Tax Alert
May 2009
Authors:
Tax Proposals Would Impact Funds
Joel D. Almquist
joel.almquist@klgates.com
+1.617.261.3104
Donald P. Board
The Administration s Fiscal Year 2010 Revenue Proposals released in May 2009
contain several revenue provisions that, if enacted, would significantly affect the
taxation and reporting obligations of private funds, their investors, and
their managers.
donald.board@klgates.com
+1.617.261.3103
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Although the prospect for enactment of these proposals is uncertain, it seems likely
that changes in the tax laws will be made this year. Congressional leaders have
identified health care reform and energy as top agenda items for 2009. In light of the
hefty price tag of those legislative initiatives, coming soon after the recent expense of
the economic recovery package and Wall Street bailout, Congress likely will be
searching for revenue measures to pay for these priorities. Moreover, pressure to
deal with the expiring estate tax, as well as other expiring tax incentives such as the
R&D tax credit and the IRA charitable rollover, likely will impel Congress to
consider tax legislation later this year. Although it is hard to predict whether one or
more of the proposals described below or altogether different proposals will be
enacted, all of these proposals merit attention.
Tax Carried (Profits) Interests as Ordinary Income and SelfEmployment Income
Under current law, a general partner s carried interest in a partnership i.e., an
interest not received in exchange for property or other invested capital retains the
tax character of the partnership income and gain allocated to the general partner. A
general partner s carried interest can include such tax-favorable items as long-term
capital gain and unrealized appreciation.
The Administration proposes to designate the interest of any partnership that is
earned as a result of a partner s services to the partnership as a services partnership
interest (SPI) and to tax the portion of that partner s SPI income that is not
attributable to invested capital as ordinary income, regardless of the character of the
allocated amount at the partnership level. In addition, the partner would be required
to pay self-employment taxes on such income, and the gain recognized on the sale of
an SPI that is not attributable to invested capital would generally be taxed as ordinary
income, not as capital gain. A partnership allocation attributable to a service
partner s invested capital, however, would retain the tax characteristics of
partnership items allocated to the partner, and any gain realized on a sale of the
interest attributable to such partner s invested capital would be characterized as
appropriate under current law.
In addition, the Administration proposes to treat income or gain arising from certain
service-related interests such as convertible or contingent debt, an option or any
derivative interest in an entity (regardless of whether or not it is a partnership for
income tax purposes) as ordinary income.
Tax Alert
Earlier legislative initiatives proposed similar
treatment only for investment services partnership
interests. The Administration s proposal would
impact all partnerships. This proposal would be
effective for taxable years beginning after December
31, 2010, and the Administration estimates that it
would raise approximately $23.478 billion over
ten years.
Eliminate Capital Gains Taxation on
Investments in Small Business Stock
Current law provides a 50 percent exclusion from
tax for capital gains realized on the sale of certain
small business stock acquired by a non-corporate
taxpayer at original issue and held for more than five
years. The American Recovery and Reinvestment
Act of 2009 temporarily increased the exclusion to
75 percent. The amount of gain eligible for the
exclusion by a taxpayer with respect to any
corporation during any year is the greater of (1) ten
times the taxpayer's basis in stock issued by the
corporation and disposed of during the year, or
(2) $10 million, reduced by gain excluded in prior
years on dispositions of the corporation s stock. To
qualify as a small business, the corporation, when
the stock is issued, may not have gross assets
exceeding $50 million (including the proceeds of the
newly issued stock) and may not be an S
corporation. The corporation also must meet certain
active trade or business requirements.
Until 2009, individual taxpayers had not derived
much benefit from the 50 percent exclusion for two
reasons. First, the taxable portion of any gain is
subject to regular tax at a 28 percent rate, resulting
in an effective tax of 14%. This is not much better
than the favorable 15 percent rate currently
applicable to long-term capital gains. Second, the
alternative minimum tax ( AMT ) applies to both
the nonexcluded portion of the gain (50 percent) and
to 7 percent of the excluded portion, typically
resulting in an AMT liability equal to 14.98 percent
of the total gain virtually identical to the rate under
the regular tax. The enactment of the American
Recovery and Reinvestment Act of 2009, which
expanded the exclusion to pick up 75 percent of the
gain, cuts both of those effective tax rates in half,
making qualified small business stock a significantly
more attractive investment.
