It is important for private equity purchasers to mitigate the creation of Subpart F income in structuring the acquisition and holding of the stock of a non-U.S. portfolio company. This article will explore what Subpart F income is, why it should be mitigated and the structuring techniques that can accomplish that goal.
Subpart F income is certain categories of income generated by non-U.S. entities that are classified as controlled foreign corporations (CFCs). Generally, this is income of a passive nature (i.e., dividends, interest, rents, royalties, capital gains). Subpart F income also includes certain income of a CFC from related party transactions, such as related party sales or services transactions.
Subpart F income is unattractive because it can be triggered in unfavorable circumstances and is subject to higher U.S. tax rates. The income is taxed to certain private equity (PE) fund investors irrespective of whether the investor actually receives cash. Said differently, Subpart F income is dry income—the recipient is in the unfortunate position of having a taxable event without necessarily having an associated cash inflow. In addition, for U.S. individual investors [whether through direct investment or investment through a flow-through vehicle, such as a limited liability company (LLC), limited partnership or S corporation], Subpart F income is taxed at ordinary income rates rather than the preferential rates that generally apply to capital gains and dividends. A U.S. investor in a PE fund will generally expect capital gains treatment (a top rate of 20 percent) on all income generated through a PE investment (with the exception of any interest income that is contemplated). Therefore, incurring a dry income inclusion at ordinary U.S. income tax rates (a top rate of 39.6 percent) as a result of a Subpart F inclusion is very unattractive. In addition, the 3.8 percent surtax on passive income enacted as part of the Affordable Care Act applies to Subpart F income. Thus, before taking into account any U.S. state or local taxes that may be due, a U.S. individual investor in a PE fund could be subject to a 43.4 percent U.S. federal tax on each dollar of Subpart F income that is created through the holding of a non-U.S. portfolio company by a PE fund. Furthermore, as noted above, it is unlikely the investor will have received any cash to pay the tax bill.
Base Case Example
To help illustrate the ill effects and structuring alternatives to mitigate Subpart F income in connection with an investment by a PE fund in a non-U.S. portfolio company, we’ll discuss various alternatives based on the hypothetical, but common, example below.
PE Fund is organized as a U.S. limited partnership. PE Fund’s investors consist of: (1) U.S. taxable individuals and flow-through entities owned by U.S. taxable individuals (e.g., LLCs and S corporations); (2) U.S. taxable corporations; (3) U.S. tax-exempt investors and (4) non-U.S. investors. PE Fund wishes to invest in a UK portfolio company, UK Target, and will acquire 90 percent of the equity of UK Target, with UK Target management receiving a 10 percent equity stake in UK Target going forward. UK Target owns multiple subsidiary companies around the world, including certain U.S. subsidiaries. To acquire the UK Target, the PE Fund establishes an acquisition vehicle in Luxembourg (LuxCo). LuxCo in turn establishes an acquisition vehicle in the United Kingdom. (UK TopCo) to acquire UK Target. PE Fund capitalizes LuxCo with cash in exchange for common equity and convertible preferred equity certificates (instruments generally characterized as equity for U.S. tax purposes, but debt for Luxembourg purposes). LuxCo then capitalizes UK TopCo with cash in exchange for common equity (90 percent) and debt (generating an interest deduction in the United Kingdom) of UK TopCo. Management of UK Target rolls over into UK TopCo. UK TopCo then acquires the stock of UK Target.
In the structure above, because each of LuxCo, UK TopCo, UK Target and any non-U.S. subsidiary of UK Target constitute a CFC, Subpart F income risks exist. To the extent Subpart F income is generated, the taxable U.S. investors (individuals and corporations) in PE Fund will be subject to U.S. taxation on such income. First, under current law, the interest income on the loan from LuxCo to UK TopCo would constitute Subpart F income. Similar loans between CFCs in the structure could generate Subpart F income. Further, dividends paid from the non-U.S. subsidiaries of UK Target to UK Target could constitute Subpart F income under current law. In addition, sales or service arrangements between UK Target or one or more of its subsidiaries could give rise to Subpart F income. Finally, as PE Fund eventually looks to monetize its investment, an exit whereby LuxCo disposes of its shares of UK TopCo could generate Subpart F income.
