Basics of Private Equity Regulations and Reporting Tax Matters

Basics of Private Equity Regulations and Reporting Tax Matters Presented at IIR s 9 th Annual Private Equity Tax & Compliance Practices 2010 By: Steven D. Bortnick June 23, 2010 Hyatt Harborside Boston, MA #12781315 v.1

2 Part I Current Withholding Regime

IRS Announcement Intention to audit all persons who make payments to non-u.s. persons that are subject to withholding tax First 5,000 letters mailed IRS knows Funds make the payments 3

Withholding Risk Trust fund tax responsible person personally liable 4

Acquisition DE LLC $ equity & debt $ DE LP equity & debt $ Cayman LP equity & debt 10x 2x SH Parent Co. (U.S.) cash $ equity Target merge Acq. Co. $ 50x Bank US1 FC1 US2 FC2 5

Six Months Later U.S. Foreign U.S. Foreign U.S. Foreign DE LLC 30X & debt repaid b.10x b.10x DE LP 30X & debt repaid Parent Co. b.10x Cayman LP 30X & debt repaid 100X New bank debt of 150X Target Acq. Bank Debt 50X pay off Acq. Debt US1 FC1 US2 FC2 90X is distributed with respect to Parent Stock 8X is used to repay SH debt of 6X and interest of 2X 6

Issues Tax impact to investors Withholding obligations of Parent Co. Withholding obligations of Funds Reporting obligations of Parent Co. 7

Classifying The Distribution - 316 Taxable as a dividend to SH to the extent of current or accumulated earnings and profits Then a return of tax basis of SH Then capital gain to SH Short term Long term 8

E&P Accumulated e&p Through close of prior year Current e&p For the full taxable year generally not based on when distribution occurs Consolidated e&p Distribution of 100X from Target to Parent never pulls pre-acquisition e&p from Target to Parent E&P post acquisition tiers up to Parent under consolidated tax return rules 9

Consolidated E&P Parent 100X Target S1 FC1 FC2 S2 Pre acquisition e&p of Target includes e&p of S1 and S2 while in CTR, or e&p distributed up to target Acquisition should close tax year, start a new CTR year 100X distribution never moves pre acquisition e&p to Parent E&P for short year (current) includes e&p of Target, S1 and S2 10

Current vs. Accumulated E&P Assume accumulated e&p is <100X> Current year e&p, determined at the close of the tax year, is 90X Distribution of 100X is 90X dividend, 10X return of basis/capital gain Nimble dividend rule 1.316-1 11

Current vs. Accumulated E&P Assume accumulated e&p 100X Current e&p <90X> Distribution of 100X on June 30 E&P available 100-45 (1/2 of current e&p) 55 55 of 100 is dividend Rev. Rule 74-164 12

Current Year E&P Issues Cost of Acquisition Deductible vs. non-deductible expenses of acquisition Deductibility of refinancing costs Deductibility of option exercise/cash out/restricted stock grants 13

Characterization of Distribution DE LLC DE LP Cayman LP b.10x in stock b.2x in debt Parent Co. Parent Co. Distributes 30X to each SH with respect to stock Parent Co. e&p is at least 42X, the post-acquisition e&p of Target that tiers up to Parent Parent Co. repays SH debt of 6X in the aggregate Pays 2X in interest Properly characterized as debt? Impact of interest on e&p 14

Taxing the Investor DE LLC DE LP Cayman LP None are themselves subject to U.S. tax, all income and expenses flow through to members/partners Assumes no CTB election Characterization of the income is handled at the entry level 15

Taxing The Investor U.S. individual 15% on qualified dividend No tax on return of basis 35% maximum rate on short term capital gain, 15% on long term capital gain 35% maximum rate on interest U.S. corporate 35% maximum rate or dividends (subject to dividend received deduction) No tax on return of basis 35% maximum rate on capital gains 35% maximum rate on interest U.S. tax exempts So long as not debt funded, interest, dividend and capital gains are not taxable 16

Taxing the Investor Non-U.S. persons 30% tax on dividend Limited by e&p No tax on return of basis No tax on capital gains (unless FIRPTA) Generally, 30% on interest, unless it is portfolio interest 17

