For years, the YA Global litigation has attracted the attention of many tax practitioners and private fund industry stakeholders. The proliferation of offshore private funds that invest substantially in many US sectors, coupled with the recent compliance campaign of the US Internal Revenue Service (“IRS”) (regarding lending and dealer status of offshore entities), has created intense interest in the result of the litigation—not only how the United States Tax Court (the “court”) would rule, but, perhaps more importantly, the analysis underpinning its ruling. On November 15, 2023, the court released its long-awaited opinion in YA Global Investments, LP v. Commissioner, 161 T.C. No. 11.

The public became aware of IRS’s challenge to YA Global’s position that its activities qualified for securities trading safe harbor of Section 864(b) of the Internal Revenue Code (the “Code”) when the taxpayer petitioned the Tax Court in 2015. Shortly before the court petition was filed by the taxpayer, the IRS released a Chief Counsel Advice memorandum, CCA 201501013 (Jan. 2, 2015), widely believed (and confirmed in the court’s opinion)1 to relate to the dispute between YA Global and the IRS. Accordingly, many facts regarding YA Global’s activities were known to taxpayers significantly in advance of the release of the court opinion. The facts of YA Global are unique, and so as expected, the opinion does not easily lend itself to clear and concise conclusions that could be applied generally.2 What’s more, the Tax Court’s analysis focuses on the YA Global’s failure to meet its burden of proof, rather than on merits of the IRS’s arguments. Nevertheless, the opinion expresses a number of views that warrant exploration and raises some questions applicable to common structures of private funds.

I. A Brief Overview of the Stakes

If a fund treated as a partnership for US federal income tax purposes, whether formed in the United States or elsewhere, is engaged in the conduct of a US trade or business, then any income and gains earned by the fund that are effectively connected with the conduct of such trade or business (“effectively connected income,” or “ECI”) are taxable to the non-US investors in the fund as though they had earned the income directly.3 Once the ECI is allocated to non-US investors, it is generally taxable in the same manner as income and gains earned by a US investor. In addition, if such non-US investors are corporations, they may be subject to an additional 30% branch profits tax.4 The partnership generating the ECI is obligated to withhold on the amounts of ECI allocated to the non-US partners, and to file returns reporting such withholding.5

The Code does not define a US trade or business, resulting in a “facts and circumstances” analysis and, in the absence of clear authority, the development of detailed industry standards. However, Section 864(b) of the Code provides important exceptions for non-dealers with respect to their income derived from trading in securities and commodities.6 Under the “trading for your own account” safe harbor, income and gains from securities and commodity trading do not generally cause funds to be treated as conducting a US trade or business, or subject non-US investors in the funds to US federal income tax on such income and gains. Credit funds, insurance companies, and various non-US vehicles acquiring and holding debt securities often find themselves evaluating whether their activities constitute trading in securities (which would be eligible for the safe harbor) or potentially distinguishable business activities, such as loan origination activities (which could be treated as constituting a US trade or business of lending) or workout business activities (which, perhaps, could be similarly treated).

If the activities of a fund with non-US partners are limited to investment activities, no matter how continuous or extended the work required may be, the fund’s activities will not constitute the carrying on of a trade or business.7 The issue as to whether financial activities, like other endeavors undertaken for profit, amount to a trade or business rather than investment activities is a question of fact.8

Accordingly, if a fund is only engaged in investment activities and/or trading in securities or commodities, its non-US partners will not be subject to net US federal income tax (with certain exceptions relating to US real property interests and assuming that the non-US investors are not themselves dealers). On the other hand, if the fund’s activities go beyond investing and/or trading in securities and commodities, its activities will generally subject its non-US partners to net US federal income tax. This tax is enforced by requiring the fund to withhold on the ECI allocable to the non-US partners.9

II. The Facts of YA Global

For the years at issue, 2006-2009, YA Global was a Cayman Islands partnership and was taxable as a partnership for U.S. federal income tax purposes.10 YA Global had an offshore feeder fund named “YA Offshore” and several other direct non-US. limited partners. The offshore feeder fund was treated as a corporation for US federal income tax purposes.

YA Global filed IRS Forms 1065 for each of the years at issue, which is the US income tax return for partnerships. YA Global did not, however, file IRS Forms 8804 for any of the years at issue. The Form 8804 reports the amount of US federal income tax withheld by the partnership in respect of ECI. Given that YA Global did not believe that it was generating ECI, its failure to file the Forms 8804 seems understandable.

