Legal Update August 6, 2015 Waiver Good-Bye: Treasury Targets Management Fee Waiver Arrangements Favored by Private Equity Fund Managers The Obama administration has had a devil of a time getting Congress to pass carried interest legislation that would tax as ordinary income the capital gain income received by private equity fund managers. The Internal Revenue Service (IRS) has moved in this direction, however, by proposing new rules that would prevent many managers from gilding the lily by waiving ordinary income management fees in exchange for a greater share of capital gains earned by the fund itself. The new rules would dramatically curtail current waiver schemes by imposing stringent requirements and treating the grants of the profits interests themselves as taxable events. In addition, the Proposed Regulations, if finalized as proposed, would affect existing arrangements because they would treat any fee waiver undertaken after the finalization as a modification that would invoke the application of the new rules. Specifically, on July 22, 2015, the US Treasury Department published Proposed Regulations under section 707(a)(2)(A) of the Internal Revenue Code of 1986, as amended (the Code) providing detailed guidance to partnerships and their partners on when a purported profits interest will be treated as a disguised payment for services. The Proposed Regulations use six factors used to determine whether an arrangement constitutes a payment for services, but provide that any arrangement that lacks “significant entrepreneurial risk” will constitute a payment for services regardless of the absence of other factors. Additionally, an interest in partnership profits that is received in connection with waiving a payment of a substantially fixed amount (such as a management fees) would not be eligible for the safe harbor from current taxation that typically applies to the receipt of profits interests in partnerships. Background Under Code section 707(a), transactions between a partner and a partnership in which the partner is acting outside his or her capacity as a partner are taxed as if the transaction occurred between third parties. Code section 707(a)(2)(A) states that if a partner provides services to a partnership and receives a related allocation and distribution, and the performance of the services and the allocation are, when viewed together, properly characterized as a transaction between the partnership and the partner acting outside his or her capacity as a partner, the transaction will be treated as occurring between the partnership and one who is not a partner. The result being that the allocations and distributions will be treated as the payment of fees rather than an allocation and distribution of partnership income. In the legislative history of Code section 707(a)(2)(A), Congress identified five factors to be taken into account in determining whether a service provider received its allocation and distribution in its capacity as a partner, with the first being the most important factor: (i) whether 2 Mayer Brown | Waiver Good‐Bye: Treasury Targets Management Fee Waiver Arrangements Favored by Private Equity Fund Managers the payment is subject to significant entrepreneurial risk, (ii) whether the partner status of the recipient is transitory, (iii) whether the allocation and distribution that are made to the partner are close in time to the partner’s performance of services, (iv) whether the facts and circumstances indicate that the recipient became a partner to obtain tax benefits for itself or the partnership that would have not otherwise been available and (v) whether the value of the recipient’s interest in general and in continuing partnership profits is small in relation to the allocation in question. Revenue Procedure 93-27 provides that a person who receives a profits interest in a partnership for the provision of services to, or for the benefit of, the partnership in a partner capacity, or in anticipation of becoming a partner, will not be subject to current taxation. For this safe harbor treatment to apply, (i) the profits interest must not relate to a substantially certain and predictable income, (ii) the partner must not dispose of the profits interest for two years and (iii) the profits interest cannot be a limited partnership interest in a publicly traded partnership. The theory behind this treatment is that the right to share in future profits that may or may not ultimately be realized is too speculative and, thus, the value of such an interest is too difficult to determine to subject the recipient to current taxation. Many private investment funds contain provisions that allow the management company to waive all or a portion of its management fee in exchange for an additional profits interest in the fund. Often, a management company affiliated with the sponsor (but not a partner in the fund) waives the management fee, while a separate sponsor affiliate that is a partner in the fund receives the additional profits interest. The management fee must be waived before it is earned in order to prevent the management company from being taxed under the “constructive receipt” doctrine. Funds with these provisions generally take the position that the sponsor has no taxable income in connection with the waiver of the management fee, and