THE CHANGING VENTURE CAPITAL LANDSCAPE:
Summary of Recent U.S. and European Legislative Proposals
Evolving PRC Investment Structures
Best Tax Compliance Practices for Funds with U.S. Investors or Managers
CVCFO November 2009 Meeting
Steven R. Franklin
sfranklin@gunder.com
GUNDERSON DETTMER STOUGH VILLENEUVE FRANKLIN & HACHIGIAN, LLP
1093430.1
U.S. Advisers Act Legislation
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U.S. Advisers Act Legislation
♦ Private Fund Investment Advisers Registration Act of
2009 (House of Representatives)
– Removes exemption from registration historically relied upon by venture capital and private
equity funds
– Authorizes SEC to collect additional information in the public interest/investor protection
– Exempts
• “Venture Capital” funds, a term to be defined later
– Unclear how this will ultimately be defined. It is intended to exclude buy-out
funds, which may pose problems for late-stage venture capital funds
• Advisers managing SBICs
• Advisers with individual funds <$150m
– Includes Non-U.S. funds that have raised money from U.S. investors
– Passed House Financial Services Comm. 67-1
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U.S. Advisers Act Legislation (Cont.)
♦ Private Fund Investment Advisers Registration Act of 2009
(Senate)
–
–
Remove Adviser Act exemption from funds with less than 15 clients
Limited foreign private adviser exemption
•
•
•
–
Exempts
•
•
•
•
–
–
“Venture Capital Funds,” term to be defined by SEC; exempt from registration
“Private Equity Funds,” term to be defined by SEC; exempt from registration, but subject to
recordkeeping and access requirements
“Family Offices,” term to be defined by SEC; excepted from the definition altogether
Advisers with individual funds <$150m
Introduced by Sen. Chris Dodd
•
•
•
–
No U.S. place of business
Fewer than 15 U.S. clients
Less then $25 million assets under management attributable to U.S. Clients
Chairman of the Senate Committee on Banking, Housing and Urban Affairs.
Likely supersedes previous legislation (including Sen. Reed’s similar proposal)
Part of >1000 page legislation on financial systems reform
Increases the minimum threshold from $25M to $100M for SEC registration; smaller
funds must register with the states.
Directs the SEC to adjust the “accredited investor” threshold under the 1933 Act every
5 years.
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U.S. Advisers Act Legislation (Cont.)
What does Adviser Act compliance entail?
♦ Electronic registration on Form ADV
– Part I – Basic information, including jurisdiction of incorporation, place of business, structure of
investment adviser, states in U.S. where they operate, criminal/civil legal proceeding history
– Part II – Nature of services, fees charged, investment objectives, risks, strategies, methods of
analysis of prospective investments, sources of information, affiliations in financial sector including
related conflicts, education and other business background
♦ Performance Fees
– May only be charged if investor is a “Qualified Client” – defined as (i) a Qualified Purchaser under
the Investment Company Act, (ii) if $750,000 is invested in fund, (iii) net worth in excess of $1.5
million or (iv) non-U.S. person
– Result = Traditional 3(c)(1) funds (i.e, funds that want to raise money from smaller institutions and
from individuals with less than $5MM of investment assets) will be more difficult to form without an
exemption
♦ SEC Examinations, compliance program, code of ethics, periodic filings to
clients and the SEC, appointment of Chief Compliance Officer, custodial
rules, prohibitations on certain forms of advertising, no assignment of
services without consent, and recordkeeping
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Additional U.S. Legislation
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Additional U.S. Legislation
♦ Other bills have been introduced to study the
effects investment funds have had on the market
and recommend further regulations.
–
–
–
–
–
Financial Oversight Commission Act of 2009
Financial Crisis Investigation Act of 2009
Hedge Fund Adviser Registration Act of 2009
Pension Security Act of 2009
Hedge Fund Transparency Act
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Additional U.S. Legislation (Cont.)
NY State Power of Attorney Statute
♦ Effective Sep. 1, 2009 all powers of attorney (“POA”)
signed in NY by natural persons must comply with a new
set of rules
– Require disclosures, certain fonts, notarization
– Any new POA revokes all previously executed POAs
♦ Major implications for funds
– Changes fiduciary relationship (GP owes duty to LP)
– Careful drafting of new POAs so as not to affect old POAs
– “Passing through New York” problems
♦ Be careful about amending vs. amending and restating
agreements so as not to extinguish existing POA
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EU Legislation
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EU Legislation
♦ The Directive on Alternative Investment Fund Managers
was proposed on April 29, 2009 by the European
Commission.
♦ Attempts to regulate investment funds that are not
already covered by current EU regulations, UCITS
(Undertakings for Collective Investment in Transferrable
Securities).
♦ Subjects fund manager with € 500 million in assets
under management with no right of redemption for 5
years (or €100 million in assets if leveraged) to various
regulatory restrictions.
