navigating challenging times: tax opportunities · 2020. 6. 4. · senior associate washington,...

Navigating

Challenging

Times: Tax

Opportunities

June 4, 2020

Confidential & Proprietary ©2020 Vinson & Elkins LLP velaw.com 2

Navigating

Environmental

Compliance in

the COVID Age

Save the

Date

• CLE Pending

Thursday, June 18, 2020

Speakers

Ronald Tenpas

Patrick Traylor

Corinne Snow

Conrad Bolston

Navigating Series

2


David Peck

Partner

[email protected]

Lina Dimachkieh

Partner

[email protected]

Gary Huffman

Partner

Washington, [email protected]

Jason McIntosh

Partner

[email protected]

Andrew Callaghan

Counsel

[email protected]

Mary Alexander

Senior Associate

Washington, [email protected]

Speakers

Navigating Challenging Times: Tax Opportunities


Agenda

1. Corporate Opportunities

2. Creative Financing & Partnership Structures

3. International Tax Planning Opportunities

4. Liability Management and Tax Attribute Preservation

Navigating Challenging Times: Tax Opportunities

5

Corporate

Opportunities


What is an Up-C?

Up-C Simplification

Traditional advantages of Up-C structure:

• OpCo Unitholders retain pass-through treatment and avoid

corporate-level taxes

• Tax-deferral for OpCo Unitholders on formation

• Step up for PubCo Inc. on OpCo Unitholder exchange

• Tax Receivable Agreement (“TRA”)

• M&A flexibility

Traditional disadvantages of Up-C structure:

• Cost and complexity of Up-C administration

• TRA liability impediment/cost to change of control transaction

• Recapture of prior DD&A deductions on exit

• Limitations on exchanges by OpCo Unitholders

• Limitations on index inclusion

PubCo Inc.

OpCo

LLC

OpCo Equity

Interests

+

Exchange Rights

OpCo

UnitholdersPublic

OpCo Equity

Interests

+

Managing

Member

Class A

SharesClass B

Shares

(Vote Only)

TRA

Payments

Exchange of

OpCo Units + Class B

Shares for Class A

Shares

Tax Basis

Step-Up

Upon

Exchange

Basic Up-C Structure


Is my Up-C stil l worth it?

Up-C Simplification

What has changed?

• Reduction in federal corporate income tax rate from

35% to 21%

• Historically low valuations

• Lower than expected profitability

So what?

• OpCo Unitholders

‒ Pass-through treatment not as clearly beneficial

o Tax distributions/DD&A recapture

‒ TRA less valuable

‒ Potentially little or no gain on exchange

• PubCo Inc.

‒ Reduced value of step-up (past & future) due to 21%

rate and low stock prices

‒ If no significant prior exchanges at higher valuations,

opportunity to eliminate TRA at low point

PubCo Inc.

OpCo

LLC

OpCo Equity

Interests

+

Exchange Rights

OpCo

UnitholdersPublic

OpCo Equity

Interests

+

Managing

Member

Class A

SharesClass B

Shares

(Vote Only)

TRA

Payments

Exchange of

OpCo Units + Class B

Shares for Class A

Shares

Tax Basis

Step-Up

Upon

Exchange

Basic Up-C Structure


Exchanges

of Units for

SharesFrequency / JurisdictionTiming Complaints Trends

8

December 31, 2017

• Value of Units: 15 MM units at $20 = $300 MM

• Tax Basis in Units: $60 MM

• Intangible/Goodwill Value: $150 MM

• Implied Value of PP&E: $150 MM

• Historic DD&A Allocated to Sponsor: $90 MM

June 1, 2020



• Intangible/Goodwill Value: $0

• Implied Value of PP&E: $45 MM

• Historic DD&A Allocated to Sponsor: $90 MM

December 31, 2017

• Corporate Tax Rate: 35%



• Step-up for PubCo Inc.: $240 MM

June 1, 2020

• Corporate Tax Rate: 21%



• Step-up for PubCo Inc.: N/A

Termination

of TRA

• Overall Gain/(Loss): ($15 MM)

