corp.

Portfolio Corp.

Carry

Carry

Electing U.S. Tax-Exempt, Non-U.S. and Non-U.S.

Governmental Investors

Alternative Investment Vehicle 43

Other Investors

Portfolio

LLC

GP

Electing U.S. Tax-Exempt, Non-U.S. and Non-U.S. Governmental Investors

Main Fund L.P.

Feeder Fund

(Offshore)

Portfolio Corp.

Feeder Fund – No Flexibility 44

Non-U.S./U.S. Tax-Exempt

Investors

Fund

U.S.

Corp. Blocker

Taxable Investors

Portfolio

LLC

Taxable investor capital

Sensitive investor capital

Subsidiary Blocker Structures 45

Agenda

Hot Topics


Key Tax Issues





46

Investing in Hedge Funds

• Hedge Funds

– Lightly regulated

– Sold in private offerings

– Sophisticated investors (e.g., “qualified purchaser”)

– Variety of investment approaches/risk profiles, often highly risky, and often employ leverage

– Often hold many small positions in public securities, with some exposure to private, illiquid investments

– Investors typically can invest/exit on a periodic basis (e.g., monthly, quarterly, annually) based on NAV, although, limitations may apply (e.g., “gate” provisions, lock-up periods, withdrawal fees)

47

Investing in Hedge Funds, cont’d

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 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

48

Types of U.S. 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 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

• Deferral of 3.8% Medicare tax on NII until distribution

• Effective deduction of management fees in non-trader fund

49

Types of U.S. 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

50

Investing in Private Equity Funds

Private Equity Funds Very lightly regulated Sold in private offerings Sophisticated investors

Investments consist of a relatively small number of controlling equity positions in private corporations

Investors invest at inception and receive cash only as underlying investments are sold and proceeds distributed

Limited term (e.g., 10-12 years)

Typically no leverage - Bridge financing not uncommon

Illiquid

51

Investing In Real Estate Funds

Real Estate Funds Very lightly regulated Sold in private offerings Sophisticated investors

Structure may vary significantly fund to fund, from private-equity type funds that make a small number of large investments, to funds that make a large number of investments in smaller deals

Funds may also be structured as REITs, or incorporate REITs into a partnership structure

May or may not have limited term; varying degrees of liquidity; many funds will utilize leverage at the fund level

52

Real Estate: ECI and UBTI-driven Structures

514(c)(9) and Real Estate Investments Exception to debt-financed UBTI rule for certain acquisition

indebtedness of Educational Organizations, Qualified Retirement Plans, and Certain Related Organizations, used to purchase real estate.

Note that it does not apply to other exempts, including charitable foundations and non-Educational charitable organizations

To fall within this exception, the debt must meet certain requirements, including (but not limited to) the following:

Purchase Price fixed as of date of acquisition or improvement of property

Payment of principal and interest (and timing of payment) not dependent on the revenue, profits or income derived from the property (Continued…)

53

– UBTI: When an investment is held through a partnership: satisfy both the “Qualified Allocations” and “Fractions Rule” with respect to allocations from the partnership

• The Qualified Allocations Rule generally requires that allocations meet the “substantial economic effect provisions of section 704(c) of the Code, and fall within the definition of qualified allocation under section 168(h)(6) of the Code.

• The Fractions Rule is satisfied if the organization receives the same distributive share of each item of partnership income, gain, loss, deduction, credit, or basis. The purpose is generally to prevent shifting of items among partners.

• Note that if you represent a Fund-of-Funds, the investors in the Fund-of-Funds will only benefit if the Fund-of-Funds itself meets these requirements.

Real Estate: ECI and UBTI-driven Structures

54

Real Estate: ECI and UBTI-driven Structures, Cont’d

- ECI: Risks for non-U.S. investors in US real estate, even through corporations.

In general, non-US persons generally do not pay U.S. tax on disposals of stock or securities of U.S. issuers

FIRPTA (Foreign Investment in Real Property Tax Act) 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

55

Real Estate: Risks of ECI

FIRPTA gains (and other “trade or business” gain) are treated as ECI, which most non-U.S. investors want to avoid. Why?

