Private Equity Alert

December 2011 Private Equity Alert Proposed Guidace Uder Sectio 892 Regardig Taxatio of Foreig Govermets o US Ivestmet Icome By Kimberly Blachard, David Bower, Robert Frastai ad Kristia Novak O November 2, 2011, the Iteral Reveue Service issued logawaited guidace cocerig the taxatio of certai icome of foreig govermets from ivestmets i the Uited States uder Sectio 892 of the Iteral Reveue Code. This guidace takes the form of proposed regulatios that modify ad expad existig temporary regulatios issued i 1988. The 1988 temporary regulatios were widely criticized as uduly restrictive. Ultimately the criticisms culmiated i the issuace of these proposed regulatios. Give the sigificatly icreased ivestig activities of foreig govermets (icludig sovereig wealth fuds) that are eligible for Sectio 892 tax beefits as compared to 23 years ago, the proposed regulatios are a welcomed step i the right directio. However, as discussed below, the proposed regulatios fail to provide guidace o a umber of critical issues. Importatly, the preamble to the proposed regulatios idicates that taxpayers may rely o the proposed regulatios util fial regulatios are issued. This is a uusual provisio to be foud i proposed regulatios. While the provisio is welcome, it would be useful for the IRS to make clear that these proposals may be relied upo by a Sectio 892 ivestor that ivests i a blid pool for all ivestmets made by that pool, eve if some ivestmets are made after ay chages that might be made to these proposals i fial regulatios. Iadvertet Commercial Activity Exceptio A cotrolled etity will ot be disqualified etirely from the beefits of Sectio 892 as a result of certai iadvertet commercial activity. Geerally, Sectio 892 exempts from US federal icome taxatio icome from ivestmets i US stocks or securities, icludig iterest icome, divided icome ad gais o the sale of domestic securities, eared by a foreig govermet. The term foreig govermet is defied by the 1988 temporary regulatios, ad i these proposed regulatios, as icludig both the itegral parts or cotrolled etities of a foreig sovereig. The distictio draw betwee itegral parts ad cotrolled etities has bee used to ratioalize a all or othig rule that disqualifies a cotrolled etity of a foreig sovereig from the beefits of Sectio 892 if it egages i ay level of commercial activity (o matter how trivial) aywhere i the world. I cotrast, a itegral part of a foreig sovereig egaged i commercial activity loses the beefits of Sectio 892 oly with respect to the icome from commercial activities, ad retais the beefits of Sectio 892 for ay other qualifyig ivestmet icome. Sectio 892 does ot exempt ay icome derived from the coduct of ay commercial activity. More importat, the exemptio does ot exted to ay icome received by or from a cotrolled commercial etity ( CCE ) or derived from the dispositio of ay iterest i a CCE. For these purposes, Weil, Gotshal & Mages LLP

Weil News Weil advised Providece Equity Parters i coectio with its acquisitio of George Little Maagemet, a trade show producer Weil advised Advet Iteratioal i coectio with its acquisitio of Bojagles Restaurats Weil advised CCMP Capital Advisors i coectio with the sale of its portfolio compay CareMore Health Group, a seior health services provider Weil advised Natioal Surgical Care (a portfolio compay of CCMP Capital Advisors ad Brazos Private Equity Parters) i coectio with the sale of substatially all of its assets to AmSurg Weil advised Summit Parters i coectio with its ivestmet i Access Iformatio Maagemet, a provider of records maagemet storage ad destructio services Weil advised DLJ Merchat Bakig Parters i coectio with its sale of Total Safety US, a distributor ad marketer of idustrial fire protectio ad gas detectio systems Weil advised TowerBrook Capital Parters i coectio with its acquisitio of CapQuest Group, a purchaser, maager ad collector of performig ad subperformig cosumer debt Weil advised Bregal Capital i coectio with its acquisitio of Novem Beteiligugs, a Germa provider of high quality decorative trim ad fuctioal elemets for vehicle iteriors a etity will be treated as a CCE if it is egaged i commercial activities (whether withi or outside the Uited States) ad the foreig govermet directly or idirectly ows at least 50% of the ecoomic or votig iterests i, or otherwise exercises effective practical cotrol over, the etity. I a effort to ameliorate the harsh applicatio of the all or othig rule, the proposed regulatios create a exceptio uder which a cotrolled etity will ot be treated as a CCE, ad, as such, will ot be disqualified from the beefits of Sectio 892, as a result of certai iadvertet commercial activity. Specifically, the proposed regulatios provide that commercial activity will be treated as iadvertet commercial activity oly if: (1) the failure to avoid coductig the commercial activity is reasoable; (2) the commercial activity is promptly cured; ad (3) certai record maiteace requiremets are satisfied. The proposed regulatios iclude a safe harbor uder which, provided there are adequate writte policies ad operatioal procedures i place to moitor the etity s worldwide activities, the cotrolled etity s failure to avoid the coduct of commercial activity durig a taxable year will be cosidered reasoable. The ew iadvertet commercial activity rule is ot a de miimis rule; rather, it is a arrow exceptio for foot faults. Cotrolled etities will therefore still be required to structure their ivestmets withi ad without the Uited States to esure that a commercial activity egaged i by oe etity does ot tait the Sectio 892 status of aother. Moreover, the proposed regulatios did ot chage, as may had hoped, a provisio uder the 1988 temporary regulatios 1 treatig a cotrolled etity that meets the defiitio of a US real property holdig corporatio as a CCE, eve if that etity ows oly stock of ocotrolled corporatios owig US real property. This rule also requires foreig govermets to structure their worldwide portfolios with great care to where i the worldwide group certai real property-related ivestmet are held. The proposed regulatios helpfully clarify that the determiatio of whether a etity costitutes a CCE will be made o a aual basis. As such, a etity will ot be cosidered a CCE for a taxable year solely because the etity egaged i commercial activities for a prior taxable year. Partership Attributio Rules The proposed regulatios modify the partership attributio rules to provide that a etity that is ot otherwise egaged i commercial activities will ot be treated as egaged i commercial activities solely because it holds a iterest as a limited parter i a limited partership. As oted above, a etity will be treated as a CCE if it is egaged i commercial activities (whether withi or outside the Uited States) ad the foreig govermet directly or idirectly ows at least 50% of the ecoomic or votig iterests i, or otherwise cotrols, the etity. The 1988 temporary regulatios provide Weil, Gotshal & Mages LLP December 2011 2