– Aimed at both EU and Non-EU domiciled funds.
– Requires disclosure requirements similar to Adviser Act of 2009.
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EU Legislation (Cont.)
♦ EU based fund managers would be subject to
local regimes (i.e. U.K. Financial Services
Authority)
– LPA must be provided to regulator
– Conduct of business principles, strict conflicts of interest rules,
risk management, GP capital account requirement (€125,000 +
0.02% of assets > €250,000), independent valuator for portfolio
valuation, custodial requirements, annual report to investors and
regulator, among other items
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EU Legislation (Cont.)
♦ Marketing to EU based investors
– EU based manager
• Must be authorized (see above)
• Can only market to “professional investors” (institutions, and only limited
high net worth individuals), except as provided by local law
• Before marketing must provide regulator with all fund related documents
– Non-EU domiciled funds → Same rules as above and must be
based in OECD compliant tax jurisdiction
– Non-EU fund mangers → Must elect to be subject to the financial
regulatory rules of at least one EU country
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EU Legislation (Cont.)
Recent developments regarding these proposed EU
regulations:
♦ Charles River study of compliance costs (as a % of
assets under management)
– VC – one-time .338%, ongoing annual.248%
– PE – one-time .421%, annual .138%
♦ European Central Bank warned in October that private
equity would flee Europe if adopted
♦ UK has mounted stiff opposition, though France, Spain
and Germany are supportive
♦ Requires approval of EU Parliament and EU
governments
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U.S. Carried Interest Tax Legislation
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U.S. Carried Interest Tax Legislation
History of Proposals
♦ In 2007 Representative Sander Levin introduced bill to
address carried interests, treating carried interests as
services income
♦ Later in 2007, House of Representatives passed the
“Temporary Tax Relief Act of 2007,” which included
provision on carried interests
♦ Similar provision passed House in “Alternative Minimum
Tax Relief Act of 2008”
♦ On April 3, 2009, Representative Levin introduced bill
revising technical aspects of House legislation
♦ On May 11, 2009, Administration budget described
provision to tax carried interests
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U.S. Carried Interest Tax Legislation (Cont.)
Recent Developments
♦ House Ways and Means Committee has announced it
intends to move forward in the coming months to pass
carried interest tax legislation
♦ Sen. Schumer, a past critic, is now in favor of such
proposals
– Any proposal will require 60 votes in the Senate
♦ Top marginal tax rate is scheduled to increase to 39.6%
in 2011; self employment tax would add another 3%
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U.S. Carried Interest Tax Legislation (Cont.)
Who is Covered?
♦ Levin Bill covers only holders of “investment services partnership interest”
♦ Obama Administration budget proposal would expand scope so that all
industries are covered by carried interest legislation
– Obama Administration proposal would apply ordinary income treatment to a “services partnership
interest”
– Accordingly, covers a common/preferred capital structure of an operating company (including a
non-U.S. company that is treated as flow-through entity)
♦ Earlier versions of the bill would have taxed even non-U.S. investment
managers (not resident in the U.S.) if the Fund had any personnel inside the
U.S. Current version appears to only affect managers who are U.S. citizens
or residents or otherwise generally subject to U.S. tax (including Green
Card holders) or who are performing services in the U.S.
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U.S. Carried Interest Tax Legislation (Cont.)
Potential Impact
♦ What is the potential impact of the Levin bill for a
party who holds a carried interest?
– Net income and net loss with respect to an investment services
partnership interest is treated as ordinary.
– However, net losses are allowed only to the extent that aggregate
net income for prior years exceeds aggregate net losses for such
years.
– Net income is also treated as self-employment income, subject to
self-employment tax
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U.S. Carried Interest Tax Legislation (Cont.)
In-Kind Distributions Will Become Difficult Impossible
for Funds with U.S. Managers
♦ Property distributions no longer qualify for favorable
deferral available under existing law
– If the partnership distributes appreciated property with respect to an investment
services partnership interest
• Gain will be triggered to the partnership as if it sold the property for its fair market
value and that gain will be allocated to the distributee as ordinary income
• The property is treated as cash with respect to the distributee partner, so that gain
will be triggered to the extent that the value of the distributed property exceeds the
partner’s basis in the partnership interest (determined after adjustment for gain
allocated)
• Distributee partner takes fair market value basis in distributed property
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U.S. Carried Interest Tax Legislation (Cont.)
Treatment of Capital Interests
♦ The Levin bill exempts from its coverage the portion of a service
provider’s partnership interest that is acquired for invested capital.
♦ This requires that the partnership interest be acquired on account of
invested capital and that allocations of distributive share to the
service partner satisfy certain requirements, primarily that the
allocations are no more favorable than those made to other thirdparty investors.
♦ A partner providing services will not be treated as having a qualified
capital interest to the extent that contributed capital is attributable to
a loan or other advance made or guaranteed, directly or indirectly,
by any partner or the partnership (or a related person).
