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Summer Recap: A Few Notable Investment Fund Tax Related Developments
August 27, 2012
Administrative Actions
I haven’t posted too much as of late due to vacation, spending more time with the family, and a somewhat busier summer season as far as investment fund deals go.  To catch up, I will recap below a few fund related tax developments that I thought were notable in the last several months.

Form 8938 Q&A

IRS updated the Q&A that it initially posted in February 2012 regarding Form 8938.  I have discussed on this blog that the form will be applicable to US investors in foreign funds considering that it captures holdings in stocks, securities and partnership interest in foreign partnerships.  For assets over $200,000, the form requires that the taxpayer specify the value of the foreign assets it owns.  One question that could have been troublesome for some investors in more illiquid private equity funds is how you determine FMV for reporting purposes.  Typically, fair values in private equity funds are much more difficult to ascertain, compared for example, to hedge funds.  Q&A 23 clarifies whether the taxpayer has to use a certified appraiser or an actuary in determining FMV for reporting purposes.  Consistently with the instructions to the form, the IRS answers the question in the negative.  The Q&A further clarifies that even if there is no information from a reliable financial institution regarding the value of the asset, a third party appraisal is not necessary.   Thus, this Q&A could alleviate some taxpayers’ concerns that they have to obtain appraisals because there are no readily available FMV reports from independent third party financial institutions regarding the taxpayer’s investment fund holdings.

Safe Harbor for CODI of Publicly Traded Partnerships (PTPs)

Publicly traded funds try to preserve their status as partnerships for federal income tax purposes by complying with the Section 7704 qualified income safe harbor (Section 7704 generally provides that a publicly traded partnership will be treated as a corporation). The test basically provides that the partnership will not be treated as a corporation as long as 90% of its gross income consists of passive income.  With the downturn of the economy and a lot of debt being cancelled or reworked, there was some confusion regarding the impact of CODI on the PTP’s qualification under the 90/10 safe harbor. To address this issue, IRS issued Rev. Proc. 2012-28 which provides that CODI will not jeopardize the fund’s qualification under the safe harbor as long as the fund can demonstrate that the CODI is attributable to debt incurred in direct connection with the PTP’s qualifying activities by any reasonable method.  According to the Service, one reasonable method is the tracing approach in Treas. Reg. 1.163-8T.  Notably, the IRS specifically pointed out that allocating the CODI based on a ratio of total gross income to qualifying gross income would not work.

Recent Developments in Open Transaction Law – The Dorrance case

It is always worth it to keep up with any “open transaction” developments. In the investment fund context the issue can come up at the time the fund sells a portfolio company and the purchase price includes an earnout. Typically the fund will have two options: (1) use the installment method and apply the rules for contingent payments under Treas. Reg. 15a.453-1(c), or (2) elect out of the installment method and report the gain under the closed transaction method. Under the former scenario the fund will prorate its basis over the period of the contingent payments and will defer a portion of its gain over that period.  Under the latter method, the fund will report all of its gain in the year the transaction took place and will later make adjustments when the earnout is paid out. A fund may contemplate a third alternative, i.e. asserting the “open” transaction doctrine which stems from the Burnet v. Logan case. Under this alternative the fund will elect out of the installment method and will claim that the exact value of the purchase price cannot be ascertained. Thus, the fund could claim that the recognition of the gain should be postponed until actual payments are received.  The difference in this method from the installment method is that the fund will claim that basis should be recovered first instead of prorated over the years the fund receives earnout payments.  Naturally, this third alternative is the most advantageous to the selling fund.  The IRS, however, is known to attack open transaction treatment when it is claimed by the seller. Treas. Reg. 15a.453-1(c) specifically provides that only in rare circumstances can open transaction be claimed.  The Dorrance case (No. CV-09-1284-PHX-GMS) is the latest case that I am aware of that addresses the open transaction issue. In this case a District Court inArizona ruled against the taxpayer.  Basically the court reasoned that the consideration received by the seller consisted of property that had ascertainable fair market value in the year of the sale, and thus, the open transaction was inapplicable.  Funds that contemplate arguing the open transaction doctrine should take a closer look at this case.  In the face of the enactment of the economic substance doctrine and the new world of strict 40% penalties, it merits very careful analysis whether the sale consideration is truly not subject to valuation, and respectively, whether the fund has a sufficient basis for winning the open transaction argument.

11th Circuit Affirms for the Government in Calloway Monetization case

I’ve kept beating the drum here that lately courts have consistently held against monetization strategies. There were many cases in the last 2 years where taxpayers’ attempts to pass tax ownership without recognizing gain on upfront cash payments have uniformly failed. To name a few cases: Landow v. Commissioner, Sollberger v. Commissioner and Anschutz v. Commissioner.  Last year the 10th Circuit affirmed for the Government in the Anschutz case.  Last week the 11th Circuit affirmed for the Government in Calloway.  In Calloway the 11th Circuit adopted a similar approach to the 10th Circuit’s decision in Anschutz in that it applied the Grodt & McKay Realty factors in testing whether the transaction was a sale for tax purposes. Running through the eight factors the 10th Circuit decided that based on the facts and circumstances the transaction was more akin to a sale than anything else.  Many taxpayers were hoping that at least one of these notable cases will be resolved in favor of the taxpayer, but as discussed here, the 11th Circuit axed these hopes and closed the loop on this issue.

PRENO-126201-12:  Success Based Fees Safe Harbor and its Contours

In April last year Matt wrote on this blog about the 70% deductibility safe harbor for success based fees. Under this safe harbor, the taxpayer would be allowed to deduct 70% of the fee if it makes an election on its tax return, attaches a statement that identifies the transaction and shows the allocation between the deductible and nondeductible portion of the fee.  Judging by the discussed herein IRS legal advice, some people have tried to reason that milestone payments should qualify for the safe harbor. In the above-quoted PRENO, however, the IRS is clearly of the opinion that such milestone payments are not swept under the safe harbor simply because they might have been part of a success based fee arrangement.  Under the facts of the PRENO, the client signed a $10M success fee contract but also provided that $1M will be paid on the signing of a merger and another $1M on shareholder approval of the transaction. The two $1M payments were creditable against the $10M success fee payment but were nonrefundable in case the transaction failed. The IRS reasoned that in respect of the $8M payment the taxpayer can make the safe harbor election but in respect of the $2M it had to prove that the fees are not facilitative before it can take a deduction.

Treasury Published a FATCA Model Intergovernmental Joint Agreement

The Treasury issued two sample agreements whereby foreign FATCA partners agree to furnish FATCA related information to the USgovernment. The difference between the two agreements is that in one agreement (reciprocal agreement) the UShas to furnish some information to the foreign FATCA partner whereas in the other it does not have to.  Basically, foreign institutions in FATCA partner countries will have to report to the foreign government instead of the USgovernment and would not have to enter into an agreement with the US. They will be deemed compliant and the foreign government will pass the collected information to the US. I would not go into much detail about the agreements because by the time I am writing this, I am sure most major law firms have released a breakdown of the agreements’ more noticeable features.  I would just point out that funds in FATCA partner countries should carefully examine the agreements and delineate the differences between reporting under the FATCA statute or under the intergovernmental agreement. There are some substantive differences that could prove material.  The agreements could be fond here: reciprocal and nonreciprocal.

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Tags: 7704 safe harbor, burnet v logan, Calloway, FATCA, Form 8938, monetization, open transaction doctrine