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Private Equity,
Venture Capital and
LBOs
© 2014 by Deborah L. Paul and Donald E. Rocap
Deborah L. Paul
Wachtell, Lipton, Rosen & Katz
Donald E. Rocap
Kirkland & Ellis LLP
Life Cycle of an LBO Transaction
Event
• Acquisition of Target
• Holding and Partial Exit
• Complete Exit
Principal Tax Goals
• Obtain stepped-up basis in Target assets
where feasible
• Avoid double tax to Target shareholders
• Achieve tax deferral for rollover shareholders
• Structure equity-based compensation for
management
• Avoid phantom income from debt and
preferred stock OID
• Avoid phantom income from subpart F
inclusions
• Maximize deductibility of LBO interest
• For partial withdrawals of cash: • Maximize basis recovery
• Maximize eligibility for 20% LTGG/QDI rate
• Minimize withholding taxes
• Deliver stepped up basis to buyer where
feasible
• Maximize eligibility for 20% LTGG/QDI rate
• Minimize withholding taxes
• Capture tax benefits triggered by transaction
2
3
Life Cycle of a Leveraged Buyout in an
Economic Downturn
Event Principal Tax Concerns
Acquisition of Target Amortizable stepped-up basis in Target assets Tax-free rollover for Target shareholders who retain equity Equity-based compensation for management Tax-efficient financing
Repurchase of Debt by the Company Cancellation of debt income to Issuer
Purchase of Debt by the Fund Cancellation of debt income to Issuer Original issue discount/market discount on resulting debt AHYDO limitations on resulting debt
Debt-for-Debt Exchange or Modification of Debt Cancellation of debt Income to Issuer AHYDO limitations on resulting debt Gain or loss recognition to Holders
Debt-for-Equity Exchange Cancellation of debt income to Issuer §382 ownership change for Issuer Gain or loss recognition to Holders Rollover of market discount to Holders
Acquisition Structure
Whether to Structure for Stepped-Up Basis (“SUB”) or Carryover Basis
(“COB”)
• Benefit of SUB
• Present value of incremental depreciation and amortization
deductions; approximately 20% of SUB, assuming:
• 15 years straight-line amortization
• Buyer taxable at 40% rate
• 10% discount rate
• Buyers are typically willing to increase purchase price by some
amount less than 20% of the potential SUB to obtain SUB, due to:
• Possible lack of post-acquisition taxable income may defer
use of depreciation/amortization deductions
• Buyer may use a discount rate higher than 10%, particularly if
paying the incremental purchase price requires additional
equity investment
• Buyer typically anticipates an exit from the investment in, e.g.,
5 years, and may doubt that a future buyer will fully pay for the
remaining unused tax benefits
4
• As rule of thumb, often assume that, to obtain SUB, buyers will be willing to
pay an incremental purchase price of roughly 10% of the potential SUB
• If transaction is structured to produce SUB, important to ensure that the
§197(f) anti-churning rules do not prevent amortization of SUB in goodwill and
other intangible assets that do not have a reasonably ascertainable useful life.
The anti-churning rules apply where:
• Some amount of the goodwill or similar intangible assets were held by
the Target on or before August 10, 1993 and
• There is a greater than 20% overlapping ownership between the Target
and the buyer (applying a number of alternative 20%-or-greater related
party tests containing broad ownership attribution rules) immediately
before or after the transaction
• Where some pre-August 11, 1993 goodwill or similar intangibles exist, all
amortization of the SUB in such intangibles is subject to disallowance --
not limited to the August 10, 1993 value of the intangibles
• Where the Target or the buyer is a partnership/LLC, the determination of
whether, and to what extent, a SUB-producing transaction is treated as a §197
related party differs significantly depending on the transaction form (e.g.,
acquisition of assets vs. acquisition of equity interests) and the particular
Code section that produces the SUB (e.g., §707 disguised sale vs. §734(b)
cash distribution in excess of basis vs. §743(b) sale of partnership interest)
5
Acquisition Structure
6
Acquisition of Target:
Stepped Up Basis in Assets
• If (domestic) target is publicly traded or is a standalone C corp, a step up
in target’s asset basis is not likely to be viable (unless target has an NOL
sufficient to absorb the asset sale gain).
• If (domestic) target is a subsidiary of a corporate parent or is an S corp,
then a step up in target’s asset basis can be achieved by: • buying the assets of target
• converting target to an LLC treated as a disregarded entity or partnership and
buying the LLC interests
• merging target into purchasing corporation or LLC
• buying the stock of target and making a §338(h)(10) or §336(c) election
• Acquisition of stock of Target S Corp or Target Bigco Sub with a
§338(h)(10) or §336(e) election achieves stepped up tax basis in Target
assets without requiring an actual transfer of Target assets, which may
be undesirable for commercial law, regulatory or transfer tax purposes
• If target is a partnership for tax purposes, then a step up in target’s asset
basis can be achieved by buying target assets or by buying all the
partnership’s equity interests or by buying some equity interests and
making a §754 election.