Taxing the Investor Exceptions Reduced rate of tax on dividends and interest under applicable tax treaties 80/20 companies More than 25% of gross income for prior three years from foreign sources from active conduct of business outside U.S. Rarely, capital gains can be taxed to individual resident in U.S. for more than 183 days, or if the capital gains are connected to a U.S. business of investor 18

Collecting The Tax - Distribution All withholding agents are responsible for collecting the 30% tax from the payment and timely depositing it with IRS. 1.1441.1 Withholding agent Any person who has control over the funds Parent, DE LLC, DE LP, Cayman LP are all withholding agents 19

Parent Withholding If Parent receives a W-9 from DE LLC or DE LP, certifying that it is a U.S. person, Parent has no withholding obligation unless Parent knows the form to be untrue Cayman LP is a non-u.s. person Unless Parent receives required information, there is 30% withholding on the dividend Dividend is the distribution supported by e&p In our example, distribution of 30X, 14X is a dividend 20

Limiting The Tax Cayman LP timely provides Parent with W-81MY, on which it certifies that it is a foreign person it is not the beneficial owner of the income it is a partnership Cayman LP also provides Parent with fully executed W-9 from U.S. investor fully executed W-8BEN from foreign investor who is beneficial owner of the distribution If foreign investor is also an intermediary; keep going up the chain Statement showing respective ownership interests of investors Qualified Partnership status may minimize forms 21

Limiting The Tax If Parent timely receives the forms, and does not know they are incorrect: The portion of the distribution allocable to U.S. investor is not subject to 30% withholding tax Portion attributable to the foreign investor is subject to the 30% withholding tax unless it may claim the benefit of a tax treaty To claim treaty benefit Form W-8BEN must have EIN or ITIN for foreign investor, unless Parent is publicly traded Form W-8BEN must claim the treaty benefit 22

Limiting The Tax U.S. 50% 50% FP Cayman LP Parent e&p 42X distributes 90X pro rata Distributes 30X to Cayman LP Dividend 14X e&p limit If Parent receives no documentation, withhold 30% on 14X If proper documentation received, but no treaty claimed, withhold 30% of 7X If proper documentation received, and treaty rate of 0% claimed, no withholding 23

Protective Withholding 30% tax is based on dividend Dividend based on accumulated and current e&p May will not know current e&p at time of the distribution Regulations direct Parent to withhold on full distribution unless it can be reasonably certain of the amount of the dividend If agent under withholds, agent is liable for the tax, interest, and potentially, penalties 24

Protective Withholding Withhold on the assumption that 100% of distribution is a dividend Report amount that is a dividend on form 1042-S for the foreign investors Foreign investors may claim refund for excess taxes paid through withholding 25

Not So Protective Withholding Withhold based on reasonable expectation of e&p Require Cayman LP on Foreign Investor to indemnify Parent if not accurate and additional taxes are due Value of indemnification? 26

Fund Withholding Delaware LP receives distribution free of withholding Delaware LP must withhold on the portion of the dividend that is allocable to foreign investor Withholding occurs at earlier of date of distribution or date on which form K-1 is to be distributed to partners No ordering rule for distributions. Conservative view first distribution after receipt of dividend is subject to withholding 27

Fund Withholding Delaware LP may reasonably rely on statement from Parent as to portion of the distribution that is a dividend If wrong, Delaware LP and Parent are liable for under withheld taxes Delaware LP may withhold on assumption that full distribution is a dividend; LPs may then file for refunds 28

Fund Withholding Delaware LP withholds at 30% on payment to foreign investor unless Delaware LP receives properly executed form W-8BEN claiming treaty benefits to reduce tax rate or, Receives W-8IMY, if foreign investor is not beneficial owner, and supporting documents that may be relied upon to exempt (or reduce the rate of) the foreign investors from U.S. tax. 29

Fund Compliance Delaware LLC From a withholding perspective, same issues as in Delaware LP Question is whether foreign investor may provide LLC with W-8BEN on which the benefits of a tax treaty are claimed 894(c) concerns 30

Fund Compliance 1.894-1(d) Foreign person may not claim treaty benefits unless the income is derived by the person Entity may claim benefits only if it is not fiscally transparent under home county rules Investor may derive the income if the entity is fiscally transparent as to the investor Derived means taxable when income is paid to the entity 31