♦ Similarly, the Common “cashless contribution” technique would
convert all returns on cashless contributions into ordinary income
rather than capital gain.
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U.S. Carried Interest Tax Legislation (Cont.)
Anti-Avoidance Rules
♦ Section 6662 would be amended to provide a
40% penalty where a person had an
underpayment as a result of being treated as
violating anti-abuse regs.
– The penalty imposes “strict liability,” as it could not be avoided by
showing reasonable cause.
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U.S. Carried Interest Tax Legislation (Cont.)
Effective Date
♦ Effective date under Levin bill would apply to
income with respect to carried interests in
taxable years after the date of enactment
– No grandfather for existing carried interests
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U.S. Carried Interest Tax Legislation (Cont.)
Obama Budget
♦ Other than applying to a broader class of service
providers, the Obama Administration proposal
appears to follow the general structure of the
Levin Bill
–
–
–
–
Ordinary income and self-employment tax
Exception for “invested capital”
No mention of 40% penalty
Administration proposal would be effective for taxable years
beginning after December 31, 2010
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U.S. Carried Interest Tax Legislation (Cont.)
Cashless Contributions
Fund Return
Multiple
GP Capital
Contribution
Taxes Paid In Year
of
Contribution
on Fees used to
Generate Cap
Contribution
Return on
Contribution
Tax on Return
Opportunity Cost of
Taxes Paid In
Year of
Contribution
Based on Cost of
Funds over
Deferral Period
Taxes Paid on
Special
Allocation of
Income Equal
to Deemed
Capital
Contribution
Net Return
(Including
Taxes Paid on
Fees Used to
Fund Capital
Contribution)
BASE CASE: NO CASHLESS CONTRIBUTION
2
10,000,000
(5,000,000)
10,000,000
(2,500,000)
(1,572,237)
N/A
187,615
3
10,000,000
(5,000,000)
20,000,000
(5,000,000)
(1,572,237)
N/A
8,687,615
4
10,000,000
(5,000,000)
30,000,000
(7,500,000)
(1,572,237)
N/A
16,187,615
BEST CASE: CASHLESS CONTRIBUTION, CARRY TAXED AT CAPITAL GAINS RATES
2
10,000,000
-
10,000,000
(2,500,000)
N/A
(2,500,000)
5,000,000
3
10,000,000
-
20,000,000
(5,000,000)
N/A
(2,500,000)
12,500,000
4
10,000,000
-
30,000,000
(7,500,000)
N/A
(2,500,000)
20,000,000
WORST (?) CASE: CASHLESS CONTRIBUTION, CARRY TAXED AT ORDINARY INCOME RATES
2
10,000,000
-
10,000,000
(5,000,000)
N/A
(5,000,000)
--
3
10,000,000
-
20,000,000
(10,000,000)
N/A
(5,000,000)
5,000,000
4
10,000,000
-
30,000,000
(15,000,000)
N/A
(5,000,000)
10,000,000
Assumes 1) a 25% federal and state capital gains rate and 50% ordinary income rate (including state and self-employment tax); 2) a 4-year deferral period;
and 3) a cost of capital of 6%, compounded annually.
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U.S. Carried Interest Tax Legislation (Cont.)
Planning Options
♦ Front-load income to the General Partner prior to the
effective date of Carried Interest bill.
♦ Change in Law provisions of the Fund limited partnership
agreement theoretically can provide future flexibility,
although difficult to negotiate in today’s fund-raising
environment.
♦ There is no effective date specified for Carried Interest
bill and it is still early in the legislative process.
– Taking steps to plan for Carried Interest bill now may be premature.
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Other U.S.Tax Legislation
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Other U.S. Tax Legislation
Elimination of Disregarded Entities
♦ The Obama budget plan proposed that after December 31, 2010,
certain Non-U.S. disregarded entities be classified as
corporations for U.S. tax purposes.
♦ Exceptions –
– An eligible entity with a single owner organized in the same jurisdiction can
elect to be classified as a disregarded entity; and
– An eligible entity owned by a single U.S. person can elect to be classified as a
disregarded entity if it is not used for U.S. tax avoidance.
• U.S. tax avoidance is so far an undefined concept.
♦ Current disregarded entities not meeting an exception will likely
be converted when and if the law takes effect.
– This could impact most of the common investment structures used by international
funds to make PRC investments
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Other U.S. Tax Legislation (Cont.)
Eliminate Look-Thru on Withholding for Non-Qualified Intermediary
♦ The Obama budget plan proposed that the rules
regarding withholding on Non-U.S. partnerships and
other pass-thru entities be tightened up.
♦ Under the proposed rules, a Non-U.S. pass-thru entity
(such as a Cayman limited partnership) would no longer
be entitled to provide the withholding agent with the
relevant tax information of its beneficial owners.