§338(h)(10) and §336(e) Compared
7
§338(h)(10) §336(e)
§338(h)(10) requires that: §336(e) requires that:
• a corporation • one or more persons (corporate, partnership, LLC or individual)
• acquires within a 12-month period • acquires within a 12-month period
• from a single U.S. corporate seller or consolidated group (Bigco)
or a group of S corporation shareholders
• from a single U.S. corporate seller or consolidated group (Bigco)
or a group of S corporation shareholders
• stock of a U.S. corporation (Target Bigco Sub or Target S Corp) • stock of a U.S. corporation (Target Bigco Sub or Target S Corp)
• representing at least 80% of Target stock (by vote and value,
disregarding §1504(a)(4) preferred stock)
• representing at least 80% of Target stock (by vote and value,
disregarding §1504(a)(4) preferred stock)
• by “purchase,” which does not include
• any acquisition of Target stock in a carryover basis exchange or
other exchange to which §§351, 354, 355 or 356 applies, and
• any acquisition of Target stock from a person the ownership of
whose stock would be attributed to the purchasing corporation
under the §318 ownership attribution rules
• by “disposition,” which does not include
• any acquisition of Target stock in a carryover basis exchange or
other exchange to which §§351, 354, 355 or 356 applies, except for
a §355 distribution that is taxable at the corporate level under
§335(d) or (e), and
• any acquisition of Target stock from a related person. Two
persons are related if stock owned by one of them would be
attributed to the other under the §318 ownership attribution rules
(with attribution between a partner and a partnership limited to 5%
or greater (by value) partners)
• Purchasing corporation and Bigco or all of Target S Corp
shareholders (including non-selling shareholders) make joint
§338(h)(10) election
• Target and Bigco or all of Target S Corp shareholders (including
non-selling shareholders) make joint §336(e) election
• in case of overlap, a §338 QSP trumps a §336(e) QSD
8
Cash
100% of Target
Stock
Investors
Purchasing
Corporation
Target
Shareholders
Target
S Corp
Basic §338(h)(10) Fact Pattern
Target
Bigco Sub
Bigco
or
9
Basic §336(e) Fact Pattern
Cash
100% of Target
Stock
Investors
Purchasing
Partnership/LLC Target
Shareholders
Target
S Corp
Target
Bigco Sub
Bigco
or
10
• Receipt of any equity in the Purchasing Corporation by historic Target Shareholders who own more than 20% of Target, in direct (or possibly recharacterized) exchange for their Target stock, raises the risk that the acquisition from these shareholders is a §351 transaction ineligible for a §338 (or §336(e)) election.
Code §338(h)(10) Trap - §351 Recharacterization
Step 1
Cash
100% of Target Stock
Investors
Purchasing
Corporation
Target
S Corp or
Bigco Sub
Step 2
Cash
> 50% of Purchasing Corp stock
Target
Shareholder(s)
11
Avoiding §351 Recharacterization Trap
• In order to bolster eligibility for a §338 election, Purchasing Corp could provide cash and Newco shares to the historic Target Shareholders. Consider impact, if any, of Rev. Rul. 2003-51.
• Target shareholders recognize gain on cash and Newco shares received.
• Even if a basis step-up is obtained, the anti-churning rules under §197 generally will prevent amortization of goodwill and certain other intangibles if there is greater than 20% overlap in ownership before or after the transaction (after attribution) and the target’s goodwill or other intangibles existed on August 10, 1993, the date that §197 was enacted.
Investors
Newco Corp Target
Shareholder(s)
Target
S Corp or
Bigco Sub Purchasing Corp
Cash and
Newco Shares
Target
shares
12
§338(h)(10) Trap – §318 Attribution
Holdco LLC
Purchasing Corp
Target S Corp
or
Bigco Sub
Investors
100%
cash
90% LLC
equity
Target
Shareholder(s)
• §338 “purchase”
definition excludes
acquisition from
person whose stock
would be attributed to
Purchasing Corp
• But §336(e) election
permitted if no single
historic Target
Shareholder owns 5%
or more (by value) of
Holdco LLC
13
Purchasing Corp
Target
§318(a)(3)(A) attribution
(no threshold under §338,
5% threshold under §336)
§318(a)(3)(C) attribution (> 50%)
Target
Shareholder(s)
Investors
Holdco LLC
14
Bifurcated Purchase –
Consistency Rules for Consolidated Group
Target
Sub
Step 3
Bigco $50 cash
Step 1
$50 cash
Step 2
$50 dividend
TB = 50
FV = 100
Division 1 Division 2
TB = 0
FV = 50
TB = 0
FV = 50
Purchaser
Entity
Investors
• Bigco has higher outside basis in Target Sub stock than Target
Sub has in its assets
• One-step sale of Target Sub stock without §338(h)(10) or
§336(e) election would trigger $50 Bigco gain, but produce no
basis step-up for Purchaser
• Sale of Target Sub’s assets or sale of Target Sub’s stock with
§338(h)(10) or §336(e) election would produce $100 basis step-
up for Purchaser, but trigger $100 Bigco group gain
• Bifurcated purchase of Division 1 assets (triggering $50 gain to
Bigco group but producing $50 increase in tax basis of Target
Sub stock) triggers only $50 Bigco group gain and allows
Purchaser to obtain $50 basis step-up
• If Purchaser is a corporation, Reg. §1.338-8 “consistency rules”
disallow basis step-up in Division 1 assets if a §338 election is
not made with respect to Target Sub stock
15
Bifurcated Purchase
• If Purchaser is a partnership/LLC, PLR 201214012 held that the §338
consistency rules do not apply because purchase by a partnership/LLC is
not a QSP
• Reg. §1.336-1(b) extends the principles of the §338 consistency rules to
“qualified stock dispositions”
• Purchase of all of Target Sub’s stock by a partnership/LLC is a “qualified
stock disposition” and basis step-up in Division 1 assets would be denied
if a §336(e) election is not made with respect to Target Sub’s stock
• If Bigco acquires 5% or more (by value) of the equity of Purchaser
partnership/LLC, the purchase should not be a QSD and the §336(e)
consistency rules should not apply
• Bifurcated asset/stock purchase may be advantageous outside of the
consolidated group context
• E.g., where Target S Corp owns 2 divisions or QSubs, one with potential
Code §1374 liability and the other without
• §338/336 consistency rules do not apply outside the consolidated group
context
16
Bifurcated Purchase
17
• S Corp shareholders may seek indemnification or higher purchase price to reflect:
• Higher federal tax if SUB transaction causes portion of the shareholders’ gain to be taxed as OI (e.g., depreciation recapture or gain on inventory) rather than LTCG
• Higher shareholder state tax if SUB transaction causes portion of the shareholders’ gain to be taxed in a state that imposes a higher tax rate than the state of the shareholders’ residence
• Accelerated federal and state gain recognition
• §338(h)(10) or 336(e) election triggers gain on any stock retained by the shareholders
• S corp gain allocated proportionately even if rollover is disproportionate
• Possible §1374 tax
• Possible state entity-level taxes
Acquisition of Target S Corp:
Stepped Up Basis in Assets
18
Drop-Down LLC as §338(h)(10)/336(e) Alternative
Target
SCorp
Newco
LLC
Investors
Assets LLC Equity Step 1
Target
Shareholder(s)
19
Drop-Down LLC as §338(h)(10) Alternative
Target
SCorp
Newco
LLC
Step 2
Cash
Investors
Target
Shareholder(s)
20
Target
SCorp
Newco
LLC
Drop-Down LLC as §338(h)(10) Alternative
Rollover
equity
• Target Shareholders defer gain recognition on retained Newco LLC equity held through Target S
Corp
• Newco LLC obtains partial SUB
• Potential application of §197 anti-churning rules and allocation of benefits of SUB between
Target Shareholders and Investors depends on details of transaction mechanics and 704(c)
elections
Investors
Purchased
equity
Target
Shareholder(s)
21
Deemed Asset Drop Down
New
SCorp
Step 1
New SCorp stock
Target
SCorp
Step 2
State law conversion to LLC
Target
LLC
Target
SCorp
stock
Target
Shareholders
22
New
SCorp
Step 3
Cash
Investors
all or part of
Target LLC equity
• Target Shareholders’ contribution of Target S Corp stock to New S Corp and Target SCorp’s
conversion to LLC (or Q sub election) qualifies as “F” reorganization
• Investors obtain basis step-up on Target LLC assets
• Target Shareholders (through New SCorp) defer gain recognition on retained Target LLC equity
• Often desirable to cause Target LLC to be treated as a partnership for tax purposes (by admitting a
second non-transitory equity owner) before the sale to Buyerco so that Buyerco obtains SUB under
Code §743(b)
Basis Step-Up Upon Acquisition
Target
LLC
Target
Shareholders
23
Special Issues Involving
LBOs of Foreign Targets: Subpart F
• §951(a) requires any “United States shareholder” (generally, a U.S. person who owns, within the meaning of §958(a) or (b), at least 10 percent of the voting power) of a CFC to include the shareholder’s pro rata share of Subpart F income if the shareholder “owns (within the meaning of §958(a))” stock in the CFC on the last day of the year.
Principals
Foreign
Targets
Foreign
General
Partner
Domestic
General
Partner
Domestic
Targets
Limited
Partners Domestic
Fund
Foreign
Fund
24
Special Issues Involving
LBOs of Foreign Targets: Subpart F
• If either the Domestic Fund invests or the Foreign Fund invests, Foreign Target will often be a CFC and the Domestic Fund will often be a “United States shareholder.” If Foreign Fund invests, for purposes of determining CFC status, Foreign Fund’s ownership in Foreign Target is attributed to Domestic Fund under §958(b).
• If Domestic Fund invests, Domestic Fund would be a “United States shareholder” and would own stock within the meaning of §958(a). As a result, Subpart F inclusions would be required under §951(a).
• If Foreign Fund instead invests, then §951(a) inclusions should be analyzed at the level of the Principals and Limited Partners, all of whom may avoid “united States shareholder” status. Additional planning at the general partner level is often required.
• A key issue is whether the Foreign Fund and the Domestic Fund will be respected as separate partnerships. If viewed as one partnership, is it domestic or foreign? Some funds are now organized solely as foreign funds.
25
Special Issues Involving LBOs of Foreign Targets:
Basis Step Up Techniques
• §338 elections are almost never made on a domestic target, unless
the transaction is eligible for a §338(h)(10) election. For example,
§338 elections are rarely made on publicly-traded domestic targets
or on domestic targets that are privately-held by private equity
funds.
• In the case of a foreign target, it is often desirable to have the
transaction treated as an asset sale for U.S. tax purposes in order to
eliminate historic E&P and Subpart F income and minimize future
E&P and Subpart F income. Therefore,
• make a §338(g) election OR
• “Check and sell”: have the seller check the box on the entities that are
being acquired so that those entities are treated as disregarded entities
for U.S. tax purposes. See Dover v. Commissioner, 122 TC 324 (2004).
• §901(m) limits foreign tax credits after a §338(g) election, “check and
sell” or similar transaction to the amount of foreign tax credits that
would have been available absent the U.S. tax basis step-up.
26
Special Issues Involving LBOs of Foreign Targets:
Investing through an Intermediate Holding Company to
Address Foreign Withholding and Capital Gains Taxes
• Eligibility for 20% rate on dividends from Luxco (if Luxco is a corporation) versus Foreign Target
• Potential PFIC status of Luxco if Luxco is a corporation and ownership by Luxco of Foreign Target drops below 25%
• Publicly traded partnership status of Luxco if Luxco is a partnership
• Avoid trade or business at Luxco and debt at Luxco if Luxco is a partnership, because of UBTI rules
• Tax consequences of exit via a sale of Foreign Target (sale or exchange treatment flows through if Luxco is a partnership)
• Tax consequences of exit via a sale of Luxco
• Phantom income on non pro rata redemption of Luxco shares if Luxco is a partnership, because income at Luxco is not necessarily allocated to redeemed Luxco shareholders
• Tax treatment of preferred stock if Luxco is a partnership (is yield an allocation of income or a guaranteed payment?)
Investors
Foreign
Target
Luxco
The country in which Foreign Target is organized may
impose withholding tax on distributions out of Foreign
Target and may impose capital gains tax on sales by
large holders of stock in Foreign Target. Often, in order
to address those issues, it is desirable to invest in
Foreign Target through a holding company organized in
a jurisdiction (such as Luxembourg) with a favorable
treaty network or that is eligible for the EU
Parent/Subsidiary Directive. If such a holding company
is used, consider whether to treat Luxco as a
corporation or partnership for U.S. tax purposes:
27
Capital Structure of the Target Going Forward: All Common vs. Tranches of Common,
Preferred and Subordinated Debt
• Advantages of subordinated debt and preferred
• For debt, interest deduction, subject to limitations
• For debt, allows tax-free return of capital as principal is repaid
• Provides senior position over holders of common (or options/warrants to acquire common) in flat or downside scenario
• Provides a return hurdle (i.e., the interest or dividend rate) prior to participation in upside by holders of common/options/warrants
• Depresses value of common stock, allowing management to purchase “cheap” common stock which represents small interest in current value but larger interest in future appreciation
• For investor purchasing debt/preferred and common, allows most of tax basis to be concentrated in debt/preferred
• If exit is IPO, underwriters more likely to permit existing owners to take cash out in repayment of debt or preferred than in sale or redemption of common
28
Potential Disadvantages of Subordinated Debt
and Preferred Stock
• For debt, potential limits on interest deductibility, OID
accrual to holders, withholding tax on payments to
non-US holders
• For preferred, potential phantom income inclusions to
holders and withholding tax on payments to non-US
holders
29
Possible Capital Structure
Holdco
T
Rollover Investors VC
20% 80%
• $40m Holdco capital • $15m jr. subordinated debt
• $24m preferred stock
• $1m common stock
• warrants to mezzanine lender
• $100m T capital • $50m Sr. debt
• $10m Sr. subordinated debt
• $40m common stock
30
Subordinated Debt:
Limits on Interest Deductibility
• Common law debt-equity rules
• Code §163(e)(5) (AHYDO)
• Code §279 (Corporate acquisition indebtedness)
• Code §163(j) (Earnings stripping)
• Code §163(l) (Debt payable in stock)
• Code §163(e)(3) (related foreign holders of debt with
OID)
• Code §267(a)(3) (payments to related foreign holders)
31
Subordinated Debt Provided by VC and
Rollover Investors: Limits on Interest Deductibility
• Common law debt/equity rules
• High degree of overlap with equity ownership
• Because of subordination to senior debt, high debt-equity
ratio
32
• §163(e)(5) AHYDO: Deferral and/or Disallowance
• Senior lenders will require term to be more than 5 years
• Subordinated position typically will dictate an arms-length interest rate
greater than AFR + 5%
• Cash flow constraints and senior debt covenants typically will require
accrual of all or part of interest yield in early years
• Typically seek to avoid §163(e)(5) limits by providing for interest catch-
up in 6th year following issuance. Interest catch-up represents
unconditional obligation as between issuer and holder, with normal
default remedies, but holder often enters into subordination agreement
with senior lenders agreeing not to assert default without permission
of senior lenders if lenders have not been repaid.
Subordinated Debt:
Limits on Interest Deductibility
33
Subordinated Debt:
Limits on Interest Deductibility
• §163(j) Earnings Stripping: Deferral
• VC often owns more than 50% of borrower’s equity. If VC is a
partnership 10% or more of the capital or profits interests in
which are owned by TEOs or FPs, interest is “disqualified
interest” subject to §163(j)
• Under §163(j), interest deduction deferred to extent
borrower’s net interest expense exceeds 50% of tax EBITDA
• Frequently impossible to structure to avoid §163(j) where
subordinated loan made by majority owner VC; must rely on
EBITDA increases to “grow out” of the interest limitations
34
Subordinated Debt:
Phantom Income to Holders
• Holder taxed on accruing yield on current basis
• Typically seek to negotiate with senior lenders to permit
portion (e.g., 45%) of interest to be paid in cash to fund
holders’ tax payments, subject to cutoff if borrower’s
performance lags
• Accrual method precedent supports ending accrual of interest
income if substantial doubt as to ultimate collectibility
• Spring City Foundry, Rev. Rul. 80-361
• IRS takes position that OID rules override this precedent -- TAM
9538007
35
CERT Limits on NOL Carryback
• Corporate equity reduction ("CERT") rules limit carry back by C
corporation of NOLs attributable to interest expense following a
"major stock acquisition" ("MSA") or "excess distribution" ("ED") to
the extent aggregate annual interest expense exceeds average during
3 prior years
• Detailed proposed regulations issued 9/12
• MSA is acquisition of 50% or more of stock of another corporation
• Under proposed regulations:
• Would include tax-free stock acquisitions as well as taxable
• Where redemption occurs as part of MSA, tested as MSA
rather than as ED
36
• ED occurs where distributions during a taxable year exceed the
greater of (a) 150% of average distributions in 3 prior years or (b) 10%
of FMV of stock as of beginning of year
• Under proposed regulations, distributions would include tax-free
distributions -- e.g., tax-free distributions under Code sec. 355
• Consolidated group treated as a single entity for purposes of
determining and tracking a CERT
• Under proposed regulations, a corporation leaving a consolidated
group would take with it a proportionate share of the group's
CERT, interest and distribution history, unless election made to
permanently waive any carryback of losses to the consolidated
group
CERT Limits on NOL Carryback
37
• Cash and accrual method holders generally not taxed on accruing stated dividend yield until paid
• If preferred sold to third party or redeemed (e.g., in connection with IPO) and redemption not recharacterized as a dividend under §302, redemption proceeds in respect of accrued dividends taxed as capital gain, provided that the accrued dividends not “declared” prior to redemption
• Capital gain treatment generaly avoids withholding tax on dividends to non-US holders
• Accrued yield on non-participating preferred is taxed (to the extent of E&P) if paid in kind (including conversion into common, e.g., in connection with IPO)
Preferred Stock:
Taxation of Stated Yield
38
• OID on non-participating preferred taxed as accrues (to
the extent of e&p)
• Where preferred is issued in unit with common or
warrants, risk that more than stated value may be
attributed to common or warrants and less than stated
value attributed to preferred, creating preferred OID
• Relevant factors bearing on valuation of preferred include
whether stated yield is lower than an arms-length rate and
whether common equity is too “thin”
• Risk that stated yield may be treated as “disguised
redemption premium” (creating OID) if “no intention to
pay currently”
Preferred Stock:
Taxation of Yield
39
• Taxation of preferred OID and dividends paid in kind generally
applies only if stock is “preferred” stock under §305, i.e., stock that
does not participate in corporate growth to a significant extent
• Ignore participation through right to convert into different class of stock
• Can add a participation feature to preferred stock, avoiding §305 preferred stock
characterization, by creating a class of stock that combines some or all of the
holder’s common stock and preferred stock rights
• Assume Investors invest $100 in Target at the time of the acquisition. They
could invest, e.g., $9 in nine shares of common stock and $91 in
participating preferred with a liquidation preference of $90, a fixed annual
yield and a right to 10% of the value of Target in excess of the liquidation
preference on the preferred.