The Administration s current proposal would pull
out all the stops. The percentage exclusion for
qualified small business stock sold by an individual
taxpayer would be increased to 100 percent and no
part of the excluded gain would be treated as an
AMT preference item. The effective tax rate on
gain from a sale of qualified small business would
therefore be zero for both regular tax and AMT
purposes. The proposal would be effective for
qualified small business stock issued after February
17, 2009 and would cost an estimated $5.835 billion
over ten years.
The changing treatment of qualified small business
stock should interest individual taxpayers who
invest in such enterprises through partnerships and
similar entities. Generally, the tax benefits
associated with qualified small business stock will
pass through to such investors as long as they have
held their interests in the partnership for the entire
period that the partnership held the qualified small
business stock. As a consequence, the recently
enacted change and the Administration s current
proposal should be especially useful to individuals
investing in private equity funds or other long-term
vehicles, who may be more comfortable waiting out
a 5-year holding period.
Prevent the Use of Swaps to Avoid
Dividend Withholding Tax
Foreign investors are subject to a 30% withholding
tax on payments of U.S.-source dividends and
certain other types of passive income. Payments
received on a notional principal contract or swap,
however, are generally treated as arising in the
jurisdiction in which the recipient resides.
Payments to a foreign investor on an equity swap
that effectively substitutes for U.S.-source dividends
are therefore treated as foreign-source income and
are not subject to withholding.
Under the Administration s proposal, income earned
by foreign persons with respect to equity swaps that
reference U.S. equities would be treated as U.S.sourced to the extent that the income is attributable
to (or calculated by reference to) dividends paid by
a domestic corporation. An exception to this source
rule would apply to swaps that have characteristics
indicating that they are not equivalent to stock
ownership. The proposal also would address the
avoidance of U.S. withholding tax through the use
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Tax Alert
of securities lending transactions. The proposal
would be effective in 2011 and would raise an
estimated $1.407 billion over ten years.
Business Entity Classification Rules
for Certain Foreign Entities
A foreign eligible entity may generally elect its
classification corporation, partnership or
disregarded entity for U.S. tax purposes. These
elections can reduce the amount of U.S. tax required
to be paid currently by a direct or indirect U.S.
shareholder of such an entity, particularly where the
foreign entity elects to be a disregarded entity. In
certain cases, locating a foreign disregarded entity
under a centralized holding company (or
partnership) may permit the migration of earnings to
low-taxed jurisdictions without a current income
inclusion of the amount of such earnings to a U.S.
taxpayer under the subpart F provisions of the Code.
The Administration s proposal would require a
foreign entity having a single owner to be treated as
a corporation for U.S. tax purposes if the entity is
created or organized under the laws of a different
jurisdiction than its parent (although this limitation
would generally not apply to a first-tier foreign
subsidiary of a U.S. person). The proposal would be
effective for taxable years beginning December 31,
2010 and would raise an estimated $86.509 billion
over ten years.
In its current form, the Administration s proposal
would not appear to impact the ability of an offshore
master fund in a classic master-feeder fund structure
to check-the-box to be treated as a partnership for
U.S. federal income tax purposes, although it may
affect the use of wholly-owned intermediary
investment structures.
Require Ordinary Treatment for
Certain Dealers of Equity Options and
Commodities
Under current law, commodities dealers,
commodities derivatives dealers, dealers in
securities and options dealers treat the income from
certain of their day-to-day dealer activities as giving
rise to capital gain. Under section 1256, these
dealers treat 60 percent of their income (or loss)
from their dealer activities as long-term capital gain
(or loss) and 40 percent of their income (or loss)
from their dealer activities as short-term capital gain
(or loss).
The Administration s proposal would require these
dealers to treat the income from their day-to-day
dealer activities as ordinary in character, not capital
gains. The proposal would be effective for taxable
years as of the date of enactment and would raise an
estimated $2.573 billion over ten years.
This proposal should also be monitored to see
whether any resulting legislation would impact the
applicability of section 1256 s 60/40 capital gain
treatment to non-dealer transactions.
Developments Relating to Foreign
Financial Accounts and Entities
The Administration proposes a number of changes
to the reporting and compliance requirements for
U.S. persons holding foreign financial accounts.