• Ordinary (DD&A Recapture) Gain: $0

• Capital Gain/(Loss): ($15 MM)

• Approx. Tax at Individual Rates: $0

• Overall Gain/(Loss): $240 MM

• Ordinary (DD&A Recapture) Gain: $90 MM

• Capital Gain/(Loss): $150 MM

• Approx. Tax at Individual Rates: ~$70 MM


Decreasing TRA Termination Payments

Up-C Simplification

At IPO 2019 10-K

Estimated as of

6/1/20*

Spark Energy $67 million TRA settled in July 2019

for $11.2 million

---

Up-C #1 $181 million $58 million $33 million




*Extrapolated based on relative stock price on June 1, 2020 as compared to stock price on December 31, 2019. Assumes no

prior exchanges and de minimis basis in exchanged units.


Is Now the Time?

Unwinding Corporate Structures

Advantages of flow-through structure:

• Single level of tax

• Ability to deliver asset-level step up to buyers

• Asset-level step up upon inheritance

• No restrictions on eligible owners vs. S corps

Exiting corporate form is often cost-

prohibitive:

• Taxable liquidation of corporation

• Tax on any built-in gain in both assets and stock

Seize the opportunity?

• Reduction in corporate tax rate from 35% to 21%

• Historically low valuations

Existing

Corporation

Shareholders

LLC

Assets

Unitholders(prior Shareholders)

Current Structure

Assets


Potential Future Legislation


*Assumes 20% deduction under §199A is available

**Assumes 20% deduction under §199A is not available

Pre-TCJA Current Law Biden Tax Plan

Corporate35% 21% 28%

IndividualOrdinary Income: Top rate of

39.6%

Qualified Dividends: Top rate

20%

Ordinary Income: Top rate

37%


20%

Ordinary Income: Top rate

39.6%


39.6%

Partnership IncomeTaxed at individual rates

Taxed at individual rates with

20% deduction for domestic

income

Taxed at individual rates with

20% deduction for domestic

income subject to a phase-

out

Effective Tax Rate for Income

from Corporations48% 36.8% 56.5%

Effective Tax Rate for

Partnership IncomeMaximum 39.6% Maximum 29.6%* Maximum 39.6%**


Partnership “Freeze”


Partnership “Freeze” Transaction

If the cost of conversion is still too high…

• Allows future appreciation above today’s prices to

be migrated out from under the existing corporation

Steps: In the most basic form, this could be

effectuated by –

• Existing corporation contributes its assets to newly-

formed LLC for Preferred Units

‒ Preferred Units entitled to par value at

today’s values and a low coupon reflecting

reduced risk

• Shareholders of the existing corporation (all or a

portion) contribute cash or property to LLC for

Common Units.

‒ Common Units are entitled to the bulk of

appreciation above and beyond the coupon

on the preferred

• The existing corporation is NOT converted and no

built-in gain is triggered

Common

Units

Shareholders /

Common

Unitholders

Partnership

LLC

Note: This example only illustrates the general

concept of a partnership “freeze” transaction.

Detailed analysis of U.S. federal income and

estate tax considerations would be required.

Existing

Corporation

Existing

Assets

“New”

Contribution

13

Creative

Financing &

Partnership

Structures


Sale/Leaseback

Creative Financing & Partnership Structures

Seller/Lessee

Property

$

Lease

Rental Payment

Buyer/Lessor

Consequences

• Cash equal to property value

• Taxable gain/loss

• Continued use of property

• Deduction for rent payments

• Varying GAAP treatment (depends on lease

terms)

Consequences

• Bonus depreciation (may enhance or create an

NOL with 35% benefit)

• Income from rent taxed (currently) at 21%

• Varying GAAP treatment (depends on lease

terms)

