Basics of Private Equity Taxation Steven D. Bortnick Partner, Pepper Hamilton LLP

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1 Basics of Private Equity Taxation Steven D. Bortnick Partner, Pepper Hamilton LLP Presented to The Wharton Private Equity and Venture Capital Club January 17, 2012 # v.1

2 The Essentials-What We ll Cover Corporate Acquisitions When can a transaction be tax-free When taxable transactions are preferred over tax-free transactions Examples of certain tax-free transactions Stock sales versus asset sales 2

3 The Essentials What We ll Cover Partnership Investments Tax efficiency Basis step up Special issues for tax-exempt investors (UBTI) 3

4 The Essentials-What We ll Cover Financing Issues Various rules that may limit deductibility of interest in the US 4

5 Some Basics on PE Funds PE Funds generally formed as limited partnerships US or foreign Partners, not partnership, subject to tax Taxed even if no distributions Character of income determined at partnership level 5

6 Some Basics on Investors US individuals taxed at rates up to 35% on ordinary income and short-term capital gain US individuals taxed at 15% on long-term capital gain and qualified dividends Think about the carry partners! US corporations taxed at 35% on all income Tax-exempt organizations not taxed except on UBTI Foreign investors generally not subject to tax in US except: withholding tax on US source income (e.g., dividends and interest, but usually not capital gains); and net basis tax on income effectively connected to US trade or business (including capital gain) 6

7 Some Basics on Investee Companies Corporations shareholders generally not taxed until distribution or sale Corporation itself subject to tax where organized/doing business Partnerships flow through for tax purposes (see Some Basics on PE Funds ) Only single layer of tax Classification of a foreign entity or corporation or partnership for US tax purposes generally elective (and may differ from country of organization) Single-member foreign entity (or US LLC) generally may be either corporation or disregarded for US tax purposes 7

8 Key Corporation Partnership Corporation taxed as a partnership in US Corporation disregarded as entity in US 8

9 9 Corporate Acquisitions

10 Corporate Acquisitions Taxable vs. Tax-Free Taxable No limit to cash consideration Buyer gets basis step up Seller taxed currently Loss available to seller Stock consideration taxed Tax-Free 50% cash general limit Carryover basis Tax deferral (What will rates be in future?) Loss also deferred No current tax on stock Cheap alternative to cash 10

11 Corporate Taxable Acquisitions Starting point tax-free deal does not work, but why? Seller wants mostly cash Buyer wants step up in basis Separation of businesses 11

12 Buyer s Perspective Asset Acquisition Preferred option Avoid unknown liabilities Get step up in tax basis Added tax depreciation/amortization Less tax on later sale of assets Stock Acquisition Generally, no step up in tax basis of assets May be good, however, if NOL exists 12

13 Seller s Perspective Asset Acquisition Double level of tax Pay full tax on appreciation State and local taxes can also apply Stock Acquisition Single level of tax - capital gains rates apply 13

14 Inside vs. Outside Basis Stock Sale Asset Sale $100 Cash Buyer Target Stock Seller Seller Target $100m basis Target $10m basis Buyer $100 Cash Assets Target $10m basis $0 basis $0 basis $100 basis $0 basis Assets Assets Assets Assets $90 Capital gain to Seller $100 gain to Target $55 gain to Seller ($65 distributed $10 basis) 14

15 The Big Deal About Step Up In Basis Reduced gain on sale of assets Increased depreciation/amortization on acquired assets Goodwill, going concern value and similar intangibles amortizable over 15 years Prior example results in $6.7m deduction (or $2.7m tax 40%) Buyer likely to pay more for company with higher asset basis 15

16 A Cross Between Stock and Asset Deals 338 Election Treats a stock deal like an asset deal Purchaser must be a corporation Must acquire 80% of target by purchase Fully taxable Watch out for tax-free rollovers Corporate and Shareholder taxation Tax is on 100% even if bought only 80% 16

17 338 S Corps and Consolidated Subs. Target is S Corporation or subsidiary that files consolidated return with seller Joint 338(h)(10) election is made Treated as asset sale Selling shareholders (in S Corp) or selling consolidated group pay tax Single tax with full basis step up!! Higher tax if outside basis greater than inside basis and Target C corp. sub. May convert some capital gain to ordinary income Beware the S Corporation that was a C Corporation in past 10 years 17

18 Avoiding Accidental Tax-Free Rollover $ Fund Newco Cash & Newco Shares SH $ $ Fund Newco 1 Newco 2 Newco Shares Cash SH Target Target Target Target Shares received by SH tax-free under 351 Not fully taxable 338 not available Transaction fully taxable 338 available 18

19 Tax-Free Corporate Transactions Easy as A-B-C Transaction must meet definition in Section 368(a)(1)(A), (B), (C), (D), (E), (F) or (G) Judicial requirements Continuity of Interest Generally requires at least 50% stock consideration Continuity of Business 19

20 A Reorganization Statutory Merger SH SH A B Target Merge Acquiring Acquiring Assets and busines s Assets and busines s Assets and business of Acquiring and Target 20