These proposals could impose new reporting
requirements on U.S. investors in offshore funds
and U.S. investors in domestic feeder funds that
invest in offshore master funds, as well as on the
funds themselves. The proposals would be effective
for taxable years as of December 31 of the year of
enactment.
Interests in Foreign Accounts. U.S. persons
must currently disclose whether, at any time during
the preceding year, they had an interest in, or
signature or other authority over, financial accounts
in a foreign country, if the aggregate value of these
accounts exceeds $10,000. This disclosure is made
by filing with the Treasury Department a Report of
Foreign Bank and Financial Accounts (FBAR).
Under the Administration s proposal, individual
taxpayers required to file an FBAR would be
required to disclose certain information on their
income tax returns. The information would be
disclosed on a schedule that would be considered
part of the individual's income tax return. The tax
return disclosure would not replace or mitigate the
individual's obligation to separately file an FBAR
with the Treasury Department. The Administration s proposal would further require any U.S.
individual to report, on the individual's income tax
return, any transfer of money or property made to,
or receipt of money or property from, any foreign
bank, brokerage, or other financial account by the
individual, or by any entity of which the individual
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Tax Alert
owns, actually or constructively, more than 50
percent of the ownership interest. Failure to report a
covered transfer would result in the imposition of a
penalty equal to the lesser of $10,000 per reportable
transfer or 10 percent of the cumulative amount or
value of the unreported covered transfers.
Pursuant to a separate proposal, a rebuttable
evidentiary presumption would be applicable in a
civil administrative or judicial proceeding providing
that any foreign bank, brokerage, or other financial
account in which a citizen or resident of the U.S., or
a person in and doing business in the U.S., has a
financial interest in or signature or other authority
over the account contains enough funds to require
that an FBAR be filed.
Third-Party Reporting Requirements. Current
law does not generally require third-party
information reporting to the IRS with regard to the
transfer of money or property to, or receipt of money
or property from, a foreign bank, brokerage, or other
financial account on behalf of a U.S. person, or with
regard to the establishment of a foreign bank,
brokerage, or other financial account on behalf of a
U.S. person. The Administration s proposal would
require any U.S. financial intermediary and any
qualified intermediary that transfers money or
property with a value of more than $10,000 to a
foreign bank, brokerage, or other financial account
on behalf of a U.S. person to file an information
return regarding such transfer.
U.S. persons must currently report certain
information with respect to certain foreign business
entities that they control. Current law does not
generally require third-party information reporting in
connection with the acquisition or formation of a
foreign business entity on behalf of a U.S.
individual. Current law does not require withholding
agents to ascertain the ownership of foreign payees
that may be entities with respect to which U.S.
persons have a U.S. reporting or income tax
obligation. The Administration s proposal would
require any U.S. person, or any qualified
intermediary, that forms or acquires a foreign entity
on behalf of a U.S. individual to file an information
return with the IRS regarding the foreign entity that
is formed or acquired.
Extend Statute of Limitations. In general, under
current law, additional federal tax liabilities in the
form of tax, interest, penalties, and additions to tax
must be assessed by the IRS within three years after
the date a return is filed. If an assessment is not
made within the required time period, the additional
liabilities generally cannot be assessed or collected
at any future time. The Administration s proposal
would extend the limitations period with respect to
any tax relating to any event or period for which
information returns are required with respect to
certain foreign transfers, foreign entities, and
foreign-owned entities to six years after the
taxpayer furnishes the information required to be
reported.
Double Accuracy-Related Penalties. Current
law imposes a 20-percent accuracy-related penalty
on (i) a substantial understatement of income tax,
(ii) an understatement resulting from negligence or
disregard of rules or regulations, and (iii) an
understatement related to a reportable transaction.
The 20-percent accuracy-related penalty increases
to 30 percent in the case of an understatement from
a reportable transaction that was not properly
disclosed. The accuracy-related penalty is not
imposed when the taxpayer demonstrates
reasonable cause for the position and acted in
good faith. Under the proposal, the 20-percent
accuracy-related penalty imposed on (i) substantial
understatements of income tax, (ii) understatements
resulting from negligence or disregard of rules or
regulations, or (iii) a reportable transaction
understatement, would be doubled to 40 percent
when the understatement arises from a transaction
involving a foreign account that the taxpayer failed
to disclose properly under the proposed requirement
that taxpayers disclose FBAR-related information
on their income tax returns.
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Tax Alert
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