attributio rules for activities of related cotrolled etities. Oe such attributio rule provides that activities of a partership are attributed to its geeral ad limited parters, subject to a exceptio for parters of publicly traded parterships. Oce agai, disparate treatmet results uder this attributio rule depedig o whether the foreig govermet costitutes a itegral part or a cotrolled etity. Where the foreig govermet costitutes a itegral part ad it ivests directly i a partership, ay icome such itegral part derives from the commercial activities of the partership will ot qualify for exemptio uder Sectio 892 exemptio; however, the icome such itegral part derives from qualifyig ivestmets will still qualify for exemptio uder Sectio 892. I cotrast, where a cotrolled etity of a foreig sovereig ivests i a partership egaged i commercial activities, the partership s commercial activities are attributed to its parters; accordigly, the cotrolled etity becomes a CCE, causig all of its icome to become ieligible for the Sectio 892 exemptio. The proposed regulatios tur off the attributio of commercial activity from a partership to a limited parter. Uder the revised exceptio, a etity that is ot otherwise egaged i commercial activities will ot be treated as egaged i commercial activities solely because it holds a iterest as a limited parter i a limited partership. Although the commercial activity of the limited partership will ot cause a cotrolled etity of a foreig sovereig to be deemed egaged i commercial activities, the limited parter s distributive share of partership icome attributable to such commercial activity will be cosidered to be derived from the coduct of commercial activity ad, therefore, will ot be exempt from taxatio uder Sectio 892.2 For this purpose, a limited parter iterest i a limited partership is defied as a iterest i a etity classified as a partership for US federal icome tax purposes where the holder of such iterest does ot have rights to participate i the maagemet ad coduct of the partership s busiess at ay time durig the partership s taxable year. It is uclear whether this defiitio imports a ew facts ad circumstaces test for determiig whether a particular partership iterest costitutes a limited parter iterest for these purposes, or if this defiitio is meat to address limited parter equivalets i limited liability compaies or other etities treated as parterships for US tax purposes. The all or othig rule, combied with the partership attributio rules uder the 1988 temporary regulatios created uecessary foot faults that could easily result i a cotrolled etity beig completely deied of the beefits of Sectio 892. The proposed regulatios essetially elimiate the eed to create separate corporate blockers solely for Sectio 892 purposes, for example where a foreig govermet ivests as a limited parter i a partership that coducts activities wholly outside the Uited States. The proposed regulatios may also elimiate the eed for US fud sposors to create parallel fuds for their foreig govermet ivestors, although blockers will still be ecessary whe ivestig i the Uited States, give that active busiess icome derived through a operatig etity would be subject to US tax. Defiitio of Commercial Activity The proposed regulatios expad the tradig exceptio to iclude fiacial istrumets. The proposed regulatios, like the statute, fail to defie the term commercial activities. Istead, the 1988 temporary regulatios ad the proposed regulatios defie commercial activities i the egative. They describe certai activities that do ot costitute commercial activities, ad at several poits state that the test for what costitutes a commercial activity is ot the same as the tests used for other purposes of the Code. Although commetators have suggested that the Sectio 864(b)(2) trade or busiess stadard be adopted for purposes of testig commercial activity uder Sectio 892, the proposed regulatios failed to adopt such approach. The proposed regulatios do add a helpful ew rule that treats ivestig i fiacial istrumets i a maer similar to ivestig i stocks ad securities, such that such ivestig is ot treated as a commercial activity. It should be oted that the revisios made to the treatmet of fiacial istrumets address oly the defiitio of commercial activity, ad do ot address whether the icome derived from such activities will be exempt uder Sectio 892. That is, the regulatios do ot make clear o their face whether icome from Weil, Gotshal & Mages LLP December 2011 3