Tax imposed at U.S. tax rates

Collected partially through withholding

Non-US person with ECI (including FIRPTA gain) also incurs a US federal income tax filing obligation

What about branch profits tax? Requires a close look at the fund structure; can push tax rate over 50%

Possible Solutions? US blockers (but note that the U.S. blocker itself may be a USRPH which

would trigger FIRPTA gain if sold, but that’s a pretty unlikely exit). Doesn’t solve tax or filing completely, but pushes it down a level. Can leverage blocker for greater efficiency.

Depending on structure, REITs can help minimize taxation, but need to be “domestically controlled”

56

Sample FIRPTA Structure

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

57

FIRPTA Structures (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

Offshore Blocker

Loan

Financing the U.S. Blocker: Potential

Complications (Withholding Tax,

Earnings Stripping, AHYDO, Section 267)

Interest

58

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

• U.S. source income = FATCA implications for fund and its investors

59

Venture Funds

Venture Funds Very lightly regulated Sold in private offerings Sophisticated investors

Investments consist of positions in companies that are in the early stages of development

Often will structure its investments as non-controlling, preferred interests

Tend to make more investments than PE funds

60

Venture Funds (cont’d)

Higher return, higher risk

Similar tax concerns to PE funds

Focus on different types of investments Preferred stock and convertible debt

Pass-through targets are more common

Fund may have more leverage over portfolio company Better access to information (e.g., CFCs, PFICs)

Increased control over tax structuring on exit

Portfolio companies more likely to use complicated compensation structures Options, SARs and restricted stock

61

Mezzanine Debt and Other Credit Funds

Can be structured similar to either PE fund or a hedge fund, depending on investment horizon

Complicated structuring alternatives

CLOs and other structured products

Key issue for non-U.S. investors: portfolio interest expense exclusion to FDAP withholding

Increasing risk of ECI from loan origination

YA Global case

Example of IRS following SEC enforcement

62

Fund of Funds

All of the above! Concerns driven by investor base and asset classes

Evergreen structures create particular complexity

Tiered filing obligations Can cause delays in reporting information to investors

Less control over tax attributes of underlying funds PFICs and CFC

Information rights

Protections against foreign tax filing and payments

Higher reliance on principles in side letters

63

Agenda

Hot Topics


Key Tax Issues





64

Carried Interest 65

General partner entitled to a profits participation (“carried interest,” “promote”, “performance allocation”)

Distribution waterfall of fund’s operating agreement sets out amount of carried interest and manner in which it is distributed: usually set percentage of profits (typically 20%, can be higher or

lower)

typically subordinated to the return of capital contributions and the preferred return to the fund’s investors

Timing of payment unpredictable

depends on profitability of fund’s investments

Lower in priority to payments to fund’s investors

Generally taxed as a capital gain to the general partner

Management Fees 66

Conflicting Interests of Managers and Investors

The key economic incentive for investors in a private equity fund is the opportunity to earn a high rate of return on their invested capital.

The key economic incentives for sponsors of the fund, on the other hand, are to earn management fees and a profit participation on the fund’s investments (i.e., the carried interest).

Management Fees 67

The fund’s investment manager or advisor will receive a management fee (typically 1.5%-2% of total committed capital) for its investment advice rendered to the fund (and to the fund’s general partner)

Management fees are: In addition to carried interest Used to cover overhead costs of a fund’s operations Paid in regular intervals (usually on quarterly or semi-annual basis) Usually taxed as ordinary income Generally paid from either (i) the investors’ capital contributions to the

fund or (ii) the proceeds from the fund’s investments

If investors make capital contributions to the fund to cover management fees, such contributions may reduce unfunded capital commitment

Deviations from Standard Fee Structures 68

Management fees often deviate from the market rate of 1.5%-2% of the fund’s capital commitments: Larger funds and funds with less oversight and monitoring

requirements typically charge lower management fees.