♦ Instead, unless the Non-U.S. pass-thru entity registered
with the IRS as a “qualified” intermediary, the pass-thru
entity could be treated as an “unknown foreign person,”
thereby requiring the withholding agent to withhold tax at
the maximum 30% rate.
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Other Tax Legislation (Cont.)
Foreign Tax Compliance Act
♦ Introduced to both House and Senate in late October
♦ Will require U.S. LPs in Non-U.S. Venture Funds to
disclose such investments
– This will, in turn, increase LP information requests
♦ Similarly, direct and indirect holders of PFICs will be
required to report details of such holdings
♦ May possibly require sponsors of Non-U.S. Funds to files
certain reports detailing U.S. investor participation in the
Fund
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PRC Permanent Establishment (“PE”)
Developments
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PRC PE Developments
Traditional Offshore Structure
Cayman
SPV
Offshore
PRC
WFOE
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PRC PE Developments (Cont.)
More Recent Offshore Structure
Cayman
SPV
Treaty SPV
(typically Hong
Kong)
Offshore
PRC
WFOE
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PRC PE Developments (Cont.)
♦ Circular 124 and Recent PRC cases (Xingjiang
and Chongging) have cast doubt on the
effectiveness of structures utilizing special
purpose vehicles (“SPV”) in tax treaty
jurisdictions where the tax treaty entity has no
substance (i.e., no office, place of business,
employees or activities) in its country of
organization
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PRC PE Developments (Cont.)
Evolving Offshore Structure
Typical Locations:
Hong Kong
Mauritius
Barbados
Switzerland
Luxembourg
Singapore
Ireland
Treaty Platform (Including Employees and
Offices)
Treaty SPV 1
Treaty SPV 2
Treaty SPV 3
Cayman 1
Cayman 2
Cayman 3
Treaty SPV A
Treaty SPV B
Treaty SPV C
WFOE
WFOE
WFOE
Offshore
PRC
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PRC PE Developments (Cont.)
♦ Query how recent U.S. international tax
proposals, including the Obama administrations
elimination of “check the box” rules will impact
the choice of optimal structure
♦ Circular 601, released last week, also calls into
question the use of intermediate SPVs
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Best Tax Compliance Practices
for Funds with U.S. Investors
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Best Tax Compliance Practices for Funds with U.S. Investors
UBTI
♦ Most funds that have raised money from U.S.
tax exempt investors will have an obligation to
avoid, or at least minimize, the generation of
“unrelated business taxable income (commonly
referred to as UBTI).
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Type of Investors Subject to UBTI
♦ U.S. private pension funds
♦ U.S. Charitable organizations
♦ U.S. Charitable Remainder Trusts
♦ U.S. Universities (including state universities)
♦ U.S. State and local pension plans if qualified under 401,
but possible exception under 115 (most state and local
plans take the position they are exempt under 115 and
thus not subject to UBTI tax)
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Tax Treatment if There Is UBTI
♦ File 990T U.S. Tax Return
♦ Pay tax at graduated corporate or trust rates as
if a taxable entity
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Non-UBTI Income Categories (“Good Income”)
♦ Assuming No Debt Financing (See UDFI discussion
below):
–
–
–
–
–
–
–
–
Capital gains
Interest
Dividends
Subpart F inclusions (except insurance)
PFIC distributions
Royalties
Some rental income from real estate
Other income from routine investments (See Rev. Rul. 78-88)
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
UBTI Income Categories (“Bad Income”)
♦ Income from business activity (e.g., sales of
goods/services) conducted anywhere
♦ Includes business conducted through lower-tier tax
partnerships (e.g., portfolio companies not treated as
corporations for U.S. tax purposes)
♦ Gains from dealer property (relevant to real estate funds)
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Fees as Potential UBTI
♦ Portfolio companies may pay fees to the Fund or
its management company, e.g.
– directors fees
– advisory fees
– transaction-related fees
♦ Issue:
– Is this UBIT for the Fund?
– What if the benefit to the Fund is indirect?
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Tax Treatment of Various Fees
♦ Directors Fees – services/UBTI
♦ Advisory Fees – services/UBTI
♦ Break-Up Fees – arguably lost profits/Non-UBTI
♦ Completed Transaction Fees – probably reduce
basis/Non-UBTI
♦ Loan Commitment Fees, Equity Commitment
Fees
– loan commitment fee is not UBTI per IRC 512(b)(1)
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Debt-Financed UBTI (UDFI)
♦
Income from debt-financed property is UBTI, in ratio that “average acquisition
indebtedness” bears to average adjusted basis
♦
“Debt-financed property” = financed with “acquisition indebtedness” (a broadly
defined term)
–
“Acquisition” indebtedness may in some cases include debt incurred before the asset was acquired
–
“Indebtedness” may include non-traditional sources of financing such as deferral of accrued management fees
–
May also include deferred payments for stock (i.e., 100 shares of stock acquired for a $50 immediate payment
and a $50 payment due six months later).