YA Global was a party to a management agreement with Yorkville Advisors (“Yorkville”), a US company that served as the general partner of YA Global, and which also agreed in the management agreement to act as YA Global’s agent with authority to buy, sell, and otherwise transact in securities for YA Global’s account. Yorkville provided similar services for two other investment entities (but the court treated these other engagements as de minimis). Yorkville conducted extensive activities through its US office on behalf of YA Global. YA Global had no employees of its own, which is typical in the fund space. Yorkville was compensated under a standard 2+20 structure; that is, it received a management fee of 2% of gross assets and a 20% carried interest in YA Global’s net gains and income.

Generally, YA Global provided direct capital to portfolio companies by purchasing convertible bonds and entering into “standby equity distribution agreements” or “SEDAs.” Under the SEDAs, in general, YA Global had the right, for a period of time, to buy stock in and from the portfolio companies at a discount to the trading price of such stock. The portfolio companies paid fees to YA Global and Yorkville under the SEDAs. The convertible bonds provided for conversion prices that were in-the-money to YA Global, and issuances were sometimes accompanied by the payment of fees. YA Global typically exercised its conversion rights only when it was going to sell the underlying stock.

In the convertible bond activities, Yorkville, on behalf of YA Global, directly negotiated with borrowers, concerning key terms of hundreds of loans and conducted extensive due diligence on borrowers before agreeing to cause YA Global to make a loan. The loans consisted of promissory notes, convertible debt instruments with discounted conversion prices determined at the time of conversion, and warrants to purchase additional shares of the borrower’s stock. YA Global and Yorkville received various fees from the borrowers and, after converting a convertible debt instrument into stock at a discount, would often seek to earn a spread by quickly disposing of the stock.

In the SEDA activities, YA Global signed distribution agreements with unrelated issuers, allowing the issuer to issue and sell its stock periodically to YA Global for a specified purchase price. YA Global purchased the issuer’s stock at a discount, sold it to the public at its market price, and earned a spread on each share sold plus fees from the issuer.

YA Global obtained access to deal flow through introductions from investment banks and referrals from securities attorneys and accounting firms. It also sponsored industry conferences. Its marketing materials stated that its “strong reputation leads many issuers to contact [YA Global] directly.” It further touted that the Yorkville principals were “authorities on structured finance.”

The IRS asserted and the court concluded that YA Global was not merely investing or trading securities, rather it was engaged in a trade or business that differed from trading in securities. In terms of the court’s analysis, readers may find it interesting that the court stated “[a]lthough the investment exception is widely recognized, its rationale is unclear. And the absence of a clear rationale for the investment exception makes it difficult to define its parameters,” and “the line separating business activities from the management of investments is not always clear.”11 Despite the perceived lack of clarity, the court’s holdings were decisively in favor of the IRS on virtually every single count.

A. The Agency Issue

The court first addressed whether it was appropriate to attribute the activities of Yorkville to YA Global. YA Global asserted that Yorkville was not an agent of YA Global, but rather a service provider. The court seems to agree that, if Yorkville were a service provider, its activities may not be imputed to YA Global. A lack of attribution of activities would have insulated YA Global from being treated as being engaged in the conduct of a US trade or business.

The court largely framed the distinction between service providers and agents in the following manner. If YA Global could only direct what Yorkville did at the outset of the provision of instructions, Yorkville should be treated as a service provider. In contrast, if YA Global had the right to give interim instructions after the charge was given, Yorkville should be treated as an agent.

It is somewhat surprising that the court did not mention the prior case law that set forth agency tests in the context of tax law questions.12 Instead, the court applied the Restatement (Third) of the Law of Agency in determining agency for purposes of imputing activities under Code § 864, while still leaving open the possibility that certain activities could be attributed for tax purposes even in the absence of an agency relationship.13 In this regard, the court focused on Yorkville’s assent to act as agent on behalf of YA Global (as an investment manager) and YA Global possessing the power under the legal arrangement to control Yorkville’s actions, particularly through the right to give interim instructions to Yorkville during the relationship.14 It is, however, not surprising that the court attributed Yorkville’s activities to YA Global, in light of the broad authority that Yorkville possessed to act on behalf of YA Global in its capacity as investment manager and general partner. However, the court’s particular focus on YA Global’s right to direct Yorkville with interim instructions as being seemingly determinative is curious. The court’s analysis could be interpreted as opening the possibility to structure a fund in a way to avoid the US trade or business taint, by eliminating the fund’s ability to provide any interim instructions to its managers.

In light of the court’s agency analysis, any applicable activities engaged in by Yorkville were treated as having been engaged in by YA Global for purposes of the rest of the court’s discussion.