Mezzanine Funds — historically 1.5% management fees.

Smaller, First-Time Funds — may have management fees of 2.5%.

Real Estate Funds — management fees often charged based on the amounts invested in properties.

Side-by-side Vehicles — investors in the co-investment entities are often charged less than 2%.

Fund managers sometimes forego market rate management fees for increased carried interest

Considerations for Fee Structures

Management Fee Waiver

Management Fee Waiver Design To ensure interest is a “profits” interest rather than a “capital” interest To reduce risk of “disguised payment for services”

New Fee Waiver Regulations Many pre-existing fee waivers won’t work IRS intent on reclassifying allocations of profits into compensation

where there is a compensatory intent If a GP keeps fee waivers, likely to change substantially

69

Considerations for Fee Structures (cont’d) 70

Other Fees and Management Fee Offsets Reduction of management fees if the investment manager receives

transactional fees directly from the fund’s portfolio companies or other activities.

Management fees are routinely reduced by 50%–100% of transaction fees, which include:

Break-Up Fees

Directors Fees

Advisory and Similar Fees

Acquisition and Disposition Fees

Affiliate Service Fees

Risk of reclassification by the IRS

Sun Capital decision (ERISA context… but apply more broadly?)

Tax Distribution Provisions

Intended to ensure that the GP (and other partners) are able to pay tax on “phantom” income

Key Questions: Who gets them? Just the GP or all investors?... can be important for

taxable investors

Are there limitations on cash flows (i.e., to avoid borrowing)?

How often will the GP receive tax distributions?

How is the “tax” calculated?

Hypothetical or actual?

What state or locality is assumed?

Cumulative or non-cumulative?

Coordination with distribution waterfall and clawback (i.e., is it treated as an advance?)

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Allocations and Clawbacks

Compare distributions, allocations and liquidation provisions to check whether structure achieves the intended economics Allocations must have substantial economic effect or be in accordance

with the partners interests in the partnership under section 704(b) of the Code in order to be respected…

GP Clawbacks – Key Questions:

Is the GP required to return excess distributions? If so, is the excess calculated before or after the GP’s tax is taken into

consideration? Does the Clawback appear to cover the full amount and is it supported by

guarantees from principals of the GP?

LP Clawbacks – Key Quesitons:

Is the LP required to return any portion of its distributions? Under what circumstances and for how long?

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Negotiating GP Undertakings

Level of Undertaking:

Will (flat), Reasonable Best Efforts, Reasonable Efforts, or Commercially Reasonable Efforts?

Nature of Undertaking:

Minimize UBTI or ECI, avoid UBTI or ECI, avoid investments that generate UBTI or ECI, or maximize after-tax returns of tax-exempt or non-U.S. investors?

Any caveat for GP discretion?

All investors or class of investors? (cf “maximize after-tax returns to the limited partners” with above)

Act in best interests of Fund, investors overall or class of investors?

Carve-out for management fee offset, or any other particular activity of a fund?

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Negotiating GP Undertakings (cont’d)

Example

(note: this is an actual example of a GP-friendly provision proposed by GP’s counsel; provisions vary greatly)

The General Partner shall use commercially reasonable efforts to structure Portfolio Investments in a manner that will not result in the realization by any Tax-Exempt Partner of more than a de minimis amount of UBTI, other than UBTI that may result from reductions in Management Fees pursuant to Section 7.2.

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Side Letters & Other Negotiation Strategies

Key Tax Issues commonly addressed

PFIC/QEF election and CFCs

Foundation issues

ERISA issues

MFN clauses

Prohibited transactions

892 Non-U.S. Governmental Investors

Non-U.S. investor-specific issues

Tax reporting

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Questions?

Kathleen (Kat) Saunders Gregor

Ropes & Gray

[email protected]

Elizabeth M. Norman

Nutter McClennen & Fish

[email protected]

Cara Howe Santoro

Nutter McClennen & Fish

[email protected]

mailto:[email protected]

