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Tax News
Noncompensatory Option Regs are Finalized: Where do Mezz Funds go from Here?
February 04, 2013
Administrative Actions
The noncompensatory option regulations have been subject to much debate and discussion, including by me on this blog. After many, many years in circulation, the famous or infamous proposed regulations were just finalized. Considering that the final regs came out just a few hours ago, I have not had the time to fully review and compare them to their proposed version, but nonetheless, I wanted to alert readers about this development. Finalizing the regulations is important because they will become immediately applicable for all deals that are closed after the date the regulations are published in the Federal register, which as of now is scheduled to be tomorrow (Feb. 5, 2013).  The regulations can have broad implications for U.S.taxpayers in general, but as to the investment fund industry, the most impacted group of taxpayers appears to be mezzanine fund investors.   The adoption of the regulations has been a concern for mezz investors for a while. The concerns were primarily due to the so called “characterization rule” which many investors believed would cause mezz loans to partnership to be treated as partnership equity interest from the get go.  Most mezzanine funds structure their investments primarily either as convertible debt, or debt plus some equity kicker such as warrants, and take the position that the investment is not a partnership interest. This position arguably alleviates concerns related to ECI or UBTI and avoids the need for a blocker entity.  The final regulations may put an end to this position.

The gist of the final regulations does not differ much from that of the proposed regs. The “characterization rule” is much alive and principally stays the same.  The regulations characterize the holder of a noncompensatory option as a partner if the option holder’s rights are substantially similar to the rights afforded to a partner. This rule applies only if, as of the date that the noncompensatory option is issued, transferred, or modified, there is a strong likelihood that the failure to treat the option holder as a partner would result in a substantial reduction in the present value of the partners’ and the option holder’s aggregate Federal tax liabilities.  A noncompensatory option provides its holder with rights that are substantially similar to the rights afforded to a partner if the option is reasonably certain to be exercised.  Reasonably certain to be exercised is a facts and circumstances query with a few non-exclusive regulatory factors. Also, Treasury has introduced two "reasonably certain" safe harbors: (1) for options that cannot be exercised earlier than 24 months from the date of grant at a strike price greater than 110% of FMV of the partnership interest at grant and (2) for options with strike price equal to or greater than the FMV of the underlying partnership interest on the exercise date.  Similarly, to the “reasonably certain to be exercised” test, the “substantial reduction” test also encompasses a facts and circumstances query.

While ultimately the answer to the question of whether the “characterization rule” will apply to a particular mezzanine investment will depend on the specific circumstances, it seems that a typical mezzanine investment such as straight debt plus penny warrants runs a material risk of causing the fund to be treated as a partner. The penny warrant generally could be viewed as reasonably certain to be exercised, and it could be further argued that not treating the mezzanine investor as a partner creates a substantial reduction in the aggregate Federal tax liability of the partners (presumably if the fund is not treated as a partner it would not be taxed on cashing out the warrants on liquidity, where as if it is, all or portion of the gain would be subject to U.S. tax).

So what’s left for mezz funds? One sensible option that comes to mind is to invest in the partnership through a blocker.  Obviously this is a common occurrence for most private equity funds with foreign and tax exempt investors, but until now, it was not something that mezzanine funds did as a general practice.  Participating in the portfolio company through a blocker poses several issues. A potential future buyer of the portfolio company will have to acquire a C-corporation and the mezzanine lender will have to enter into an agreement that the blocker is sold at the same price and parri-passu with the partnership investors. The buyer would further not be able to get a step up in the assets of the partnership to the extent of the acquired C-co shares without incurring additional tax cost. Lastly, the mezzanine fund will have to deal with U.S. reporting for the blocker entity, bargain for tax distributions under the portfolio company partnership agreement, and possibly deal with tax withholding issues.  Are these major inconveniencies? I would not describe them as such, although introducing the blocker may ultimately have some $$ impact on the fund's overall return. As I said, many private equity funds invest through blockers.  Mezzanine funds could adopt the same strategy.

Are there any alternatives? As I mentioned, I have not reviewed the regulations in that much detail at this time, but in my prior explorations of this issue, I thought that there was somewhat of an argument that the mezz investment does not create a substantial reduction in the present value of the partners’ and the option holder’s aggregate Federal tax liabilities.  One may reason for example that for purposes of computing “substantial reduction” only partnership distributive share income will count and the tax consequences on a liquidity event (i.e. sale or redemption of the warrants) will be disregarded.  Under this logic, not treating the mezzanine investor as a partner may not necessarily lead to a “substantial reduction” in the aggregate liabilities.  The logic may be supported by language from the “substantial reduction” factors in the regulations that speaks in terms of “[t]he interaction of the allocations of the issuing partnership,” which seems to suggest that in making the determination you look to distributive share.  Thus, for example, assuming that the a mezzanine UBTI investor is taxed at the same, or lower, rates on UBTI income as the portfolio company’s other U.S. partners, then it could be reasoned that the characterization rule should not apply (UBTI is generally taxed at U.S. corporate tax rates which for 2013 are still at 35% compared to the 39.6% individual rates).  This conclusion obtains even if the investment is carried out through penny warrants.  Obviously, aside from its technical merits (i.e. not clear whether you account for tax on liquidity), this argument also poses logistic issues because the mezzanine investor or the portfolio company have to be able to ascertain everybody’s tax rate and figure out, as a practical matter, whether there is a “substantial reduction.”  This may be difficult particularly in light of the fact that the final regulations purportedly take into account tax consequences that result from the interaction of the allocations with the partners’ and noncompensatory option holder’s Federal tax attributes that are unrelated to the partnership.  Presumably, the partnership will have to get a hold of every investor and crunch the numbers taking into account the investor’s entire tax attribute set.  I’d venture to say that this may be doable only for a limited number of entities.   Other than that, the fund may abandon the penny warrant strategy altogether and switch to convertable debt that meets one of the two safe-harbors of the regulations.  Those safe harbors require a conversion price that is tied to the FMV of the partnership interest either at grant or at conversion.  I am not sure to what extent this is comparable to a penny warrant deal, and to what extent it is feaseble from a business perspective considering that a lot of debt is typically converted at a discount.

So where do we go from here? Well, the regulations just came out, but I’d guess that going the blocker route is the safest approach. It does have detriments, but this approach merely puts mezzanines on par with other private equity funds that face similar issues.  As to the “substantial reduction” argument, frankly, as if now I am not certain how this pans out. I am sure there will be more commentary regarding this in the future as practitioners digest the newly finalized regulations. I will probably write another post about the regulations once I’ve reviewed them in more detail.  In the meanwhile, considering that these regs become applicable immediately, mezz funds need to address their status as partners for all ongoing and future deals taking into account the specific provisions of the regulations (as opposed to just relying on prior penny warrant common law).
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Tags: mezzanine fund lending, noncompensatory option, noncompensatory partnership options, reasonably certain to be exercised, Reg. 1.761-3