Rev. Proc. 2001-28


Sale/Leaseback


• Primary Factors Needed for Lease Treatment

− Upfront Purchase Price: The property should be purchased at fair market value

− Buyer’s Amount at Risk: Buyer-Lessor should have a minimum “at-risk” investment (i.e., equity or recourse debt) of at least 20% of the purchase price. Seller-Lessee should not lend funds to Buyer-Lessor or guarantee any debt incurred by Buyer-Lessor in the acquisition

− Rent: Rent should also be market-based (it is preferable if the rent is not triple-net)

− Lease Term: The lease term should not exceed 80% of the economic life of the property

− Residual Value: Expected residual value (undiscounted) at the end of the lease term should be at least 20% of the original cost

− Purchase Option: Any repurchase option granted to Seller-Lessee should be for fair market value, measured at the end of the lease term

− No Put Right: Buyer-Lessor generally cannot have a “put” right with respect to property

− Fair Market Value Documentation: Any fair market values referred to above would ideally be supported by an independent valuation, but at the very least, by a detailed model prepared by an investment professional involved in the transaction

Rev. Proc. 2001-28


Oil & Gas Drilling Financing


Consequences

• “Out of budget” cash for drilling

• No tax gain/loss

• Residual income and cashflows after

investor capital returned

Consequences

• Immediate deduction for use of cash in

drilling operations (may enhance or create

an NOL with 35% benefit)

• Income from production taxed (currently) at

21%

Oil & Gas Co. Investor

Drill Sites $

Tax

Partnership


Foreign Subsidiary Collateral


• Section 956

− A U.S. shareholder of a controlled foreign corporation (a CFC) must include in income an amount based on the CFC’s investments in U.S. property, calculated under Section 956

− Section 956 may treat a CFC as holding the obligation of a U.S. person in certain circumstances:

o Stock representing two-thirds or more of the voting power of a CFC is pledged;

o CFC guarantees payment of the obligation; or

o CFC grants a security interest to the lender in its assets to secure the obligation

− The amount of U.S. property is the unpaid balance of the obligation in question on the determination date

− Rationale was that Section 956 amounts are effectively repatriated – and thus are “substantially the equivalent of a dividend”

• Section 245A

− Section 245A, which allows tax-free dividends from CFCs to corporate shareholders (by providing a dividends received deduction for 100% of the foreign-source component), does not apply to Section 956 inclusions (which are not actual dividends)

− House and Senate bills both proposed repealing Section 956 for corporate shareholders but the final TCJA did not amend Section 956


Foreign Subsidiary Collateral


• Treas. Reg. §1.956-1

− The purpose of Section 956 is to treat dividends and amounts substantially

equivalent to dividends the same

− In 2019, the Treasury released final regulations that reduce the amount

determined under Section 956 with respect to certain domestic corporations that

own stock in CFCs

o The final regulations reduce the Section 956 inclusion by the Section 245A deduction that

would hypothetically be allowed if the Section 956 amount were an actual dividend

o If a domestic partnership is a U.S. shareholder of a CFC, the Section 245A deduction with

respect to the hypothetical distribution is the aggregate amount of the Section 245A

deductions that domestic corporations that are partners in the partnership would be

allowed.

− Section 956 still applies to non-corporate shareholders of CFCs

19

International Tax

Planning

Opportunities


Outbounding Foreign Assets

U.S. Owner

Existing Foreign Entity

International Tax Planning Opportunities

ForeignOperations

Corporate or

Flow-thru

Entity?

Problem:

• U.S. tax reforms in 2018 (TCJA) reduced the benefits for U.S.

persons holding foreign operations through a flow-thru entity

Foreign Branch Structure

Foreign Flow-thru Foreign Corporation

U.S. Corporate

Owner

U.S. Individual

Owner

U.S. Corporate /

Individual Owners*

Generally

(GILTI):21% 37% 10.5%

Certain Oil &

Gas Income:21% 37% 0%

Certain Passive

/ Related Party

Income:

21% 37% 21%

*Assumes a U.S. individual makes an election to be taxed like a U.S. corporation, and the foreign

corporation does not make a dividend

• But on transition from a flow-thru entity to a corporate entity,

U.S. owner:

• Must recognize built-in gain; and

• May have to recapture losses in excess of built-in gain



Potent ia l So lut ion: Full Incorporation


• Convert foreign entity from

flow-thru to corporation:

• Triggers built-in gain, but

may be substantially

less in low value

environment

• Also triggers loss

recapture, but in the

current market, taxpayer

may have other losses to

offset any gain or loss

recapture




Potent ia l Solut ion : Partial Incorporation

New Foreign Corporation

Existing

Foreign

Entity

US Person

“New” Cash /

Investment

“New” Cash /

Investment (at

fixed price?)

