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Tax News
CCA 201501013 – An Inbound Fund Runs into a U.S. Lending Trade or Business Mishap of Enormous Proportions
January 06, 2015
Administrative Actions
U.S. lending trade or business is one of those issues that haunt U.S. investment fund tax advisers like the boogie man. If you get it wrong, a lot of things go bad. To outline the issue succinctly, inbound investment funds with foreign investors are generally not subject to tax on interest income and capital gains. However, if this income is derived from a U.S. lending business, the income is taxed on net basis. So, if you get it wrong, you go from a situation of no tax (for example on interest under the portfolio interest exemption), to a situation of 39.6% tax (plus possibly state tax). That is a conspicuously horrendous result. The issue comes up a lot, particularly for Mezz, CDO, and Distressed investment funds. As readers would gather, all of these funds are somehow involved in debt securities. These types of funds would have various guidelines, approaches, or legal arguments regarding why they are not engaged in a U.S. lending trade or business. These approaches may impose limits on the number of annual loans, impose a prohibition on origination, or require a “seasoning” from related or unrelated parties. Regardless, none of these approaches are bulletproof. They are not bulletproof simply because there is no clear-cut guidance that applies to inbound funds that debt-finance private businesses. The guidance trickles in the form of once-in-a-blue-moon rulings as the one we are about to discuss here.

So what do we have here? We have what appears to be a U.S. managed Mezz fund which also undertook some underwriting activities. The fund was initially formed as a U.S. partnership but was later moved to the Caymans. Apparently, this did not affect the rationale of the ruling. If we can summarize the facts that sealed the fund’s faith, so to speak, those would include:
  • The fund had a U.S. manager which negotiated directly with borrowers concerning all key terms of the loans;
  • Before agreeing to make a loan, the fund conducted extensive due diligence on a potential borrower;
  • During the years at issue the fund made numerous loans and dedicated significant time, resources and efforts to these activities;
  • Fund actively solicited potential borrowers and issuers;
  • The fund’s manager dedicated some of its investment banking personnel to sourcing and originating deals;
  • Fund received compensation in the form of fees, discounted property, and spreads instead of taking risk and capital appreciation, and
  • The fund engaged in underwriting activities through distribution agreements whereby it was obligated to purchase issuer stock at a discount and pre-sell it at market to U.S. and foreign investors.
The IRS held against the fund on all fronts. First, the fund was engaged in a U.S. lending trade or business. The reason was that the fund made numerous loans and engaged in lending type activities such as due diligence, solicitation of borrowers and sourcing loans. Then, the IRS ruled that the fund’s activities did not qualify under the Sec. 864(b)(2)(A) “trading safe harbor.” The simple enough logic here, at least to the IRS, was that lending and trading are two distinct activities and lending goes beyond the scope of trading. Without too much rationale, the IRS reasoned that Treas. Reg. § 1.864-4(c)(5) demonstrates that lending does not qualify for the “trading safe harbor” and since the fund was engaged in the lending activities described in 1.864-4(c)(5), the fund did not fall under the safe harbor. The IRS bolstered its analysis by pointing out that there is plenty of judicial authority that shows that lending and trading are two separate things that do not go hand-in-hand (citing e.g., United States v. Wood,943 F.2d 1048, 1051-52 (9th Cir. 1991)). Because the fund profited from lending by earning fees, spreads and interest payments, it did not seek to profit from the change in value of securities, and therefore its activities did not constitute trading. This was despite the fact that the fund converted loans and sold stock. Lastly, Chief Counsel concluded that even if the activities of the fund were to fall within the meaning of securities trading, the fund nonetheless would not have met the “trading safe harbor.” For one, the fund did not meet the (A)(i) safe harbor because it did not have employees and its manager was not a resident broker, commissions agent or an independent agent. Two, it did not meet the (A)(ii) safe harbor because the fund acted as a dealer. The IRS reasoned that the fund was a dealer because it engaged in underwriting activities whereby it earned spreads for the performance of services instead of capital appreciation based on fluctuations in market value. Lastly, the fund was not entitled to the exception in Treas. Reg. § 1.864-2(c)(2)(iv)(b)(1) & (c)(2)(iv)(c), Example (1) because it sold stock to foreign and domestic persons instead of only foreigners.

As most of the other authorities reviewed and discussed here, many things went wrong for the taxpayer. That said, considering the business of the fund, as depicted by the facts discussed in the ruling, it is hard to say whether the fund could have avoided the poor tax result without significantly altering its business model. The plain fact is that the rules, as they stand now, establish a clear policy against favoring foreign lenders, dealers and underwriters at the expense of their U.S. counterparts. Ergo, it is difficult to shoehorn on paper this type of a business into “investing”, and then close your eyes and hope that the IRS will be magnanimous. Notwithstanding, the likelihood of a favorable outcome is even smaller if the fund doesn’t even attempt to shoehorn its business into “investing.” Regrettably, however, the ruling does not give much indication as to what this “shoehorning” could be since it does not elaborate on how the usual “investing” plumbing funds use in their governance stacks up. Simply, the ruling did not mention any of the favorable facts, or the importance thereof, relied on by funds such as limited number of investments per year, management rights, equity components, “seasoning” and so on. For example, the IRS just looked at the large percentage of convertible and promissory notes held by the fund and that many were originated during the years at issue but did not analyze any equity components such as convertibility or warrants. Hopefully, this does not mean that these facts do not matter to the IRS, but merely that they were not present in this case.

What are funds that engage in lending to do after rulings like this one? It is apparent that the IRS is not in the mood to be lenient. The best approach is to take heed and minimize some of the big no-no’s such as originating multiple loans in a single year. If multiple loans is the fund's business however, well, in that case a reasonable “seasoning” policy may be enough to convince the IRS that the fund is generating earnings from market fluctuations instead of for providing services and loan origination. That said, save for some future regulatory guidance, it seems that under the current modus operandi nobody is safe. While some of the facts of the ruling were not that typical (e.g. the underwriting part), many other facts coincide with what Mezz funds are usually doing, which is extending convertible loans and cash/PIK interest notes with warrants through U.S. offices. Some are doing it on larger, other on smaller scale but judging by this ruling, few are safe without some serious precautions. The ruling can be found here.
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Tags: 864(b)(2)(A), investment fund lending, mezzanine fund lending, private equity fund trade or business, private equity lending, trade or business, trading safe harbor