B. The Trade or Business of YA Global

YA Global asserted that it was not engaged in a lending business by positing that the convertible securities that it acquired directly from issuers were not true loans. It further asserted that the fees paid to it under the SEDAs were akin to option premiums and not true fees. The court analyzed whether YA Global was engaged in a trade or business by engaging in a three-part analysis:

  1. Were the YA Global transactions continuous, regular, and engaged in for profit?
  2. Were the YA Global transactions limited to the management of its own investments?
  3. Did the YA Global transactions constitute trading in securities within the meaning of the Code Section 864(b)(2) safe harbor?

The answer to the first question, unsurprisingly, was a clear “yes.”

The court’s approach to the second question was unexpected. The IRS argued that YA Global was either or each of a lending business, an underwriter business, a dealer business, and/or a servicing business. The court called the tax treatment of investment activities a judicially created safe harbor, and rather than specifically labeling the activities, it focused on whether YA Global’s activities were other than the management of its investments. In the words of the court, its activities went “beyond the management of investments.” It seems the court implicitly viewed YA Global as engaging in a service business; however, the court noted that this does not depend on identifying specific services that the relevant agreements required.

While the court did not articulate a standard or the elements for making this determination, and while the facts of the case were unique, the court did focus on the following three items: (i) the taxpayer earning income that was not “returns on invested capital,” (ii) issuers paying fees, and (iii) issuers realizing a benefit from a taxpayer (other than, perhaps, a mere receipt of capital on an existing offering where the taxpayer bears no conditions to participation).

The third question regarding the securities trading safe harbor was allocated a single paragraph in the court’s written opinion, which explained that the activities were not trading for the same reason YA Global was not merely an investor: it did not earn returns only on the capital invested. The hallmark of trading is recognizing gains on invested capital from short-term fluctuations in the value of the securities purchased and sold. The court seemed to reject the notion that “identifying, sourcing, and negotiating transactions” (performed by Yorkville Advisors) should be viewed as part of or closely related to purchasing and selling securities and, thus, under the purview of the securities trading safe harbor. It instead focused on whether YA Global (itself or through Yorkville) provided benefits to the issuers other than simply infusing capital. It saw the payment of “fees” by the issuers as evidence of the receipt of such other benefits.

The court extensively discussed the fees the issuers paid in connection with YA Global’s activities. The court noted that fees were paid to Yorkville as well as YA Global, and that fees paid to Yorkville were retained as compensation for its expenses, except to the extent certain fees exceeded such expenses. Such excess could be paid to YA Global, or applied as an offset to YA Global-owed management fees. In fact, Yorkville remitted to YA Global certain amounts of such excess fees during two of the years in question. The importance of the form of the fees, or the fact that Yorkville shared fees with YA Global, is unclear, but the court concluded that the fees indicated that negotiating, structuring, and documenting the terms of the transactions provided a benefit to the portfolio companies. The court found that the portfolio companies’ payment of fees in connection with the transactions was a strong indication that the generation of fee income was a key incentive to the transactions. The court held that such value creation was the provision of services to the portfolio companies and, thus, not protected by the securities trading safe harbor. It further held that these capital-raising services were antithetical to the conclusion that YA Global was acting as an investor. YA Global’s activities of providing direct capital to companies were not merely investing but provided substantial value to the companies in which YA Global invested. In effect, the court viewed the activities as some sort of capital solutions business or purveyor of structured capital raise products.

One troubling aspect of this approach is that fee income is a common feature of the sophisticated investment ecosystem, and the court did not clearly articulate within its analytical framework the weight given by the court to the fact that many fees effectively compensated Yorkville. A second troubling, more specific aspect is (perhaps in dicta) the court’s dismissal of certain commitment fees as being a “return of invested capital” because the fees were payable before the issuer sought any advances. Modern investing in the current marketplace evaluates opportunity cost as a basic economic input. Therefore, it is arguably very investment-like for an investor to earn non-use and similar commitment-type fees that compensate for the investor’s need to maintain available capital and limit its deployment to other investments. Moreover, such payments are seemingly economically equivalent to a premium for an option to cause a third party to purchase a security at a pre-negotiate price, as was argued by YA Global. The court did not appear to heavily distinguish among the different types of fees being charged to the portfolio companies in its analysis. As a result, the court’s analysis treats fees such as commitment fees as being income from services.

