The U.S. Small Business Administration’s (“SBA”) final rule to revise the Small Business Investment Company (“SBIC”) regulations regarding investments in passive businesses and the use of double holding companies in structuring SBIC investments went into effect as of November 20, 2014. This final rule is substantially similar to the proposed rule issued by SBA on December 23, 2013.
SBIC investments in passive businesses (those that are not operating companies) are generally prohibited. The SBIC regulations have included a limited exception to this general prohibition for situations where an SBIC uses one passive small business to pass through the investment proceeds to one or more non-passive small business subsidiaries or to use the investment proceeds for the purpose of acquiring a majority ownership interest in a non-passive business.
The final rule expands this exception to permit SBICs to structure investments using two holding companies. In such a circumstance, the passive business that is the direct recipient of the SBIC investment must indirectly, through the second passive business, own at least 50% of the non-passive small business. The final rule allows a maximum of two holding companies and specifically states that the SBA is opposed to allowing investments to be structured with more than two passive levels. The rule also clarifies that an SBIC may use a blocker corporation for any purpose as one of the two permitted passive entities.
The modification will provide SBICs greater flexibility in structuring investments and help SBICs take advantage of the double holding company structure that is frequently utilized by non-SBICs in the venture capital and private equity sectors. Double holding company structures can address a number of concerns, including (1) simplifying the process of allocating income to different classes of investors in a syndicated transaction involving a number of participants, (2) accommodating investors’ needs for a mix of taxable and non-taxable entities, and (3) taking advantage of favorable tax treatment under Internal Revenue Code section 338(h)(10) in transactions involving the purchase of s corporation stock.