♦
Property is debt-financed property if there is acquisition indebtedness at any time
during the taxable year in which the income is earned or, with respect to sales, the
preceding 12 months
♦
Applies to borrowing by the exempt entity or by an investment partnership such as a
venture capital fund
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
UDFI Solutions
Borrowing is usually restricted, e.g.,
♦ To short-term borrowing pending receipt of capital calls, or where borrowing
is essential (e.g., to fund commitments where there are defaulting partners)
♦ If viewed as “acquisition indebtedness,” (perhaps) the debt will be “history”
by the time there is significant income or gains (i..e, paid off more than 12
months prior)
♦ Borrowing incidental to the management of an investment portfolio and not
increasing its size does not create UDFI (Rev. Rul. 78-88)
– Application not clear to Venture Funds
♦ Occasional borrowing incident to investment, but also serving exempt
function, and not increasing the overall portfolio size, does not create UDFI
(PLRs 8721104; 8721107)
– Application not clear to Venture Funds
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Management Fee Offsets and UBTI Risk
♦ Offset is a reduction in the periodic management fee
otherwise payable by the Fund to its manager on
account of fees payable by portfolio companies or other
parties to the manager
♦ Offset typically range from 50% to 100%, and unused
offsets carry forward to reduce the management fee in
future periods
♦ Sometimes fee amounts not offset against management
fee prior to the end of the Fund’s term will be payable to
the investors upon the liquidation of the Fund
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Guarantees Of Portfolio Company Debt and UDFI
♦ UDFI could be created as a result of fund’s guarantee of
portfolio company debt if the fund, rather than the
portfolio company, is the true borrower (Plantation
Patterns). Should turn on portfolio company’s ability to
service the debt based on its own assets/anticipated
revenues.
♦ GP may be contractually obligated not to allow fund to
provide a guarantee unless GP first determines that
there is not a material risk of UBTI
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Fees (such as cash or warrants) For Guaranteeing
Portfolio Company Debt as Potential UBTI
♦ Guarantee Fee should not be UBTI if the
guarantee activity was isolated and not regularly
carried on.
♦ This could be helpful, but as fund size increases,
perhaps multiple guarantees will be given and
multiple fees will be charged.
♦ Unclear whether recurring guarantee fees will be
treated as services income and thus UBTI
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Critical Portfolio Company Information
Rights and Covenants
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Summary of Portfolio Company Information
Rights and Covenants:
♦ In general, in connection with each investment in
a Non-U.S. portfolio company, a Fund with U.S.
taxable and tax-exempt investors should:
– Corporate Status: confirm that the Non-U.S. portfolio company
will be classified as a corporation for U.S. income tax purposes,
and not as a partnership or other pass-through entity. For those
entities that are eligible to elect to be treated as a pass-through
entity, obtain a representation that the entity will not elect to be
treated as a partnership for U.S. income tax purposes;
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Summary of Portfolio Company Information
Rights and Covenants (Cont):
– CFC: obtain protective provisions addressing CFC
issues;
– PFIC: Negotiate to obtain the information necessary for
the Fund’s investors to make a QEF election or
protective statement for U.S. income tax purposes, and
obtain protective provisions facilitating this election; and
» Misc: obtain other miscellaneous information reporting provisions.
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Representations and Warranties Regarding
Classification as a Corporation for U.S. Tax
Purposes
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Classification of Portfolio Company as a Corporation
♦ Generally, investment in an entity treated as a
corporation for U.S. income tax purposes will not result
in either UBTI or effectively connected trade or business
income.
♦ Investment in a business organized as a partnership or
other pass-through entity, however, will give rise to UBTI
and trade or business income, both of which are
prohibited under most Fund agreements.
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Classification of Portfolio Company as a Corporation (Cont.)
♦ A Non-U.S. portfolio company will be classified as a corporation or a
partnership under the entity classification regulations (the
“Regulations”). The Regulations provide that certain Non-U.S.
entities will always be treated as corporations for U.S. income tax
purposes.
♦ If the corporate form of a prospective Non-U.S. portfolio company is
not mandatory under the Regulations, then the Non-U.S. portfolio
company should represent that it will either elect to be treated as a
corporation for U.S. income tax purposes or refrain from making an
election to be treated as a partnership if it would otherwise be taxed
as a corporation.
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
♦ Sample Entity Classification Representation:
– The Company shall take such actions, including making an
election to be treated as a corporation or refraining from making
an election to be treated as a partnership, as may be required to
ensure that at all times the company is classified as corporation
for United States federal income tax purposes
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Representatons and Warranties from Portfolio
Companies Regarding Controlled Foreign
Corporation (CFC) Status and Subpart F Income
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Controlled Foreign Corporation
♦ If a Non-U.S. corporation is a Controlled Foreign Corporation (“CFC”)
for an uninterrupted period of 30 days during any taxable year, then
certain income of the CFC, whether or not distributed, will be
currently taxed to certain U.S. shareholders (“U.S. Shareholders,”
as defined below) who are shareholders of the CFC on the last day
of the CFC’s taxable year.