Another troubling aspect of the court’s analysis is that the court implicitly assumes that that fees received by Yorkville from portfolio companies should be treated as fees for services provided by YA Global. It is not clear whether this assumption was made because Yorkville remitted a portion of such fees to YA Global, or whether Yorkville had the ability to apply such fees as an offset against the management fees. It is relatively common for managers of private equity funds and other types of funds to receive fees for services provided to the portfolio companies such as directors fees or advisory fees. Typically, these services are considered as not being performed on behalf of the fund, and therefore those funds take the position that such fees, or associated service activities, are not attributed to the funds they manage. While fund managers often agree with limited partners to offset such fees against management fees otherwise payable by the fund to the managers, such offset in and of itself is not generally considered sufficient to attribute such services and associated fees to the funds. Because the fee arrangements in YA Global appear to encompass some of these practices in addition to YA Global at times being entitled to directly receive fees, it is not clear the extent to which some of the more typical practices in the fund industry were implicated by the court’s analysis. The court’s opinion may suggest that there would be a spectrum of risk, with situations less favorable to taxpayers particularly when the fund has the right to directly receive the fees charged by managers, and comparatively lower risks when the fees are payable to the manager and there is no management fee offset arrangement.

The court largely limited its reliance on precedent to two Supreme Court cases regarding US trade or business, without entering the fray of prior authorities that addressed the outer limits of a lending business in contexts such as bad-debt deductions and personal holding companies. However, arguably, one could posit that the court’s line of thinking (ostensibly influenced by the facts focused on in the parties’ briefs)—that YA Global should be considered engaged in the conduct of a trade or business—follows the similar logic of the promoter line of cases. The promoter line of cases deals with the question of whether an individual can take a business bad debt deduction under Code Section 166 for unrepaid loans advanced to business entities promoted by the taxpayer on the basis that the taxpayer’s promotional activities are trade or business activities, even though the taxpayer is not strictly in a lending business per se.

In Newman v. Commissioner,15 the court set forth the requirements for promoter status:

  1. Compensation sought is other than the normal investor's return, and income received is the direct product of the taxpayer's services and not primarily from the deployment of capital.
  2. The activity is conducted for a fee or commission or with the immediate purpose of selling the securities at a profit in the ordinary course of the taxpayer’s business.16
  3. The taxpayer had a reputation in the community for promoting, organizing, financing, and selling businesses.

In addition to these specific requirements, courts have looked to some of the same criteria applied to determine the presence of a lending business, including the amount of time spent on promotion activities and the number of business ventures promoted.17

The recitation of the facts of the activities of YA Global generally follow these requirements. First, YA Global and Yorkville earned substantial fee income in connection with the financings. Second, the financings were frequently undertaken for immediate sales and generation of fees. Third, YA Global’s business was known in the industry for promoting and financing businesses and selling equity in companies. Arguably, it would have been more helpful to the tax community if the court had explicitly referenced this type of analysis.

C. The Mark-to-Market Issue

The IRS asserted that YA Global should be treated as a dealer in securities under Code § 475.18 Dealers in securities generally are required to use mark-to-market accounting to determine their income for US federal income tax purposes.19 All income and loss marks are ordinary in character, and the use of such accounting method would have deprived the non-corporate investors in YA Global of the favorable tax rate applicable to the substantial long-term capital gains recognized by YA Global. While a taxpayer subject to the dealer mark-to-market rule can designate certain securities as held for investment (and thereby exempt such securities from mark-to-market accounting), the court held that YA Global did not make appropriate investment designations. It was clear that YA Global did not sell securities to customers. Accordingly, the dispute was whether YA Global purchased securities from customers, and whether this was sufficient to cause YA Global to be treated as a dealer for purposes of the mark-to-market rules.

The court held that the portfolio companies that sold securities to YA Global should be treated as its “customers” for purposes of the mark-to-market accounting rules. The linchpin of that analysis was not the nature or interpretation of the portfolio companies as “customers” but rather that YA Global held itself out as being willing to provide capital to portfolio companies as illustrated by Yorkville’s reputation, industry sponsorships, press, and referral network. Therefore, the court sustained the IRS’s position that YA Global was a dealer, and was required to use mark-to-market accounting for all of its positions. It is worth noting that the court did not expressly conclude that YA Global was a dealer, for purposes of Section 864.

D. Characterization of All of YA Global’s Income as ECI

The court concluded that all of YA Global’s net income and gains, including its net mark-to-market gains, were ECI, and that YA Global and Yorkville should be held liable for failure to withhold appropriate US federal income tax from the amounts allocable to its non-US investors.20

Liability for Withholding Tax

YA Offshore, a limited partner in YA Global, directly incurred expenses with respect to its investment in YA Global. YA Global asserted that its withholding tax liability should be decreased by taking these deductions into account. A Treasury regulation allows a non-US person to claim advantage of such deductions by providing notice to the withholding agent.21 Since YA Offshore did not follow these procedures, however, the court refused to allow YA Global to reduce its withholding obligation by taking these deductions into account.