21 B Reorganization Stock for Voting Stock Acquiring Voting Stock SH Target Shares Target Target No boot Only voting stock Control requirements 21

22 C Reorganization Assets for Voting Stock Acquiring Voting Stock SH Assets Target Substantially all requirements (90% net / 70% gross) Liquidation of Target Solely for voting stock Limited boot 22

23 Triangular Mergers Acquiring Shareholder s Purchaser Shareholder s $100 Stock $1 Cash $100 Stock $1 Cash Target Stock Target Merger Sub Merge Target Failed B Reorganization Stock fully taxable Same end result but tax-free receipt of Stock (Permits up to 20% boot ) 23

24 Foreign Mergers Get Equal Treatment 2006 change in regulations allows mergers involving foreign corporations to qualify as A reorganizations Changes over 70 years of contrary regulatory treatment Substantially eases ability to do tax-free cross-border deal Must run the 367 obstacle course 24

25 351 Transfer to Controlled Corp. Transferor 1 Transferor 2 All transferors control transferee immediately of the transfer Stock Assets NEWCO Assets Stock No gain/loss to transferor No tax to corporation Carryover assets basis Substitute stock basis Assets 25

26 26 Partnership Acquisitions

27 Partnership Acquisitions Partnerships Single level of tax (partners) Capital gain on sale except for hot assets Flow-through income character Distributions first tax-free return on capital UBTI & ECI flow through Can transfer assets to partnership tax free (investments company exception) Corporations Double (or more) tax (corporation and shareholder) Capital gain on sale (PFIC and CFC exceptions Character determined under distribution rules Distributions-dividends to extent of E&P, then return of basis, then as capital gain Blocks UBTI & ECI Can transfer assets to corporation tax free and transferors control (investment company exception) 27

28 Partnership Acquisitions Partnerships Tax free receipt of profits interests Corporations Receipt of stock for service taxable 28

29 Partnership Acquisitions Buyer takes cost basis in partnership interest 754 basis step up in assets of partnership for Buyer No tax to B A gets capital gain (except for hot assets) $ Buyer A B Partnership Interest Partnership Assets 29

30 30 US Financing Issues

31 Financing Debt financing tax issues PIK Debt HYDO Earnings Stripping Payable in Equity Withholding Tax Concerns Other Concerns 31

32 PIK Debt Payable in kind You can be taxed even if do not get cash Original Issue Discount or OID Market Discount Rules Is it good debt for tax purposes? 32

33 HYDO High yield debt obligations More than 5 year maturity High interest rates AFR + 5% - deferral AFR + 6% - no deduction High yield debt obligations Signification OID Must pay up accrued interest after 5 years so that you are left with only one accrual period of interest not paid to date. 33

34 Earnings Stripping Rules No Deduction for Disqualified Interest Expense but only to extent of Excess Interest Expense and Only if Debt-Equity Ratio is greater than 1.5:1 34

35 Debt Payable in Equity If substantial portion of principal or interest may be paid in equity, then no deduction even if pay the interest in cash. 35

36 Other Concerns Section 279-Deduction lost for: Debt incurred to buy stock or equity if (i) insubordination, (ii) convertible & (iii) 2:1 or greater debt equity ratio. 36

37 Steven D. Bortnick Partner in Tax Practice Group of Pepper Hamilton LLP Resident in the Princeton and New York offices Focuses practice on domestic and international tax and private equity matters Handles broad range of cross-disciplinary transactions including asset, stock, cross-border and domestic acquisitions, tax-free spinoffs, recapitalizations and reorganizations Experienced in structuring of domestic and international private equity transactions from tax and venture capital operating company standpoints Worked with pooled investment vehicles Counsels corporate entities on tax issues Advises U.S. citizens and corporations in overseas investment Involved in formation of private equity and hedge funds 37

38 Pepper Hamilton LLP Offices BERWYN 400 Berwyn Park 899 Cassatt Road Berwyn, PA FAX BOSTON Suite Federal Street Boston, MA FAX: DETROIT Suite Renaissance Center Detroit, MI FAX HARRISBURG Suite Market Street P.O. Box 1181 Harrisburg, PA FAX NEW YORK The New York Times Building 37th Floor, 620 Eighth Avenue New York, NY FAX: ORANGE COUNTY Suite Park Plaza Irvine, CA FAX PHILADELPHIA 3000 Two Logan Square Eighteenth and Arch Streets Philadelphia, PA FAX PITTSBURGH 50th Floor 500 Grant Street Pittsburgh, PA FAX PRINCETON Suite Carnegie Center Princeton, NJ FAX WASHINGTON Hamilton Square 600 Fourteenth Street, N.W. Washington, DC FAX WILMINGTON Hercules Plaza, Suite Market Street P.O. Box 1709 Wilmington, DE FAX

39 Pepper Locations Pepper has expanded from its Philadelphia origins to 11 locations. Detroit, MI Pittsburgh, PA Philadelphia, PA Boston, MA New York, NY Princeton, NJ Berwyn, PA Wilmington, DE Harrisburg, PA Orange County, CA Washington, DC 39

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