that the receipt of the additional profits interest in the fund meets the requirements of Revenue Procedure 93-27. A substantial portion of the income ultimately allocated to the sponsor in respect to its additional profits interest is often expected to be long-term capital gain that is generated by the fund after the date on which the profits interest is issued. New Guidance The IRS and the Treasury Department have expressed concern that some fee wavier arrangements, as well as other arrangements in which a service provider receives an interest in partnership profits in lieu of a fee, have been structured in a manner that inappropriately protects the service provider from the entrepreneurial risks of the partnership. In those cases, the IRS believes that it may be more appropriate to treat the arrangement as a disguised payment for services and tax it accordingly (generally, ordinary income to the service provider and an expense that is deducted or capitalized by the partnership). One of the most important aspects of the Proposed Regulations is contained in the preamble. The preamble states that the IRS intends to modify the safe harbor conditions set forth in Revenue Procedure 93-27 that treat grants of profits interests as nontaxable events. If the IRS follows through, the safe harbor will not apply to a profits interest issued in conjunction with a partner forgoing payment of an amount that is substantially fixed (including a substantially fixed amount determined by formula, such as a fee based on a percentage of capital commitments) for the performance of services. Thus, even if a profits interest that is granted in connection with a fee wavier is found not to be a disguised payment for services under the Proposed Regulations, the receipt of such interest would not be eligible for the safe harbor under Revenue Procedure 93-27. Consequently, 3 Mayer Brown | Waiver Good‐Bye: Treasury Targets Management Fee Waiver Arrangements Favored by Private Equity Fund Managers the recipient may have current ordinary income in an amount equal to the fair market value of such profits interest at the time it is issued. This change could potentially overwhelm the more technical rules and make management fee waivers a thing of the past. The Proposed Regulations provide six nonexclusive factors for determining whether an arrangement constitutes a disguised payment for services. The Proposed Regulations adopt the five factors identified above from the legislative history of Code section 707(a)(2)(A) and add one additional factor: whether the arrangement provides for different allocations or distributions with respect to different services received, where the services are provided either by a single person or by related persons, and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly. This additional factor is intended to address the scenario in which an affiliate of a fund sponsor receives a profits interest in connection with a fee waiver and that profits interest is subject to significantly less business risk than the (typically 20 percent) carried interest in the fund that is held by another affiliate of the sponsor. The rule is intended to cause management fee waivers that are not subject to the high-water mark for carried interests to fail to be treated as profits interests. Because the first of the six factors, the existence of significant entrepreneurial risk, is the most important factor, the Proposed Regulations provide that its absence is determinative; thus, if an arrangement lacks significant entrepreneurial risk, the arrangement constitutes a disguised payment for services regardless of the other factors. Even if an arrangement has significant entrepreneurial risk, the other factors may nonetheless indicate that the arrangement is a disguised payment for services. The Proposed Regulations set out a list of arrangements that are presumed to lack significant entrepreneurial risk (and, thus, constitute a disguised payment for services) unless other facts and circumstances can establish the presence of significant entrepreneurial risk by clear and convincing evidence. The arrangements that are presumed to lack entrepreneurial risk are: (i) capped allocations of partnership income if the cap would reasonably be expected to apply in most years, (ii) allocations for a fixed number of years under which the service provider’s distributive share of income is reasonably certain, (iii) allocations of gross income items, (iv) an allocation (under a formula or otherwise) that is predominantly fixed in amount, is reasonably determinable under all the facts and circumstances, or is designed to ensure that sufficient net profits are highly likely to be available to make the allocation to the service provider (for example, if the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods and this allocation does not depend on the overall success of the enterprise) and (v) arrangements in which a service provider either waives its right to receive payment for the future performance of services in a manner that is nonbinding or fails to timely notify the partnership and its partners of the waiver and its terms. The Proposed Regulations provide several examples to illustrate the application of the factors, including certain examples aimed to address common fee waiver arrangements. In example 3, M performs services for which a fee would normally be charged to partnership ABC, and M also contributes $500,000 in exchange for a 1 percent interest in ABC’s capital and profits. M is also entitled to receive a priority allocation and distribution of net gain from the sale of any one or more assets during any 12- month accounting period. A is a company that controls M and is also the general partner of ABC. A will be allocated 10 percent of the net profits and losses of ABC earned over the lifetime of the partnership and undertakes a “clawback obligation.” 