Next, YA Global argued that the statute of limitations prohibited the assessment of withholding tax against it. It argued that the tolling of the statute of limitations should be measured by the dates on which it filed its Forms 1065. It argued that any Forms 8804 that it would have filed would have simply shown all zeros (no withholding tax due), because YA Global believed that it was not engaged in the conduct of a trade or business in the United States. Thus, any Forms 8804 would have been meaningless to the IRS. The court disagreed, and held that the statute of limitations should be determined with reference to the dates on which it filed the Forms 8804, and since such forms were not filed, YA Global had no statute of limitations defense. In dicta, the court stated that it “might” have computed the statute of limitations from the date of the filing of the Forms 8804 even if such returns were “zero” returns, as long as such returns described its activities, and explained the grounds for the belief that it was not engaged in a US trade or business.

To make matters worse, the court sustained a 25% penalty on YA Global for its failure to file the Forms 8804. YA Global had defended against the penalty on the grounds that its failure to file was due to reasonable cause. Specifically, it had received advice (though no formal written opinion) from a prominent accounting firm that it was not involved in activities that would have generated ECI, and a likewise prominent law firm prepared offering material on the same basis (though fell short of delivering YA Global a clear view on the question). The court rejected this defense because YA Global had sued the accounting firm for providing negligent advice in 2015 when the case went to court and YA Global could not offer evidence that it was unaware, prior to 2007, of whatever lack of information available to, or negligence performed by, the accounting firm for which YA Global was relying on in its malpractice suit.

III. A Few Takeaways

  • The YA Global case may embolden the IRS to be more aggressive, and expend more resources in its compliance campaign on offshore credit and other private funds.
  • Funds should be cognizant of issuers paying fees in connection with an investment, whether to the manager or the fund, and evaluate any increased risk presented by such fees.
  • Somewhat surprisingly, the court’s reasoning raises the specter that advancing cash even for equity securities on a regular and continuous basis could cause a fund to be considered to be a promoter, and to be engaged in a US trade or business, particularly if the portfolio companies are paying material fees to the fund or its manager. We believe the court’s conclusion is best limited to the unique facts of this case, and does not suggest that funds would be treated as engaged in a US trade or business, simply because their fund manager receives material fees from the portfolio companies that offset the fund’s management fee owed to the manager. In these more common arrangements, the fund and/or its limited partners have effectively negotiated a variable management fee with its manager so that the fund pays less for the manager’s investment services to the extent that the fund’s investments create more opportunities for the manager to provide its (other) services to portfolio companies in exchange for fees (that are taxed in the US in the hands of the manager).
  • It is conceivable, or perhaps appropriate, to view all of the court’s analysis through the lens of the activities of Yorkville Advisor and YA Global simply being “too much” to constitute investing, particularly given the “promoter” cases cited above. YA Global was a specialty direct-to-company funder that generally funded companies through bespoke discount arrangements that provided its returns through subsequent sales. We expect few offshore taxpayers frequently engage in the type of investments made by YA Global, particularly in the same manner, and so we are reticent to read too much into the opinion. However, the court’s choices in expressing its conclusions are unsatisfying. We believe it is fair to speculate that many practitioners believed that, unless a taxpayer constituted a dealer for Section 864 purposes, loan origination and work-out ventures could perhaps be treated as a US trade or business, but any other profiting from stocks and securities ought to be considered investment or within the bounds of the securities trading safe harbor. The court does nothing to comfort or confirm this perspective, and arguably chips away at it by narrowly describing investing and trading.
  • We do not expect this opinion to have meaningful implications on those credit funds that rely on the “business profits” article of an applicable treaty, or that have adopted a blocker structure to deploy credit, as those funds are already taking the position that the fund (or the blocker) could be engaged in a US trade or business.
  • It would be prudent for fund partnerships with non-US partners to file protective IRS Forms 8804 along with its tax returns even if the funds takes the position it is not engaged in the conduct of a US trade or business.
  • The court further expanded the already broad Section 475 mark-to-market classification, by effectively supplanting the “customer” requirement to mean any counterparty to a taxpayer that regularly holds itself out as being willing and able to buy from, or sell to, market participants. Taxpayers seeking to avoid mark-to-market treatment should carefully consider whether it is prudent to properly and timely identify its securities as held for investment under Section 475(b).