ivestig i fiacial istrumets is icluded withi Sectio 892 s exemptio for icome from stocks ad securities. For example, the term fiacial istrumet likely ecompasses equity swaps described i Sectio 871(m) of the Code, which treats a divided equivalet as a divided for purposes of the provisios subjectig foreig persos to US tax uder the Code ad the correspodig withholdig provisios. The proposed regulatios, however, do ot explicitly address the treatmet of divided equivalet paymets. It would be ufortuate if divided equivalet paymets received by foreig govermets were ot exempt from tax uder Sectio 892 where such paymets would have bee exempt if the uderlyig stock had bee held directly by the foreig govermet. The dispositio of a US real property iterest does ot, by itself, costitute the coduct of a commercial activity. The proposed regulatios clarify that the dispositio of a Uited States real property iterest, icludig a deemed dispositio uder Sectio 897(h)(1), does ot, by itself, costitute the coduct of a commercial activity. However, the icome derived o the dispositio of such iterest, other tha gai from the sale of stock of a ocotrolled US real property holdig compay, will ot qualify for exemptio uder Sectio 892. Issues Not Covered The proposed regulatios, while helpful i some respects, fail to address a variety of importat iterpretive issues arisig uder Sectio 892. Amog these, some of the most importat are: Sectio 892 treats a etity as a cotrolled etity if the foreig govermet has effective practical cotrol over the etity. The 1988 temporary regulatios ad the proposed regulatios do ot defie effective practical cotrol ad provide o examples illustratig the meaig of effective practical cotrol. As such, ucertaity still exists i may situatios as to whether a foreig govermet has acquired effective practical cotrol over a etity. This determiatio is particularly difficult to make, give that Sectio 892 employs a 50% or more test rather tha a more tha 50% test for cotrol. The proposed regulatios fail to refie the distictio betwee itegral part ad cotrolled etities. The defiitios i the 1988 temporary regulatios create ucertaity ad produce materially differet tax results based o what are ofte purely formalistic distictios. The proposed regulatios eglect to defie the term commercial activity i ay useful way. 1 Treas. Reg. 1.892-5T(b). 2 Additioally, the proposed regulatios provide that a etity ot otherwise egaged i commercial activities will ot be cosidered to be so egaged solely because it is a parter i a partership that effects trasactios i stocks, bods, other securities, commodities or fiacial istrumets for the partership s ow accout. This exceptio, however, does ot apply i the case of a partership that is a dealer i stocks, bods, other securities, commodities or fiacial istrumets. Weil, Gotshal & Mages LLP December 2011 4

Private Equity Alert is published by the Private Equity Group of Weil, Gotshal & Mages LLP, 767 Fifth Aveue, New York, NY 10153, +1 212 310 8000, http://www.weil.com. The Private Equity Group s practice icludes the formatio of private equity fuds ad the executio of domestic ad cross-border acquisitio ad ivestmet trasactios. Our fud formatio practice icludes the represetatio of private equity fud sposors i orgaizig a wide variety of private equity fuds, icludig buyout, veture capital, distressed debt ad real estate opportuity fuds, ad the represetatio of large istitutioal ivestors makig ivestmets i those fuds. Our trasactio executio practice icludes the represetatio of private equity fud sposors ad their portfolio compaies i a broad rage of trasactios, icludig leveraged buyouts, merger ad acquisitio trasactios, strategic ivestmets, recapitalizatios, miority equity ivestmets, distressed ivestmets, veture capital ivestmets ad restructurigs. Editors: Doug Warer (foudig editor) (doug.warer@weil.com) + 1 212 310 8751 Michael Weisser (michael.weisser@weil.com) + 1 212 310 8249 If you would like more iformatio about the cotets of this issue, or about Weil s Private Equity practice, please speak to your regular cotact at Weil or to the editors or authors. Kimberly Blachard (kimberly.blachard@weil.com) + 1 212 310 8799 David Bower (david.bower@weil.com) + 1 202 682 7112 Robert Frastai (robert.frastai@weil.com) + 1 212 310 8788 Kristia Novak (kristia.ovak@weil.com) + 1 212 310 8855 2011. All rights reserved. Quotatio with attributio is permitted. This publicatio provides geeral iformatio ad should ot be used or take as legal advice for specific situatios which deped o the evaluatio of precise factual circumstaces. The views expressed i these articles reflect those of the authors ad ot ecessarily the views of Weil, Gotshal & Mages LLP. If you would like to add a colleague to our mailig list or if you eed to chage or remove your ame from our mailig list, please log o to www.weil.com/weil/subscribe.html, or sed a email to subscriptios@weil.com. Weil, Gotshal & Mages LLP www.weil.com 5