Existing

Investment

• Make new investments in existing

foreign entity through a corporation:

• May not trigger any built-in

gain or loss recapture

• May be able to “lock-in”

historically low valuations for

purposes of future investments

in foreign operations

• But only a portion of the

foreign operations will benefit

from incorporation

Form New Entity


Unwinding Sandwich Structures


P O T E N T I AL S O L U T I O N :

Sell (or distribute) the foreign

subsidiaries to the foreign parent to

move them out from under the U.S.

subsidiary (so their income and

cash flow no longer move through

the U.S. subsidiary).

• Sale/distribution is generally

taxable - costly in normal

markets with appreciated

values.

• With lower values and low

corporate tax rates, tax is

reduced or eliminated

Foreign Parent

U.S. Subsidiary

Foreign Subsidiaries

Cash/

Note

Stock of

Foreign

Subs

December 31, 2017

Value of Foreign Sub: $1,000 MM

Tax Basis in Foreign Sub: $ 600 MM

Gain: $ 400 MM

Tax @ 2017 Corp. Rates: $ 140 MM

Value of Foreign Sub: $700 MM

Tax Basis in Foreign Sub: $600 MM

Gain: $100 MM

Tax @ 2020 Corp. Rates: $ 21 MM

April 1, 2020

(30% Decrease in Value)

VS

P R O B L E M :

“Sandwich

structures” may result

in unnecessary U.S.

income and

withholding tax as

earnings are

repatriated up the

ownership chain from

the foreign subsidiaries

through the U.S.

subsidiary to the

foreign parent


Unwinding Sandwich Structures PROBLEM: In some cases, the

sale/distribution solution may still

trigger too much gain

POTENTIAL SOLUTION: Create a

new joint venture (“JV”):

(1) U.S. subsidiary contributes foreign

subsidiaries to the JV in exchange

for preferred equity with limited

upside in the JV; and

(2) foreign affiliate contributes other

foreign subsidiaries (or assets) to

the JV in exchange for common

equity with unlimited upside in the

JV

• While the joint venture solution

does not immediately remove all

the value from under the U.S.

subsidiary, it can limit the growth of

value over time under the U.S.

subsidiary

• Foreign affiliate’s common equity

captures more of the growth from

the JV in the future

• The preferred par value is set in

the current low-value environment,

allowing more opportunity for

common appreciation outside of

U.S. subsidiary


Foreign Parent

Foreign AffiliateU.S. Subsidiary

Foreign Subsidiaries

Preferred

Subs

Contributions to New JV

New JV

Common

Other Foreign

Subsidiaries

Subs


European Holding Company Jurisdictions –

Comparison Matrix


1 Absent application of a relevant double tax treaty2 Subject to certain exemptions (e.g. payments to banks, or listing on a recognised

stock exchange)3 Except under certain profit-sharing arrangements4 Unless interest paid a on debt instrument that is treated as equity

26

Liability

Management and

Tax Attribute

Preservation


Example Terms of an NOL Rights Plan

NOL Poison Pills

Threshold 4.95% threshold

Term 3-year term (may have earlier expiration for (i) Stockholder Ratification, and/or (ii) certain Board

determinations)