• Unfavorable dividend or recapitalization basis recovery rules may apply if
the preferred element of the participating preferred is paid off (e.g., in
connection with IPO) while the common element remains outstanding.
Preferred Stock:
Taxation of Yield
40
Cheap Common Issues
• If yield on preferred or subordinated debt is too low or
common is too thin (resulting in “option value” for common), FMV of common stock may be greater than purchase price
• Resulting Risks • Executives purchasing common stock may have ordinary
income under §83
• Company may have GAAP compensation charges under FASB 123R
• Employee options on common stock may be in-the-money at grant, triggering §409A penalties
• Holder of preferred or subordinated debt may have OID
• Might alleviate §83 cheap common concerns by creating partnership/LLC holding company and issuing to management profits interests rather than common corporate shares. But: • Some accountants are concerned that Rev. Proc. 93-27
(allowing use of §83 liquidation value methodology for partnership/LLC interests) may not apply to this fact pattern
• May result in ordinary income on exit without compensation deduction if carried interest legislation enacted.
41
Cheap Common Issues
42
• Nonqualified preferred (“NQ Pfd”) stock is treated as
boot.
• Stock is NQ Pfd if it does not participate significantly in
corporate growth and is mandatorily redeemable within
20 years after issuance, puttable within 20 years after
issuance or callable within 20 years after issuance, with
it being more likely than not to be called.
• Although NQ Pfd is treated like debt for gain recognition
purposes, recognized gain cannot be deferred under the
installment sale rules.
Preferred Stock Issued to Rollover Investors
43
Preferred Stock Issued to Rollover Investors
• Can avoid NQ Pfd treatment by issuing to rollover investors a
separate class of preferred stock that is neither mandatorily
redeemable nor puttable within 20 years
• Company may desire call right (e.g., in connection with IPO). Is right
more likely than not to be exercised? §305 regulations provide safe
harbor under similar rules if issuer and holder are not related, call is
not compelled and call would not reduce yield to maturity. This safe
harbor should apply by analogy but no definitive guidance exists.
• Holder right to convert (or issuer’s right to force conversion) into
common stock at IPO price should not be treated as a put right for
this purpose because conversion is not a “redemption” or
“purchase”
• If preferred stock received by rollover investor is not NQ Pfd and
receipt of cash would have been treated as a dividend, preferred
stock may be §306 stock
44
• Can avoid NQ Pfd treatment by issuing to rollover
investors a class of stock (treated as “common” stock)
that combines some or all of the holder’s common stock
and preferred rights
• Unfavorable dividend or recapitalization basis recovery rules
may apply if subsequently the preferred element of the stock
is paid (e.g., in connection with IPO) while the common
element remains outstanding. Not important issue for rollover
investors if tax basis in rollover shares is low.
Preferred Stock Issued to Rollover Investors
45
Withdrawal of Cash from Target:
“Leveraged Recap”
• If Target borrows funds and then distributes the funds to the Investors, the first
dollars paid to the Investors could qualify as §301(c)(2) basis recovery if Target
has no current or accumulated earnings and profits.
(1) Dividend to the
extent of earnings
and profits
(2) Basis recovery
(3) Capital gain
§301(c)
Target Lenders Cash
Investors
Cash
46
Withdrawal of Cash from Target:
“Leveraged Recap”
• If a §338 or §336(e) election was made on the acquisition, the pre-acquisition E&P of Target was eliminated.
• If a §338 or §336(e) election was not made on the acquisition, the pre-acquisition E&P of Target would generally not flow up to Purchasing Corp.
• Whether or not a §338 or §336(e) election is made, post-acquisition E&P, if any, of Target would generally flow up to Purchasing Corp (unless Purchasing Corp and Target do not file consolidated returns).
Purchasing
Corp Lenders
Investors
Target
Cash
Cash
Cash
Lenders
or
Cash
47
Withdrawal of Cash from Target
Funded by Sale of a Business
• The distribution of cash could qualify as a “partial liquidation” under §302(b)(4).
• If so, certain Investors would recover a portion of their basis and be taxed at capital gains rates.
• Partial liquidation treatment is desirable if the Investors have held Target stock for more than one year, but undesirable if they have held for one year or less (and qualified dividend income treatment would otherwise be available).