♦ In addition, disposition of CFC shares in a merger may result in tax
in what would otherwise be a nontaxable transaction for U.S. income
tax purposes.
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Determination of U.S. Shareholder Status
♦ Three requirements must be met before the Fund or its investors
could be subjected to tax on undistributed income from a CFC.
– First, the Fund or its investors must be “U.S. Shareholders” (generally U.S. persons that
own, directly or indirectly 10% or more of the voting power of the stock of the Non-U.S.
portfolio company). Note that the General Partner of a Fund is arguably deemed to
own ALL of the Voting Power of the stock owned by the Fund.
– Second, the Non-U.S. portfolio company must be a CFC (generally a Non-U.S.
corporation in which “U.S. Shareholders” own or control, directly or indirectly, 50% of
the voting power or value of the stock). Note that a Fund formed under the laws of the
United States (e.g. Delaware) will itself be a U.S. Shareholder if it owns more than 10%
of the Portfolio Company.
– Finally, either the CFC must earn certain types of income or the CFC must be acquired
in a transaction that would otherwise be nontaxable under U.S. income tax law.
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Sample CFC Representations to be Obtained from Non-U.S. Portfolio Companies
♦ Minimum Representation:
– Immediately after the Effective Time, the Company [will] [will not] be a “Controlled Foreign Corporation” (“CFC”) as defined in
the U.S. Internal Revenue Code of 1986, as amended (or any successor thereto). The Company shall make due inquiry with its
tax advisors on at least an annual basis regarding the Company’s status as a “Controlled Foreign Corporation” (“CFC”) as
defined in the United States Internal Revenue Code of 1986, as amended (or any successor thereto) (the “Code”) and
regarding whether any portion of the Company’s income is “subpart F income” (as defined in Section 952 of the Code)
(“Subpart F Income”). Each Investor shall reasonably cooperate with the Company to provide information about such Investor
and such Investor’s Partners in order to enable the Company’s tax advisor’s to determine the status of such Investor and/or any
of such Investor’s Partners as a “United States Shareholder” within the meaning of Section 951(b) of the Code. No later than
two (2) months following the end of each Company taxable year, the Company shall provide the following information to the
Investors: (i) the Company’s capitalization table as of the end of the last day of such taxable year and (ii) a report regarding the
Company’s status as a CFC. In addition, the Company shall provide the Investors with access to such other Company
information as may be necessary for the Investors to determine the Company’s status as a CFC and to determine whether
Investor or any of Investor’s Partners is required to report its pro rata portion of the Company’s Subpart F Income on its United
States federal income tax return (and if so, what such portion is), or to allow such Investor or such Investor’s Partners to
otherwise comply with applicable United States federal income tax laws. For purposes of the foregoing as well as the
representations contained in Sections ___ [Note: insert section references for all CFC/PFIC representations], (i) the term
“Investor’s Partners” shall mean each of the Investor’s partners and any direct or indirect equity owners of such partners and (ii)
the “Company” shall mean the Company and any of its subsidiaries.
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Sample CFC Representation to be Obtained from Non-U.S. Portfolio
Companies (Cont.)
♦
In addition to the foregoing representation, in the event that the Company is a CFC
and any of the Investor’s Partners are “United States Shareholders” with respect to
such CFC, then if possible one or more of the following additional representations
should be obtained:
–
–
–
–
#1: The Company and the shareholders of the Company shall not, without the written consent of Investor, issue
or transfer stock in the Company to any investor if following such issuance or transfer the Company, in the
determination of counsel or accountants for Investor, would be a CFC.
#2: In the event that the Company is determined by the Company’s tax advisors or by counsel or accountants for
the Investor to be a CFC, the Company agrees to use commercially reasonable efforts to avoid generating
Subpart F Income.
#3: In the event that the Company is determined by the Company’s tax advisors or by counsel or accountants for
the Investors to be a CFC, the Company agrees to use commercially reasonable efforts to annually make
dividend distributions to the Investors, to the extent permitted by law, in an amount equal to 50% of any income
of the Company that would have been deemed distributed to the Investor pursuant to Section 951(a) of the Code
had the Investor been a “United States person” as such term is defined in Section 7701(a)(30) of the Code.
#4: (If the company is or ever was a CFC): The Company will not be required to determine its Subpart F Income
for any taxable period (or portion thereof) ending after the Closing Date by taking into account the
recharacterization provisions of Section 952(c)(2) of the Code.