Stockholder

Ratification

Consider a provision requiring the Board to submit the NOL rights plan to the stockholders for

ratification at the next annual meeting or the NOL rights plan will expire on the day after such

meeting pursuant to its terms

Board

Determinations of

Expiration Terms

Consider provisions establishing that the NOL rights plan will expire, pursuant to its terms, upon

either (i) the date set by the Board following a determination by the Board that the NOL rights

plan is no longer necessary or desirable for the preservation of the Company’s NOLs or

other tax attributes and/or (ii) the first day of a taxable year to which the Board determines that

NOLs or other tax attributes are no longer available to be carried forward or are otherwise

unavailable to offset future taxable income or tax

Exercise Price 3 - 6 times the current market price of the Company’s common stock

Exchange Ratio 1:1 (i.e., each right would be exchanged for one share)

Grandfather

Provision

The rights plan would “grandfather” existing stockholders that hold 4.95% or more of the

Company’s stock without triggering the rights plan. However, grandfathered stockholders would

not be permitted to acquire any additional shares

Certain Exemptions The Board may exempt, among other things, (i) private placements and underwritten share

issuances of the Company approved by the Board and (ii) any inadvertent triggering of the

rights plan if excess shares are divested promptly


Steps for Adoption

NOL Poison Pills

How to Adopt an NOL Rights Plan

• Adopt board resolutions to authorize the NOL rights plan and rights issuance

• Enter into NOL rights agreement with the rights agent

• File a Certificate of Designations with the Delaware Secretary of State

• Issue a press release regarding the adoption of the NOL rights plan

• Submit SEC filings‒ File a Form 8-K disclosing the adoption of the NOL rights plan

‒ File a Form 8-A with respect to the registration of rights under the NOL

rights plan

• Notify stock exchange of the adoption of the NOL rights plan

• Mail summary of rights for NOL rights plan to stockholders

29Confidential & Proprietary ©2020 Vinson & Elkins LLP velaw.com 29Confidential & Proprietary ©2020 Vinson & Elkins LLP velaw.com

What?

Why?

• Rights triggered once ownership stake of an Acquiring Person crosses a

predefined ownership threshold (e.g., 4.95%)

• Rights not held by the Acquiring Person become exercisable

• Rights held by the Acquiring Person become void

• Then, if the Board does not elect to exchange the Rights, the Rights holders

may exercise their Rights by paying the exercise price

• Following the triggering event, Rights allow holders to purchase additional

shares of common stock with a then-market value equal to twice the

exercise price

• Amounts to a right to purchase shares for ½ market price

• For example, if the initial exercise price is $15.00 (6x share price of

$2.50) and the share price of the Company is still $2.50 when the

rights are triggered, each holder of common stock could purchase up

to 12 shares of common stock at $1.25 per share:

($15.00 * 1) / (50% * $2.50) = 12 shares

• Alternatively, the Board can elect to exchange the Rights after the triggering

of the plan. The exchange ratio is one share of common stock for each

Right

How

What

• Issuance of non-exercisable warrants

(“Rights”) to existing stockholders that

is initially to buy shares of preferred

stock at an exercise price that is out-of-

the-money (often 3 - 6 times the market

price)

• Delaware law endorses the use of

stockholder rights plans

Why

• Protects the Company’s NOLs and

other tax attributes from substantial

impairment

• Creates a barrier to stock

accumulation beyond a certain

threshold

• Deters any stockholder from

acquiring, including by increasing its

current stake in the Company, an

interest in the Company greater than

4.95%

When?

How?

When• Can be adopted and implemented on short notice and

without stockholder approval


Overview

Related Party Debt Repurchases

• Debt repurchased by related parties may result in

cancellation of debt income (CODI)

• A borrower will have CODI when it repurchases its own

debt at a discount

• When debt is purchased by a party “related” to the

borrower, it is treated as if it is repurchased by the

borrower

• “Related parties” generally include any (i) person/entity that

owns more than 50% of the borrower, or (ii) entities with

more than 50% common ownership

• However, this determination is not always intuitive because

the ownership attribution rules are complicated and have

some unusual features


Partnership Debtor & Purchaser


Are Portfolio Company and Purchaser related?