• Qualification as a partial liquidation is highly formal. For example, a sale of stock of a subsidiary (without a §338 (h)(10) (or §336(e)) election) followed by a distribution of the proceeds is not a partial liquidation, but an actual or deemed sale of assets by Target (or a sale of assets by a subsidiary of Target followed by a liquidation of the subsidiary) and a subsequent distribution of the proceeds could qualify. Rev. Ruls. 75-223, 79-184.
Cash
Target Cash
Investors
Business
48
Partial Exit through an
Initial Public Offering
• If structured as a secondary sale, Investors would have sale or exchange treatment on the shares sold.
• If structured as a primary sale of shares by Target to the public followed by a payment of cash by Target to the Investors, the transaction raises a number of issues, such as (1) whether it will be recast as a secondary sale under the step transaction doctrine, see Waterman Steamship v. Commissioner, 430 F.2d 1185 (5th Cir. 1970); Rev. Ruls. 71-336, 75-447, and 75-493, and (2) if not recast as a secondary sale, whether the transaction between Target and the Investors will be analyzed as a §301 distribution, a §302 redemption, a §356/368(a)(1)(E) recapitalization with boot or, if a holding company is used, a §304 transaction.
Cash
Target
shares
Secondary Sale Primary Sale and
Distribution/Redemption/Recapitalization
Target
Public Investors
Target
Target
shares
Cash
Target
shares
Cash
Investors Public
49
Partial Exit Through an Initial Public Offering
• If §302 or §356 applies, the reduction in percentage interest
experienced by the Investors as a result of the public obtaining
shares in Target should be taken into account in determining
whether the Investors’ percentage interest has gone down
sufficiently to result in sale or exchange treatment under §302 or
§356. See Zenz v. Quinlivan, 213 F.2d 914 (1954), Rev. Ruls. 54-
458, 55-745, 84-114. Cf. Bazley v. Commissioner, 331 U.S. 737
(1947); Treas. Reg. Sec. 1.301-1(l).
• If §301(c)(1) applies and the Target is U.S., then withholding would
be required with respect to non-U.S. investors.
50
Partial Exit Through an Initial Public Offering:
Tax Receivables Agreements
• Market is thought not to value tax attributes (e.g., basis, net
operating losses) of IPO company since not reflected in GAAP
earnings.
• Tax Receivables Agreement causes IPO company to pay historic
owners a portion (e.g., 85%) of IPO company’s tax savings as tax
attributes are used.
• May cover basis step-up arising from exchange of
partnership interests for IPO company stock in connection
with or after IPO
• May cover historic stepped-up tax basis or NOLs
• Treatment of TRA to historic investors depends on structure. In
basis step-up case, TRA payments are often viewed as
installment payments.
51
Partial Exit through an Initial Public Offering:
Basis Concentration Using Participating Preferred Stock
• Suppose Investors invested $100 in Target at the time of the acquisition. They would invest, e.g., $9 in nine shares of common stock and $91 in participating preferred.
• The participating preferred has a liquidation preference of $90, a fixed annual yield and a right to 10% of the value of Target in excess of the liquidation preference on the preferred. At the time of an IPO, the preferred converts into a number of common shares having a value equal to the liquidation preference plus common shares representing 10% of the remaining value of Target.
• For example, suppose an IPO is going to occur at $10 per common share at a time when the value of the Target is $200 (and assume the preferred liquidation preference has grown to $100). The preferred would convert into 11 shares (equal to $100 liquidation preference/$10 per share plus one additional common share representing 10% of the value of the company in excess of $100) with a basis of $8.27 per share. A portion of these high-basis common shares would be sold to New Investors in the IPO resulting in only a small amount of gain recognized.
Cash
Investors
New
Investors
Target
low basis common
high basis participating
preferred
converts
to common
at IPO
52
Partial Exit through an Initial Public Offering:
Basis Concentration Using Participating Preferred Stock
• Treasury Regulation §1.1012-1(c) permits specific
identification of shares sold.
• Valuation of the preferred at the time of original
investment is a key issue as it determines the Investors’
basis in the preferred.
• Preferred is intended not to be preferred stock for §305
and 306 purposes as a result of the participation feature.
53
Restructurings/Workouts
• Cancellation of Indebtedness Income (“CODI”) and related
tax issues can arise in three principal situations:
• Debtor repurchases its own debt at a discount to par, either
for cash, stock or a new debt instrument;
• A party “related” to the debtor acquires the debtor’s debt at a
discount; or
• The debtor and creditor agree to modify the terms of a debt
instrument, and the debt instrument has been traded at a
discount on an “established securities market” (broadly
defined) during the 31-day period ending 15 days after the
modification
54
Restructurings/Workouts
Mitigation of CODI Income
• Use of Net Operating Losses against CODI Income. Note
that NOL carryovers will not completely eliminate tax,
because of AMT.
• Bankruptcy Exception
• Insolvency Exception
• State tax consequences also must be considered as
State results do not always conform to federal.
