Current issues in hedge funds and private equity: Debt-equity regulations, convertible bonds conversion rates, and the end of deferred compensation

Authored by: Gregory Kastner

New debt-equity regulations impact on hedge and private equity funds

On April 4, 2016, new proposed Treasury regulations became effective covering Internal Revenue Code (IRC) §385. They cover debt issuance between related parties and provide for reclassification to equity, if certain thresholds are met. These regulations could have significant impact on the way some hedge funds and private equity vehicles do business.

Reclassification to distribution from interest expense

Hedge funds and private equity vehicles often make use of so-called “blocker corporations” to prevent United States sourced income from flowing through to a foreign investor. Use of these blocker corporations alleviates the need to withhold federal and often state/city income taxes on US effectively connected income that is directly attributable to foreigners. In the past, the profit in these entities has sometimes been zeroed out through the use of notes offerings. Assuming the debt-equity ratio did not run afoul of the IRC §163(j) rules, charged interest essentially negated all income. These new proposed regulations prohibit this practice between entities of an Expanded Group (EG). Hence, if a purported debt instrument is re-characterized as equity under the proposed regulations, interest expense could be reclassified as a distribution and could be classified as a dividend depending on the magnitude of the entity’s positive earnings and profits.

If the payment can be classified as portfolio interest under IRC §871, it can avoid being subject to withholding. To qualify, it can’t be received by a 10% shareholder. If the payment instead is reclassified as a dividend, the result can be disastrous. Absent any beneficial treaty, the rate of withholding on such income could exceed 60 percent when the branch profits tax and state withholding are included. The branch profits tax is imposed on foreign corporations that have US based earnings and profits – its purpose is to even the playing field with domestic corporations that are subject to double taxation on corporate earnings (first when income is earned, second upon distribution to the shareholder as a dividend). In the foreign jurisdiction, the reclassified domestic interest income would not necessarily be treated as a distribution and could be taxed as interest income offshore as well, increasing the effective tax rate even higher.

Keep in mind, these rules also apply when debt is issued to acquire equity of a related entity and when debt is distributed to a related entity as boot in an asset reorganization.

Expanded Group

An Expanded Group (EG) is defined as any group of foreign or domestic entities connected through direct or indirect ownership of at least 80 percent of voting power or value. The voting power side might have real impact when the entity used to zero out profits is controlled by the same person that is directing the US sourced business in another entity. However, for now, what constitutes “voting power” has not been clearly defined, although it might end up following the courts’ previous findings under IRC §304 and §1502 Tax practitioners will, no doubt, interpret this differently, especially when more complex structures and ownership options are in place. 

Traps to be wary of

While the proposed regulations became effective from April 4, 2016 onward, there are traps funds might fall into:

  1. During a 36-month period before and a 36-month period after the funding of a transaction, any interest payment could be reclassified under these rules. This could wreak havoc on loans between related companies just to fund day-to-day operations and cause all sorts of bookkeeping nightmares going forward, as entities will essentially be treated as shareholders of each other when before there was only a debt-creditor relationship. As this is a mechanical test, no exceptions exist for extenuating circumstances.
  2. If a debt instrument issued prior to April 4 is modified thereafter, the IRS could subject the debt instrument to reclassification as equity. Hedge fund and private equity vehicles will have to be very cautious when modifying an instrument’s terms, receiving a settlement fee, or any changes in ownership to be sure they don’t run afoul of this rule, as these occur frequently in renegotiations of distressed debt.
  3. There is a catch-all anti-abuse clause the IRS can use to review transactions they feel are implemented solely to avoid taxation.

Exclusions

There are exclusions.

  1. The entity has no current earnings and profits.
  2. Aggregate debt of the EG members that would be reclassified to equity does not exceed $50 million (once it reaches $50 million, all debt is re-characterized).
  3. The transfer is of property to an EG member in exchange for equity, if the transferor owns greater than 50 percent for 36 months after.
  4. The debt is issued in the ordinary course of business in connection with the purchase of goods or services – this has a narrow range of applicability under an ordinary and necessary expense definition.

Modified Expanded Group

Adding to all of this complexity, if certain documentation requirements aren’t met, the IRS solely can treat a fraction of the interest expense as a distribution under the Modified Expanded Group (MEG) rule - which basically changes the test from 80 percent under an EG to 50 percent. Who bears the burden of proof on the percentage used for bifurcation is another area still unclear at this time. This proposed regulation becomes effective when final.

Documentation as debt must be maintained year to year by entities:

  1. Publicly traded or
  2. With more than $100 million in assets or
  3. With more than $50 million in annual revenue.

In small shops, this requirement could easily be overlooked with other responsibilities, such as FATCA compliance, seeming to multiply year to year.

Despite a very recent IRS hearing on this topic on July 14, 2016, look for the IRS to finalize these regulations by Labor Day of 2016.

Convertible bonds: Change in conversion rate may create dividend

A proposed amendment to the IRC §305 regulations issued on April 13, 2016 clarified that a change in the conversion rate of a convertible bond could have the effect of giving bondholders rights to more of the issuer’s earnings and profits, thereby earning an undistributed dividend. Depending on where the bondholder is domiciled, this undistributed dividend might be subject to withholding if the entity is an US corporation and the shareholder is offshore without a beneficial treaty rate in place. Bond issuers will be required to disclose the amount of these deemed dividends on Form 8937 and to withhold accordingly, even if no cash actually changes hands. However, most tax practitioners have concluded the impact will be rather minimal on most hedge funds and private equity vehicles.

End of deferred compensation: Changes in method of accounting no longer automatic

Under the old deferred compensation rules, hedge funds and private equity vehicles had the opportunity to defer taxes on incentive fees earned on foreign entities’ appreciation accrued, but not paid to US managers. This practice was effectively ended by new IRC §457A created by the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 which said all deferred tax on income of this nature had to be paid before the 2018 tax year. Perhaps in response to what some tax practitioners had planned, the IRS issued Revenue Procedure 2015-13 that removed conversion of cash to accrual method of accounting from the list of changes that could be approved automatically and without the consent of the IRS. Generally, when a change in the method of accounting results in an increase of tax, the taxpayer is allowed to take such an increase ratably over four years. Some hedge funds and private equity firms with offshore incentive receivables either did or were planning to convert from the cash method of accounting to accrual before the 2017 deadline, to take advantage of a further three year deferral of taxes. Now, they must receive IRS approval to do the conversion. If there is a true business purpose to the conversion, it might still be respected, but the IRS will certainly look at any deferred fees.

For more information on these topics, or to learn how Baker Tilly asset management industry specialists can help, contact our team.


The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.