Since the beginning of the year, there has been a steady stream of notable and somewhat unanticipated announcements and new rules coming out of the IRS that impact the private equity community, and not all of them relate to the current scandals that have gotten so much attention in the press. Below is a brief round-up of these developments.
Spin-Off Announcement #1
The IRS surprised the tax community on January 3rd by suspending the issuance of private letter rulings that bless three transaction structures frequently implemented in connection with tax-free spin-offs while it studies the issues involved. The three so-called “no rules” cover (1) some intercompany transactions that are commonly undertaken in order to prepare a company for a spin-off, (2) some transactions used by a distributing company to extract cash from the business being spun-off, and (3) the creation of high-vote/ low-vote governance structures in connection with a spin-off.
While some tax-free spin-offs are consummated without a private letter ruling, the types of transactions covered by the new “no-rules “ have generally been done only with an IRS ruling because of uncertainty as to how the relevant tax rules apply. In some cases, the transaction is central to the spin-off being considered (e.g., an intercompany transaction undertaken in order to get the assets and liabilities in the right place). In other cases, the transaction makes the spin-off more attractive (e.g., the extraction of cash from the spun-off business). As a result, the new no rules are likely to discourage some companies from pursuing a spin-off and make it essentially impossible for some businesses to be spun-off.
Spin-Off Announcement #2
On June 25th, the IRS announced an even more significant curtailment of the private letter rulings it would issue going forward in the spin-off context. Under the revised IRS procedure, the IRS will stop issuing private letter rulings as to the overall tax-free nature of a spin-off and will generally limit its rulings to so-called “significant issues.” Since the tax consequences of a spin-off could be catastrophic if it failed to achieve tax-free treatment, taxpayers effecting a spin-off have generally sought the halo effect of a private letter ruling that covered the entire transaction. The new IRS procedure applies to private ruling requests made after August 23rd. The new procedure also applies to certain other corporate transactions.
New Election to Treat a Stock Purchase as an Asset Purchase
IRC Section 338(h)(10) has long enabled taxpayers to elect to treat a stock purchase as an asset purchase for tax purposes, so that the tax basis of the assets of the purchased company is stepped up to fair market value. A variety of requirements must be satisfied in order to make a valid Section 338(h)(10) election, including a requirement that at least 80% of the stock of the target corporation be “purchased” and that the buyer be taxed as a “corporation.”
IRC Section 336(e), which was enacted way back in 1986, authorizes the IRS to issue regulations that would create a similar election in other contexts. A few weeks ago, the IRS issued regulations under Section 336(e) that allow the equivalent of a Section 338(h)(10) election, but with slightly liberalized requirements. Specifically, an election is permissible under Section 336(e) where the acquirer is a partnership (or other non-corporate entity) and where the acquisition was not effected by “purchase.” (The term “purchase” is narrowly defined in the Section 338(h)(10) context to exclude certain taxable distributions and exchanges, such as transactions involving multiple acquirers or non-corporate acquirers.)
We believe that this liberalization in the requirements will make these elections available in a number of additional transactions and will therefore increase structuring flexibility in the M&A context.
Partial 338(h)(10) Elections Limited
Earlier this year, an IRS private letter ruling blessed what has been described as a “partial” Section 338(h)(10) election. The transaction effectively allowed the buyer to receive a step up in the basis of some (but not all) of the assets of a target corporation assets of a target corporation in a manner that did not create any incremental tax to the target corporation or the seller, resulting in an unusual “tax bargain.” (This type of transaction is described in greater detail in the Summer/Fall 2012 issue of the Debevoise & Plimpton Private Equity Report.)
Surprisingly, the new section 336(e) regulations prospectively change the result of the private letter ruling for taxpayers engaging in similar transactions going forward. While there are a few alternative methods of effecting a so-called partial Section 338(h)(10) election to which the new section 336(e) regulations do not apply, the alternative transaction may be somewhat more difficult to execute and/or provide for a somewhat reduced tax benefit.
Management Fee Waivers
In the last month, the tax press has reported on statements made by IRS personnel indicating that they are looking at the so-called “management fee waiver” mechanisms used by some private equity funds (there have, of course, been separate reports that the New York attorney general is also analyzing these arrangements). These statements indicate that the IRS understands that management fee waiver mechanisms come in a variety of forms, that the IRS is more troubled by some of the forms than others and that the IRS is planning to address the use of the mechanism through the audit process rather than published guidance.
New 3.8% Medicare Tax
As has been widely reported, a new 3.8% “Medicare tax” went into effect on January 1 of this year. The tax applies to certain types of investment income recognized by U.S. individuals and certain trusts and, in effect, increases their cumulative tax rate on such income. For most private equity professionals, the tax will apply to the professional’s share of the carried interest (which typically flows through as capital gain, dividends and interest) but will generally not apply to amounts received from the “manager” (typically ordinary compensation income or an allocation of management fees). In some cases the proposed regulations may encourage hedge funds that do not generate significant amounts of long-term capital gain to restructure their carried interest as a “fee” rather than a partnership “profits interest.”
While simple in theory, the proposed regulations exceed 40 pages and raise a host of issues in certain contexts – such as the application of the tax to income flowing from non-U.S. corporations and treatment of various deductions and loss carryovers in computing the net investment income subject to the tax. As a result, there should be plenty for your tax lawyer to talk to you about.