GUNDERSON DETTMER STOUGH VILLENEUVE FRANKLIN & HACHIGIAN, LLP
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Portfolio Company Representations and
Warranties Regarding Passive Foreign
Investment Company (“PFIC”) Status
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Passive Foreign Investment Companies
♦ In general, the “Passive Foreign Investment Company” or “PFIC” rules are
broader in scope than the CFC rules discussed above since they are not
dependent upon control by U.S. shareholders.
♦ Any Non-U.S. portfolio company may be a PFIC regardless of the size or
number of U.S. shareholders if (i) 75% or more of its gross income is
passive income or (ii) if 50% or more of the company’s assets generate
passive income.1
1
This determination is made based on the adjusted bases (as determined for the purposes of computing earnings and profits) of the
company’s assets if (a) the company is not a public company and (b) either the company is a CFC or it elects to have this method of
determination apply. Otherwise, the determination is made on the basis of the value of the company’s assets.
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Passive Foreign Investment Companies (Cont.)
♦ Subject to certain exceptions, if a Non-U.S. portfolio
company meets either the passive income test or the
passive asset test during the shareholder’s holding
period for such company’s stock, the PFIC rules will
apply in all subsequent years, including those during
which the company ceases to earn significant passive
income and/or ceases to own a majority of passive
assets.
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Passive Foreign Investment Companies (Cont.)
♦ If (i) a Non-U.S. corporation is a PFIC and (ii) the Fund (or, in the
case of a Non-U.S. fund, its U.S. LPs) has not elected to be taxed
under the Qualified Electing Fund rules described below, then the
Fund and its investors would be taxed currently on all actual
dividend distributions from the PFIC, such dividends being ineligible
for the preferential rate applicable to “qualified dividends.”
♦ In addition, to the extent that any distributions, including gains from
the disposition of PFIC stock, constitute “excess distributions,” such
distributions will be deemed distributed ratably throughout the
Fund’s ownership of the PFIC, with an annual interest charge
applied to amounts deemed allocable to past taxable years.
♦ The annual interest charge and taxation of excess distributions is
intended to eliminate any benefit to a shareholder of retaining assets
in a PFIC rather than distributing all available assets on an annual
basis.
GUNDERSON DETTMER STOUGH VILLENEUVE FRANKLIN & HACHIGIAN, LLP
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Passive Foreign Investment Companies (Cont.)
♦ To avoid being subjected to tax upon a return of capital, the special interest
charge, and loss of ability to engage in tax-free transactions, the Fund (if it
is formed in the U.S.) or its U.S. investors (if the fund is formed outside the
U.S.), may make a Qualifying Electing Fund (“QEF”) election to pay tax on
its proportionate share of a PFIC’s earnings and profits annually, as if such
earnings and profits had been distributed to shareholders.
♦ This election may not be particularly costly, since many Non-U.S. portfolio
companies will not generate any earnings and profits (notwithstanding
earning passive interest income on the proceeds of financings) during the
early years of their operations, as earnings and profits are determined in the
aggregate, and passive interest income will likely be offset by losses related
to business operations.
GUNDERSON DETTMER STOUGH VILLENEUVE FRANKLIN & HACHIGIAN, LLP
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Passive Foreign Investment Companies (Cont.)
♦
In a year in which the PFIC ceases to receive 75% “passive income” and ceases to
have at least 50% “passive assets,” those U.S. shareholders that have previously
made the QEF election avoid both the deemed distribution of company’s current
income to the shareholder and the application of the special interest charge to any
gains realized on the disposition of the PFIC’s stock, while those shareholders that
failed to make a timely QEF election would continue to be taxed as discussed above.
♦
If the Investor has a “reasonable belief” that a Non-U.S. portfolio company does not
exceed the PFIC passive activity limits before the Fund has made a valid QEF
election for its interest in the company, the Fund may make a “protective statement”
to preserve its right to make a retroactive QEF election if the company is ever
determined to be a PFIC.
♦
The “cost” of making the protective statement is the elimination of the statute of
limitations for the IRS to raise PFIC issues on tax returns filed after the protective
statement is made.
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Sample PFIC Representation to be Obtained from NonU.S. Portfolio Companies
♦ Minimum PFIC Representation.
The Company has never been, and, to the best of its knowledge after consultation with its tax
advisors, will not be with respect to its taxable year during which the Effective Date occurs, a
“passive foreign investment company” within the meaning of Section 1297 of the Internal Revenue
Code of 1986, as amended (or any successor thereto). The Company shall use its [commercially
reasonable] [best] efforts to avoid being a “passive foreign investment company” within the
meaning of Section 1297 of the Internal Revenue Code of 1986, as amended (or any successor
thereto). In connection with a “Qualified Electing Fund” election made by any of Investor’s
Partners pursuant to Section 1295 of the Internal Revenue Code of 1986 or a “Protective
Statement” filed by any of Investor’s Partners pursuant to Treasury Regulation Section 1.1295-3,
as amended (or any successor thereto), the Company shall provide annual financial information to
Investor in the form provided in the attached PFIC Exhibit (or in such other form as may be
required to reflect changes in applicable law) as soon as reasonably practicable following the end
of each taxable year of the Company (but in no event later than 90 days following the end of each
such taxable year), and shall provide Investor with access to such other Company information as
may be required for purposes of filing U.S. federal income tax returns of Investor’s Partners in
connection with any such Qualified Electing Fund election or Protective Statement.