Mitigating Subpart F
The recent expiration of certain U.S. tax provisions preventing Subpart F income on interest or dividend payments between related non-U.S. companies has created new challenges in mitigating the negative consequences of generating that type of income. During the last several years, a helpful provision has been Internal Revenue Code section 954(c)(6), which generally allows for dividends, interest, rents and royalties to be paid to related CFCs without creating Subpart F income. Under section 954(c)(6), the interest on the loan from LuxCo to UK TopCo in the base case example above would not be Subpart F income. However, section 954(c)(6) was enacted as a temporary provision and expired on December 31, 2013. While it is largely anticipated that the provision will be extended retroactively to the beginning of 2014 as part of the extension of a package of similar temporary measures (including, for example, the research and development tax credit), this provision is currently unavailable. Therefore, under current law, the interest on the loan from LuxCo to UK TopCo (and potentially others loans in the structure between related CFCs) constitutes Subpart F income.
One mechanism that is currently available to manage Subpart F income is through tax rules commonly referred to as “check-the-box” rules, allowing for the elective tax classification of non-U.S. entities. Specifically, these provisions allow taxpayers to choose the classification of a non-U.S. entity as between a corporation, partnership or branch (disregarded entity). As discussed above, Subpart F income can arise as a result of transactions between related companies. Thus, there is often a preference to make elections for U.S. tax purposes to treat entities as branches (or disregarded entities) of a single non-U.S. company such that transactions between the entities are disregarded for U.S. tax purposes. In the base case, it would likely be possible to check-the-box to treat all the entities below UK TopCo as disregarded entities. This strategy would allow transactions between subsidiaries of UK TopCo to be disregarded for U.S. tax purposes and limit the situations where Subpart F income can be created. However, because UK TopCo has two owners (LuxCo and management), an election cannot be made to treat it as a disregarded entity for U.S. tax purposes. Rather, under the check-the-box rules, UK TopCo can only be classified as a corporation or partnership. Therefore, there will continue to be risk of Subpart F income on the interest income of LuxCo on the loan to UK TopCo.
Separate from tax elections of the acquired entities themselves (and the holding company structure above them), proper fund structuring can mitigate Subpart F risks, as well. As discussed above, the Subpart F rules are only applicable to the extent one or more non-U.S. entities in the target’s structure are characterized as CFCs. A CFC is a non-U.S. entity that is owned more than 50 percent (by vote or value) by “U.S. Shareholders.” A U.S. Shareholder is any U.S. person (U.S. individual, corporation or partnership) that owns 10 percent or more of the voting stock of the CFC. Complex attribution rules apply to determine whether the above-described threshold is met. In the base case example, LuxCo, UK TopCo, UK Target and other non-U.S. subsidiaries of UK Target will be characterized as CFCs because PE Fund is organized as a U.S. partnership. PE Fund is a U.S. person that owns 10 percent of the voting stock of LuxCo (and, as a result, 10 percent of the voting stock of its subsidiaries, including UK TopCo and UK Target), which means PE Fund is a U.S. Shareholder. Further, PE Fund owns more than 50 percent by vote and value of the stock of LuxCo (and, as a result, 50 percent by vote and value of the stock of its subsidiaries, including UK Topco and UK Target), which means LuxCo and its subsidiaries are CFCs.
The characterization of the above non-U.S. entities as CFCs creates Subpart F risk for all of the taxable U.S. investors in the PE Fund, irrespective of their economic interest in PE Fund. However, it could be and is likely the case that if the PE Fund were not organized as a U.S. partnership, the entities would not be characterized as CFCs. For example, assume that 50 percent of the Fund’s investors were non-U.S. investors and 50 percent of the investors consisted of 10 U.S. investors, each with a 5 percent stake. Under this example, if the investors owned the stock of LuxCo directly (or were treated as doing so for U.S. tax purposes), neither LuxCo nor any of its subsidiaries would be characterized as a CFC, thereby eliminating Subpart F concerns. Therefore, to mitigate Subpart F risks, PE Fund may want to consider creating a parallel fund or other alternative investment vehicle, such as in the Cayman Islands, for its investors to invest through (rather than a U.S. partnership).