Dutch Pension Funds DE LLC Dutch Funds Dutch Funds dividend dividend Parent For dividends paid directly, no U.S. withholding tax per treaty Quite likely that DE LLC is not a look through for Dutch tax purposes 894(c) Result would be that the 30% rate would apply See Announcement 2003-21 What if Irish resident? 32

Taxation Of The Interest US1 FP1 US2 FP2 US3 FP3 90% 10% DE LLC DE LP 33% 33% 33% Cayman LP Parent Parent pays interest to DE LLC, DE LP and Cayman LP DE LLC and DE LP timely provide executed W-9 certifying as to U.S. status No U.S. withholding tax by Parent Interest paid to Cayman LP is subject to 30% withholding tax unless there s an exception 33

Taxation Of The Interest Cayman LP may provide W-8IMY certifying its status as intermediary W-9 certifying U.S. status of US3 Statement of allocation of interest among partners W-8BEN from FP3 certifying foreign status So long as interest qualifies as portfolio interest, interest allocable to FP3 is not subject to U.S. tax 34

Portfolio Interest Debt in registered form Bears bonds only if issued outside U.S. Must know owners Amount of interest not contingent Recipient must be foreign person Recipient not a CFC Recipient not a 10% owner of Parent equity 10% ownership is tested at partner, not partnership level. 1.871-14 Cayman LP owns > 10%, but FP3 owns 10% of 33%, or 3.3% 35

Portfolio Interest Testing for 10% Done at time withholding would have been required Distributed from fund K-1 due date Practical application? 36

Reporting Portfolio Interest through LP and LLC Reporting at Parent level Reporting at Fund level Audit risks 37

38 Part II - FATCA

Current Rules Payments to financial institutions participates loan Bank U.S Borrower interest 39

Current Rules Interest is subject to 30% U.S. withholding tax unless exception applies Tax treaty Deliver from W-8 BEN Ownership of bank not relevant Portfolio interest Participant is not a bank Deliver form W-8 BEN Ownership of participant not relevant 40

Current Rules Fund payments FPC 10 LPs U.S. Partnership 30% interest Portfolio Company 41

Current Rules U.S. partnership gave PC W-9, certifying U.S. person U.S. partnership had W-8 BEN from FPC No withholding as portfolio interest Ownership of FPC not relevant 42

Current Rules Fund Payments FPC 10 LPs Cayman Partnership interest 30% Portfolio Company 43

Current Rules Cayman Partnership provides W-8 IMY and W-8 BEN from FPC (and other LPs) No withholding as interest is all portfolio interest Ownership of FPC not relevant 44

Current Rules Abuse SH Acct. Holder FPC UBS interest & capital gains invests in U.S. securities 45

Current Rules UBS provides U.S. payor with certificate that interest and capital gains allocable to FPC No U.S. tax on interest (portfolio interest) or capital gains SH is U.S. person Evades U.S. tax 46

Current Rules Abuse SH FPC 30% interest Portfolio Company No U.S. tax withheld; no reporting If SH is U.S. person, tax is evaded 47

FATCA(T) Imposes new reporting and withholding tax regime on payments of U.S. source withholdable payments to foreign entities The world is divided into Foreign financial institutions ( FFI ) Non financial foreign entities ( NFFE ) Effective date Generally for payments made after 12/31/2012 No FATCA withholding on obligations that are outstanding on or before March 18, 2012 48

FATCA(T) New Regime Payments of withholdable payments to foreign entities subject to 30% withholding tax unless recipient agrees to comply with new disclosure rules Withholdable payment U.S. Source Interest (including portfolio interest), dividends, and other fixed determinable annual or periodic income AND Gross proceeds from the disposition of property (stocks or bonds) that can produce U.S. source interest or dividends 49

Payments to FFI Withholdable payment subject to 30% withholding unless FFI enters into agreement with IRS to disclose information about certain U.S. account holders, including name, address, account balance, gross receipts, OR FFI agrees to be treated as a U.S. financial institution and treat each holder of a U.S. account that is a specified holder as a U.S. person, and thus being subject to 1099 reporting, etc. Eliminates need to report account balance Known as 1471(b) agreements 50