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Sample PFIC Representation to be Obtained
from Non-U.S. Portfolio Companies (Cont.)
Additional PFIC Representation. Depending upon the circumstances, it may be
possible to negotiate this additional representation as well:
– In the event that an Investor’s Partner who has made a “Qualified Electing Fund” election must
include in its gross income for a particular taxable year its pro rata share of the Company’s
earnings and profits pursuant to Section 1293 of the United States Internal Code of 1986, as
amended (or any successor thereto), the Company agrees to make a dividend distribution to the
Investor (no later than 90 days following the end of the Company’s taxable year or, if later, 90 days
after the Company is informed by Investor that such Investor’s Partner has been required to
recognize such an income inclusion) in an amount equal to 50% of the amount that would be
included by Investor if Investor were a “United States person” as such term is defined in Section
7701(a)(30) of the Code and had Investor made a valid and timely “Qualified Electing Fund”
election which was applicable to such taxable year.
GUNDERSON DETTMER STOUGH VILLENEUVE FRANKLIN & HACHIGIAN, LLP
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Representations and Warranties from Portfolio
Companies with Respect to Miscellaneous U.S.
Reporting Requirements
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Miscellaneous Information Reporting Requirements
♦ Certain information reporting requirements apply to owners of control
positions in Non-U.S. corporations and persons making transfers of property
to Non-U.S. business entities that would be tax-free transfers if undertaken
between U.S. parties. Failure to comply with these requirements may result
in the imposition of monetary penalties by the IRS.
♦ The IRS requires a U.S. person who owns a control position (more than
50% of voting power or more than 50% of total value) in a Non-U.S.
corporation, along with U.S. residents or citizens who are officers or
directors of a Non-U.S. corporation in which a U.S. person has acquired at
least 10% of such corporation’s stock (vote or value), to file an informational
return. For the purposes of determining stock ownership, certain
constructive ownership rules apply.
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Miscellaneous Information Reporting Requirements (Cont.)
♦
Generally, the Fund will be considered to own not only the stock it holds directly, but
also any stock owned by its U.S. partners as well as a proportionate share of the
holdings of most entities in which the Fund has interests. If the Fund is determined to
hold a control position in a Non-U.S. corporation, it will need to attach an
informational return (on Form 5471) to its tax return for each year in which it held the
control position. The information required on the return is basic financial information
(assets, liabilities and stock structure) of the controlled foreign corporation as well as
information about any transactions between the Fund and the Non-U.S. corporation.
♦
The IRS generally requires a U.S. person who transfers cash or property to a NonU.S. business entity, in a transaction that would be tax-free if the transfer occurred
between two U.S. persons, to file an informational statement. The contents of the
statement can vary based on the type of transfer, but will normally include general
information about both parties as well as a description of the property transferred, the
property received and the transaction as a whole. An additional information
statement may be required in certain transfers of intangible property.
GUNDERSON DETTMER STOUGH VILLENEUVE FRANKLIN & HACHIGIAN, LLP
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Best Tax Compliance Practices for Funds with U.S. Investors (Cont.)
Sample Representation to be Obtained from Non-U.S. Portfolio
Companies with respect to Miscellaneous Information
Requirements
The Company shall make due inquiry with its tax advisors (and shall cooperate with
Investor’s tax advisors with respect to such inquiry) on at least an annual basis
regarding whether Investor’s or any Investor’s Partner’s direct or indirect interest in the
Company is subject to the reporting requirements of either or both of Sections 6038 and
6038B of the Code (and the Company shall duly inform the Investor of the results of
such determination), and in the event that Investor’s or any Investor’s Partner’s direct or
indirect interest in Company is determined by the Company’s tax advisors or the
Investor’s tax advisors to be subject to the reporting requirements of either or both of
Sections 6038 and 6038B Company agrees, upon a request from Investor, to provide
such information to Investor as may be necessary to fulfill Investor’s or Investor’s
Partner’s obligations thereunder.
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Thank You
GUNDERSON DETTMER STOUGH VILLENEUVE FRANKLIN & HACHIGIAN, LLP
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IRS Circular 230 Disclosure
♦ This presentation was not intended or
written to be used, and it cannot be
used, by any taxpayer for the purpose
of avoiding penalties that may be
imposed on the taxpayer under U.S.
Federal tax law.
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