• PE Fund owns (directly or constructively) more

than 50% of Portfolio Company

• PE Fund forms, and also owns more than 50%

of, Purchaser

• Two partnerships are related if more than 50% of

the capital or profits of the partnerships are

owned (directly or constructively) by the same

persons

• Because Portfolio Company and Purchaser are

each more than 50% owned by PE Fund, they

are related persons and a discounted purchase

would result in CODI

Scenario #1

Portfolio

Company

(Debtor)

PE Fund

Purchaser

PE Fund

Investors

Noteholders

Notes

$

> 50% > 50%


Corporate Debtor & Partnership

Purchaser






of, Purchaser

• A partnership and a corporation are related if

more than 50% of the capital or profits of the

partnership are owned (directly or constructively)

by the same persons that own more than 50% of

the value of the stock of the corporation





Scenario #2

PE Fund

Purchaser

PE Fund

Investors

Noteholders

Notes

$

> 50% > 50%

Portfolio

Company

(Debtor)


Partnership Debtor & Corporate

Purchaser






of, Purchaser

• A partnership and a corporation are related if

more than 50% of the capital or profits of the

partnership are owned (directly or constructively)

by the same persons that own more than 50% of

the value of the stock of the corporation





Scenario #3

PE Fund

PE Fund

Investors

Noteholders

Notes

$

> 50% > 50%

Portfolio

Company

(Debtor)

Purchaser


Potential Solution


Portfolio

Company

(Debtor)

PE Fund

Purchaser A

Investor

Group A

Noteholders

Notes

$

Investor

Group B

Investor

Group C

Purchaser B Purchaser C

$

Notes Notes

$

< 50% < 50%< 50%

Note: Same result if Portfolio

Company were a corporation


Potential Solution (cont’d)


• None of the Purchasers are related to Portfolio Company.

– No purchasing entity will be treated as owning more than 50% of Portfolio Company provided

that each group of Investors owns less than 50% of PE Fund and there is no overlap in the

investor groups.

– Therefore, no group of persons directly or constructively owns more than 50% of each of

Portfolio Company and each Purchaser.

– Note that overlap of investors (including ownership of GP) could affect the percentage of

constructive ownership.

• This is also true if Portfolio Company is a corporation and the Purchasers are

partnerships or the Portfolio Company is a partnership and the Purchasers are

corporations.


Corporate Debtor & Purchaser



• PE Fund owns (directly or constructively) more than 50%

of Portfolio Company.

• PE Fund forms, and also owns more than 50% of,

Purchaser.

• Two corporations are related if a group of 5 or fewer

persons who are individuals, estates, or trusts (ITEs)

own (directly or constructively) more than 50% of the

stock in each of Portfolio Company and Purchaser.

• An ITE that owns at least 5% of the capital or

profits of a PE fund will be treated as owning a

portion of the stock of the Portfolio Company and

Purchaser that is owned by the PE fund in

proportion to the ITE’s interest in the capital or

profits of the PE fund, whichever is greater.

• If PE Fund does not have ITEs that are 5% or greater

partners that collectively own more than 50% of the PE

fund, the Purchaser and Portfolio Company would not be

related.

Scenario #4

PE Fund

PE Fund

Investors

Noteholders

Notes

$

> 50% > 50%

Purchaser

Portfolio

Company

(Debtor)

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Austin

T +1.512.542.8400

Dallas

T +1.214.220.7700

Dubai

T +971.4.330.1800

Hong Kong

T +852.3658.6400

Houston

T +1.713.758.2222

London

T +44.20.7065.6000

New York

T +1.212.237.0000

Richmond

T +1.804.327.6300

Riyadh

T +966.11.250.0800

San Francisco

T +1.415.979.6900

Tokyo

T +81.3.3282.0450

Washington

T +1.202.639.6500

• THANK YOU

This content is intended for educational and informational purposes only and does not constitute legal advice or

services. It does not constitute the provision of legal advice or services by any of the speakers or by Vinson & Elkins

LLP.

navigating challenging times: tax opportunities · 2020. 6. 4. · senior associate washington,...

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