55
Situation 1: PC Purchases Debt at Discount
Equity Fund
PC $2B Notes
Partners
60%
Other
Shareholders
40%
Lenders
$350m cash
$500m face Notes
56
Debt Purchase Tax Issues
• PC’s purchase of $500m debt for $350m triggers $150m
CODI
• CODI excluded from PC’s taxable income
• If purchase occurs in PC’s bankruptcy proceeding, or
• To extent PC was insolvent prior to the purchase
• CODI excluded under bankruptcy or insolvency exception
applied to reduce PC’s NOLs and other tax attributes
• If PC is a partnership or LLC, bankruptcy and insolvency
exceptions applied at the partner/member level and hence
are generally unavailable
57
Situation 2: Related Party Purchases Debt
Equity Fund
PC $2B Notes
Lenders
60%
Other
Shareholders
40% $350m $500m face Notes
Partners
58
Purchase of Debt by Related Party
• Code §108(e)(4) and Reg. §1.108-2 -- Where debt acquired by
person related to issuer from an unrelated person at
discount:
• Acquisition discount = CODI to issuer
• New debt deemed to be issued with issue price = purchase price
of debt
• Whether person acquiring debt treated as related to issuer
tested under §267(b) and §414(b) and (c)
• Partnership and corporation treated as related if same persons
own > 50% of value of corporation’s stock and capital or profits
interest in partnership (§267(b)(10))
• Stock owned by partnership or corporation treated as
constructively owned by the entity’s owners (§267(c)(1))
• Result: Partners of Equity Fund own 100% of Equity Fund
and treated as constructively owning 60% of PC
59
Purchase of Debt by Related Party
• Hence Equity Fund’s purchase of PC debt triggers
§108(e)(4):
• $150m taxable CODI to PC
• For 2009 and 2010 transactions, PC may elect to defer CODI
recognition under Code § 108(i)
• $150m OID income (rather than market discount) to Equity Fund
accrued over remaining term of debt
• $150m OID deductions to PC, but may be limited by §163(e)(5)
(AHYDO rules) or §163(j) (interest stripping rules)
• Upon resale of debt by Equity Fund, debt has same CUSIP as
other PC notes but is not fungible because of OID taint
60
Determining Related Party Status -- Partnership
with Overlapping Ownership Purchases Debt
Equity Fund Distressed
Debt Fund
PC $2B Notes
Lenders
Non-Overlapping
Partners
60%
Other
Shareholders
40% $350m $500 face Notes
Non-Overlapping
Partners
Overlapping
Partners
30% 55% 45% 70%
61
Determining Related Party Status -- Partnership with
Overlapping Ownership Purchases Debt
• Actual common ownership of PC and Distressed Debt Fund
<50%
• But assume that one or more of Overlapping Partners is an
individual
• An individual who owns stock (directly or constructively
through an entity) in a corporation treated as owning stock
owned by his partner (§267(c)(3))
• Individual Overlapping Partner treated as constructively
owing 100% of PC stock owned by Equity Fund
• Therefore Overlapping Partners own 55% of Distressed Debt
Fund and treated as constructively owning 60% of PC
62
Determining Related Party Status -- Corporation
Owned by Equity Fund Purchases Debt
Equity Fund
PC $2B Notes
Lenders
Partners
60%
Other
Shareholders
40%
$350m
$500m face Notes
Cayman
Corp
$350m
63
Determining Related Party Status -- Corporation
Owned by Equity Fund Purchases Debt
• Whether PC and Cayman Corp treated as related persons is
tested under §267(f) and §414(b) and (c)
• PC and Cayman Corp treated as related if:
• 5 or fewer individuals, trusts or estates own > 50% of both PC and
Cayman Corp,
• Under applicable constructive ownership rules, individual not treated as
owning stock owned by partner
• Equity Fund is treated as the parent of a chain of “trades or
businesses” under common control that includes PC and Cayman
Corp
• Equity Fund should not be treated as engaged in a trade or business and
hence this test should not apply (see, e.g., Rev. Rul. 2008-39)
• 1st Circuit has held (in Sun Capital case) that a private equity fund may be
the parent of a chain of trades or businesses under common control for
purposes of ERISA controlled group tests
64
Determining Related Party Status -- Corporation
Owned by Equity Fund Purchases Debt
• Cayman Corp subject to 30% withholding tax on interest
income if treated as a 10% shareholder of PC under Code
§871(h)(3)
• Applying §871(h)(3)(C) constructive ownership rules,
Cayman Corp would own > 10% of PC
• Therefore, portfolio interest exemption apparently not
available
• Tax leakage may be reduced if corporation purchasing PC
debt is formed in jurisdiction that may make available tax
treaty reductions in withholding tax
• May make QEF election for Cayman Corp, which is likely a
PFIC, to preserve capital gain treatment on eventual sale
of debt
65
Determining Related Party Status -- Corporation with
Overlapping Ownership Purchases Debt
$2B Notes Lenders
Partners
60%
Other
Shareholders
40%
$350m
$500m face Notes
$350m
Equity Fund
PC
Cayman
Corp
66
Determining Related Party Status -- Corporation
with Overlapping Ownership Purchases Debt
• PC and Cayman Corp should not be treated as related for
purpose of §108(e)(4)
• Applying §871(h)(3)(C) constructive ownership rules,
Cayman Corp apparently treated as owning < 10% of PC
• Therefore, portfolio interest exemption apparently available
67
Situation 3: Debt Restructuring
SHs
Other Holders
$1.5B Notes
$1.5B face New Notes
PC
Distressed
Debt Fund
In debt restructuring transaction:
• Other Holders exchange $1.5B face old Notes for $1.5B face New Notes
with revised terms (e.g., extended maturity, higher or lower interest
rate, revised covenants)
• Distressed Debt Fund exchanges
• $200m face old Notes for $200 face New Notes
• $300m face old Notes for 60% of PC’s post-restructuring equity
• FMV of old Notes and New Notes = 70% of face
68
Debt Restructuring Tax Issues
• Exchange of new debt for old debt held by Distressed Debt
Fund and other holders may trigger CODI
• Upon exchange of old Notes for New Notes with “significantly
modified” terms (or upon “significant modification” of old Note
terms by amendment), old Notes treated as satisfied for amount
equal to “issue price” of New (or amended) Notes
• Whether change in terms represents a “significant modification” is
determined under Treas. Reg. § 1.1001-3(b)
• Increase in interest rate is a significant modification if greater than a de
minimis safe harbor
• Payment of a fee to a lender to cure a covenant default or obtain a waiver or
consent is treated as an increase in the interest rate
• Extension of the term of a debt instrument beyond safe harbor levels
can be a significant modification
69
Determining “Issue Price” of New Notes:
• If neither old Notes nor New Notes are treated as “market
traded,” “issue price” equals the principal amount of the
New Notes, unless interest rate less than applicable
federal rate (“AFR”)
• If either old Notes or New Notes are treated as “market
traded,” issue price of New Notes generally equals the
FMV of the New Notes at the time of the exchange
70
Debt-for-Debt Exchange Tax Consequences --
Notes Not Market Traded
If Notes not treated as market traded:
• PC treated as satisfying $1.7B old Notes with New
Notes having issue price of $1.7B
• No CODI for PC
• Holders realize gain or loss on exchange based on
$1.7B face amount, generally deferred under
“recapitalization” tax rules if the old Notes and New
Notes are “securities” for tax purposes
• No OID for holders
71
Debt-for-Debt Exchange Tax Consequences --
Notes Market Traded
If Notes are treated as market traded:
• PC treated as satisfying $1.7B old Notes with New Notes
having issue price of $1.19B (FMV = 70% of face)
• PC realizes $510m CODI
• Holders realize gain or loss on exchange based on $1.19B
FMV, generally deferred under “recapitalization” tax rules
if the old Notes and New Notes qualify as “securities” for
tax purposes
• New Notes have $510m OID
• OID deductions for debtor, potentially limited under
AHYDO rules
• OID income for holders
72
Broad Definition of Market Traded
• Under Treas. Reg. § 1.1273-2(f), old Notes or New Notes are
“traded on an established market” if at any time during the 31-day
period ending 15 days after the exchange date:
• An actual sales price for the old Notes or New Notes is reasonably
available to market participants;
• One or more firm quotes for the old Notes or New Notes is available
from a broker or dealer, or
• One or more indicative quotes for the old Notes or New Notes is
available from a broker or dealer.
• Value is presumed to be sales price or quotes price.
• If indicative price materially misrepresents value, taxpayer can use
any method that provides reasonable basis to determine value.
• Small issuance exception: outstanding stated principal amount of
$100 million or less
• Issuer’s determination binding unless holder discloses on tax
return for year that includes acquisition date
73
Anti-Abuse Rule
• If a temporary restriction on trading is implemented, a
purpose of which is to avoid characterization of a debt as
market traded, then the debt instrument or property is
treated as market traded under Treas. Reg. 1.1273-2(f)(7)
• This anti-abuse rule applies even if a third party (and not
the issuer) has imposed the restriction, e.g., the holders
themselves or a federal bankruptcy court
74
AHYDO
• In a debt-for-debt exchange or modification where the face
amount of the debt is unchanged, but CODI is triggered because
the new debt is treated as having an “issue price” less than
face, the new debt will generally have an equivalent amount of
OID, the debtor’s deduction of which may offset the tax cost of
the CODI
• However, for applicable high-yield debt obligations (those with
terms >5 years and YTM > AFR + 5% and OID accruals in excess
of cash payments plus one year’s worth of interest)
(“AHYDOs”):
• No deduction is available for OID to the extent that it exceeds AFR +
6%, and
• the remaining OID is only deductible when paid in cash or property
75
Debt Restructuring Tax Issues
• CODI on equity-for-debt exchange
• Distressed Debt Fund's exchange of PC debt for PC equity
triggers CODI equal to excess of issue price of exchanged PC
debt over FMV of PC equity received in exchange
• § 382 ownership change
• Distressed Debt Fund's acquisition of > 50% of PC's equity
triggers ownership change of PC under § 382, resulting in limits
on use of PC's NOLs and built-in losses
• If debt issuer is a subsidiary of equity issuer, consider
application of Treas. Reg. §1.1032-3, §351 and Revenue
Ruling 59-222.
76
Debt Restructuring Tax Issues
• Potential additional CODI as result of Distressed Debt
Fund becoming related to PC
• Distressed Debt Fund's original acquisition of PC debt at a
discount did not trigger CODI because Distressed Debt Fund
was unrelated to PC
• But CODI also triggered under Treas. Reg. §1.108-2 if
Distressed Debt Fund treated as acquiring PC debt "in
anticipation of becoming related” to PC
77
Debt Restructuring Tax Issues
• If Distressed Debt Fund acquires > 50% of PC's stock within 6
months of purchasing PC's debt at a discount:
• Purchase deemed to be in anticipation of becoming related
• PC has CODI on restructuring date equal to excess of face of debt
purchased by Distressed Debt Fund over Distressed Debt Fund's
purchase price
• PC deemed to issue new debt instrument to Distressed Debt Fund
with issue price equal to Distressed Debt Fund's purchase price,
resulting in OID equal to discount
78
Debt Restructuring Tax Issues
• If Distressed Debt Fund acquires > 50% of PC's stock more
than 6 months after purchasing PC's debt at a discount,
whether Distressed Debt Fund purchased the PC debt "in
anticipation of becoming related" to PC determined based on
all relevant facts, including:
• Distressed Debt Fund's intent at time of debt purchase
• Any pre-purchase discussions with PC
• Period of time between purchase of debt and acquisition of stock
and
• Significance of PC debt as a proportion of Distressed Debt Fund's
total assets
79
Debt Restructuring Tax Issues
• If Distressed Debt Fund becomes related to PC more than
6 months after purchase of PC debt at a discount and
purchase treated as "in anticipation of becoming related"
to PC:
• CODI measured by reference to FMV of PC debt on date
Distressed Debt Fund becomes related to PC (rather than
Distressed Debt Fund's purchase price)
80
Restructurings/Workouts
• Holders’ treatment
• Recapitalization treatment of debt-for-debt
(“securities”) or debt-for-stock exchange
• Determination of “issue price” of new debt is key (e.g.,
OID on new debt if traded at a discount)
• Worthless stock deduction