What is an FFI? Foreign bank, foreign custodian and foreign entities primarily engaged in the business of investing, re-investing or trading in securities, partnership interests or commodities or any interest in such items Includes foreign hedge funds, foreign private equity funds, Foreign Entity means any entity that is not a U.S. person Place of organization key for corporations and partnerships 51

Fund Structures FPC USTP Foreign Individuals USTE FPC Cayco LLC Cayco U.S. Fund U.S. Fund pays U.S. source interest or capital gains Cayco and Cayco LLC must enter into agreement with IRS to provide information on all U.S. account holders (LPs), including looking through FPC 52

Fund of Fund Structure Cayco Fund Foreign Hedge Fund U.S. source interest capital gains from investment Payment to Foreign Hedge Fund is subject to 30% unless FHF is compliant with reporting For FHF to be compliant Cayco Fund must advise FHF of the specified U.S. persons in Cayco Fund and comply with information reporting 53

Syndicated Loans Bank note loan Interest paid to USC syndicate banks Note syndicated to more banks Most syndicated notes provide for no gross-up if lender fails to provide appropriate form W-8 After FATCA, each syndicate Bank will need to have IRS agreement on 30% withholding needed Loans existing March 12, 2012 grandfathered for payments made after 12/31/12 New loans including FATCA language? 54

FATCA and Treaties The 1471 withholding is independent of treaties If the 30% is withheld, FFI can claim refund based on treaty, but no interest will be paid with respect to the refund To claim refund, must prove FFI is not U.S. owned foreign entity 55

FATCA and NFFE Accounts payable department renders USC services in U.S. OR licenses IP for use in U.S. U.S. source fee FC Current law 30% withholding unless treaty applies To claim treaty deliver W-8 BEN with EIN FATCA 30% withholding unless FC certifies it has no substantial U.S. owners, or It provides name, address and TIN of each substantial U.S. owner USC doesn t know or have reason to believe certificate is wrong USC provides substantial U.S. owner information to IRS 56

57 Part III Reporting Uncertain Tax Positions

Proposed Schedule UTP Who Covered Who must file? Corporations required to file Form 1120 Insurance companies required to file Form 1120 L or 1120 PC Foreign corporations required to file Form 1120 F Threshold Corporation must have assets of at least $10m Corporation or related party must issue audited financial statements that cover corporation s ops 58

Schedule UTP Private Equity Portfolio companies Impact on instruments held by fund Management company 59

Schedule UTP What is Reported Positions required on Schedule UTP FIT position for which corporation or related party recorded a reserve FIT position if decided not to record reserve because Decision to litigate IRS administrative practice Timing Reserve or decision >= 60 days before return filing Prior years Included if timing met Only required in one year 60

Schedule UTP Info on Schedule Primary Code section involved Whether permanent or temporary TIN of pass through entity Maximum tax adjustment Concise description of UTP 61

62 Part IV - FBAR

FBAR Filing Requirement Form TD F 90-22.1 Due June 30 Must be received by June 30 (no timely mailing rule as with most IRS forms) 63

US Persons US Citizen US Resident Domestic entity Includes US LLC that elected to be a DRE Exclusion for foreign person in and doing business in the US 64

FBAR Reportable Accounts Bank Securities brokerage Commodities future or option and other financial accounts in foreign country CDs Checking accounts Mutual funds or similar pooled funds that issues shares available to the general public with regular asset valuations and regular redemption periods NOT hedge, venture or private equity funds (though being considered) 65

Financial Interest in Foreign Account Owner of record or legal title even if not beneficial owner Beneficial owner In a financial account of corporation if own (directly or indirectly) > 50% voting power in corp. In a financial account of partnership if own (directly or indirectly) > 50% of capital or profits of partnership In a financial account of another entity if own > 50% voting power, total value of equity, assets or interests in profits 66

Deemed Financial Interest Trust settlor if deemed to be owner Beneficial interest in > 50% of the assets of trust or receives > 50% of the current income of trust 67

Signature Authority Officers or employees that have signature or other authority over a foreign financial account may be required to file FBAR Exception for certain persons with no financial interest in account Extension of deadline to June 30, 2011 if no financial interests 68

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Steven D. Bortnick 609.951.4117 212.808.2715 bortnicks@pepperlaw.com 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 70