4 Mayer Brown | Waiver Good‐Bye: Treasury Targets Management Fee Waiver Arrangements Favored by Private Equity Fund Managers The Proposed Regulations conclude that, in this example, the arrangement with respect to M is a disguised payment for services. The arrangement with M, according to the Proposed Regulations, lacks significant entrepreneurial risk because the facts indicate that the allocation to M is reasonably determinable under all of the facts and circumstances and that sufficient net profits are highly likely to be available to make the priority allocation to the service provider. The relevant facts to this determination were that the priority allocation to M is an allocation of net profit from a 12-month period and thus does not depend on the overall success of the enterprise, and that the timing of gains and losses is controlled by a company related to M. In contrast, Examples 5 and 6 of the Proposed Regulations illustrate fee waiver fact patterns that do not constitute a disguised payment for services. In Example 5, A is the general manager of ABC responsible for providing management services, but delegates that responsibility to M, a company controlled by A. The partnership agreement provides that A will contribute nominal capital to ABC, ABC will pay M an amount equal to 1 percent of the capital committed by the partners and A will receive an interest in 20 percent of the future partnership net income and gains measured over the life of the fund. A will also receive an additional interest in future partnership net income and gains determined by a formula (approximately equal to the present value of 1 percent of capital committed by the partner determined annually over the life of the fund), subject to a clawback obligation. The Proposed Regulations conclude that, in this example, the additional interest paid to A has significant entrepreneurial risk because the allocation is of net profits, the allocation is subject to a clawback obligation over the life of the fund, and the allocation is neither reasonably determinable nor highly likely to be available. In Example 6, the facts are similar to Example 5, except M is entitled to receive an annual fee in an amount equal to 2 percent of capital committed by the partners and the partnership agreement permits M to waive all or a portion of its fee for any year in exchange for an interest determined by a formula in subsequent partnership net income and gains (approximately equal to the estimated present value of the fee that was waived). M must provide written notice of its intention to waive the fee at least 60 days prior to the commencement of the partnership taxable year for which the fee is payable. The Proposed Regulations conclude that, in this example, the allocations do not lack significant entrepreneurial risk because the allocations are based on net profits, the allocations are subject to a clawback obligation and the allocations are neither reasonably determinable nor highly likely to be available. The preamble to the Proposed Regulations notes that the major distinctions between Example 3 and Examples 4 and 5 are that, in Example 3 the allocations do not depend on the long-term future success of the enterprise and a party that is related to the service provider controls the timing of the purchases, sales and distributions. It is also important to the conclusion in Examples 5 and 6 that the service provider waived its right to receive fees before the period begins in a manner that was binding, irrevocable and clearly communicated to the other partners. The Proposed Regulations would be effective on the date the final regulations are published and apply to any arrangement entered into or modified on or after that date, and the safe harbor in Revenue Procedure 93-27 would be modified at the same time. Although it appears that any arrangement entered into prior to such time would be grandfathered unless modified, this is not the case because the Proposed Regulations treat any subsequent fee waiver as a modification for this purpose. However, it should be noted that it is the position of the Treasury Department and the IRS that the Proposed Regulations reflect Congressional 5 Mayer Brown | Waiver Good‐Bye: Treasury Targets Management Fee Waiver Arrangements Favored by Private Equity Fund Managers intent regarding the treatment of disguised payments for services under current law. For more information about the topics raised in this Legal Update, please contact any of the following lawyers or any member of Transactional Tax practice. Jeffrey M. Bruns +1 312 701 8793 firstname.lastname@example.org Anne Marie Konopack +1 312 701 8467 email@example.com Mark H. 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