basics of private equity taxation - pepper hamilton llp
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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
#15411207v.1
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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
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The Essentials – What We’ll Cover
• Partnership Investments − Tax efficiency − Basis step up − Special issues for tax-exempt investors (UBTI)
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The Essentials-What We’ll Cover
• Financing Issues − Various rules that may limit deductibility of interest in the
US
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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
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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)
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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
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Key
Corporation
Partnership
Corporation taxed as a partnership in US Corporation disregarded as entity in US
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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
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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
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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
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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
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Inside vs. Outside Basis
$10m basis
$0 basis
Buyer
Target
Assets
Target
Assets
Seller $100 Cash Target Stock
$100m basis
$0 basis
• $90 Capital gain to Seller
Stock Sale
Buyer
Assets
Target
Assets
Seller
$100 Cash Assets
$10m basis
$0 basis $100 basis
• $100 gain to Target • $55 gain to Seller ($65 distributed
– $10 basis)
Asset Sale
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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
benefit @ 40%) • Buyer likely to pay more for company with higher
asset basis
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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%
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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
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Avoiding Accidental Tax-Free Rollover
Newco
Target
SH Cash & Newco Shares
$
• Shares received by SH tax-free under 351 • Not fully taxable • 338 not available
Target
Fund
Newco 2
Target
SH
• Transaction fully taxable • 338 available
Target
Fund
$ Newco
1
$
Newco Shares
Cash
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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
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“A” Reorganization – Statutory Merger
Target Merge
Assets and
business
Assets and
business
Acquiring
SH SH A B
Assets and business of
Acquiring and Target
Acquiring
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“B” Reorganization – Stock for Voting Stock
Target
Voting Stock SH
Target
Acquiring
Target Shares
• No “boot” • Only voting stock • Control requirements
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“C” Reorganization – Assets for Voting Stock
Voting Stock
SH
Target
Acquiring
• Substantially all requirements (90% net / 70% gross) • Liquidation of Target • Solely for voting stock • Limited “boot”
Assets
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Triangular Mergers
Merger Sub
$100 Stock $1 Cash
Shareholders
Target
Purchaser
Merge
Failed “B” Reorganization Stock fully taxable
$100 Stock $1 Cash
Shareholders
Target
Acquiring
Target Stock
Same end result but tax-free receipt of Stock – (Permits up to 20% “boot”)
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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
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351 Transfer to Controlled Corp.
• All transferors “control” transferee immediately of the transfer
• No gain/loss to transferor • No tax to corporation • Carryover assets basis • Substitute stock basis
Assets
NEWCO
Stock
Transferor 1
Transferor 2
Assets Stock
Assets
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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)
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Partnership Acquisitions
• Partnerships • Tax free receipt of profits
interests
• Corporations • Receipt of stock for service
taxable
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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)
Assets
Partnership Interest
A B
Partnership
Buyer
$
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Financing
• Debt financing tax issues − PIK Debt − HYDO − Earnings Stripping − Payable in Equity − Withholding Tax Concerns − Other Concerns
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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?
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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.
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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
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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.
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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.
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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
609.951.4117 212.808.2715 bortnicks@pepperlaw.com
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