INVESTMENT FUND managers remain troubled by a decision by a US appeals court this summer that suggests such funds may sometimes be engaged in the US trades or businesses of portfolio companies the funds own that are corporations. The court declined in late August to rehear the case.

The decision has led to lots of speculation at industry conferences about potentially far-reaching tax implications.

The decision had the effect in the particular case of making two investment funds potentially liable for underfunding in a union pension plan to which one of its portfolio companies had been contributing before the portfolio company went bankrupt.

Two investment funds managed by Sun Capital Advisors bought a company, Scott Brass, Inc., that made high-quality brass, copper and other metals. The funds purchased the company in 2007 for $7.8 million.

Sun Capital describes the business of the funds it manages as buying underperforming but market-leading companies at below intrinsic value with the aim of turning them around and then selling them for a profit.

Scott Brass made contributions to a Teamsters pension fund under a collective bargaining agreement. Sun Capital employees were heavily involved in the business after the acquisition. However, falling copper prices in the fall 2008 reduced the value of the Scott Brass inventory, and the company was forced into bankruptcy in November 2008. Scott Brass had stopped making contributions to the pension fund shortly before the bankruptcy. There had been some underfunding of pension benefits even before the Sun funds bought the company.

After the bankruptcy, the Teamsters pension fund sent a demand for $4.5 million in withdrawal liability to Scott Brass and Sun Capital.

It claimed that the two Sun Capital investment funds and Scott Brass were under common control and, therefore, were jointly and severally liable for the withdrawal liability for the underfunding.

The Sun funds asked a court for a declaration that they were not liable.

The Multiemployer Pension Plan Amendments Act of 1980 allows the US government to recoup unfunded pension liabilities in union, multi-employer plans. Any employer withdrawing from a plan must pay its proportionate share of the plan’s vested but unfunded benefits. The Act treats all trades or businesses under common control as a single employer of workers who work in any of the businesses. Two conditions have to be satisfied to impose liability on an entity for underfunding in a pension plan. The entity must be under common control with the entity employing the union workers, and the entity must be a “trade or business.”

The court noted that the US taxpayers would have to pick up the underfunding through the US Pension Benefit Guaranty Corporation if the Sun funds are found not liable. It said the only authority on when investment funds are engaged in a “trade or business” for this purpose is a 2007 appeals letter, a form of PBGC ruling, in which the PBGC said it would apply a two-prong test based on a US Supreme Court decision in an income tax case. The PBGC said an investment fund is engaged in a trade or business if it is doing “investment plus,” meaning more than just managing investments in shares by digging more deeply into managing the work force and assets directly of the invested companies.

In this case, the court said, the two funds sought out potential portfolio companies in need of extensive intervention, and they were heavily involved, through their asset manager, in running the companies in which they invested.

It concluded that one of the two funds was engaged in the Scott Brass trade or business and sent the case back to a district court to look more closely into the facts surrounding the other fund and to determine whether Scott Brass and the funds were under common control.

The decision has led to considerable hand wringing over whether it will have broader tax implications.

Among the potential implications are the decision could cause income earned by fund managers to be treated as ordinary income rather than investment returns. It could lead foreign investors who hold shares in US corporations to be considered engaged in US trades or businesses and force them to file US tax returns and possibly cause them to lose protections under US tax treaties that reduce or eliminate US withholding taxes on dividends and interest the foreign investors receive from US sources. It could also require tax-exempt investors to have to pay taxes on corporate dividends received through funds as “unrelated business taxable income.”

Craig Gerson, a lawyer in the tax policy section at Treasury, said at an American Bar Association tax section meeting in San Francisco in late September that the government recognizes the decision may give it the opportunity to take an expansive view of what a trade or business means, but there will not be a rush to exercise any such authority.

The case is Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund.