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Fantastic Tax Voyage January 22, 2009. Arnold May Proskauer Rose LLP [email protected] 617.526.9757. Chris DeMasi Deloitte Tax LLP [email protected] 212.436.4046 . Background. Fund: PEI Capital Vintage: 2006 Strategy: Buyout. Voyage #1 Distressed Debt. Purchase of Debt.

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Fantastic Tax VoyageJanuary 22, 2009

Arnold May

Proskauer Rose LLP

[email protected]


Chris DeMasi

Deloitte Tax LLP

[email protected]


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Fund: PEI Capital

Vintage: 2006

Strategy: Buyout

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Voyage #1Distressed Debt

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Purchase of Debt

  • Assumptions

  • Ordinary Income Tax Rate (individual) – 35%

  • U.S. Corporate Tax Rate – 15%

  • Capital Gain & Qualifying Dividend Tax Rate – 15%

  • Face Value of Debt is $10,000,000

  • Purchase price of Debt is $4,000,000



PEI Capital





Debt Holder

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Related Party Flow-Through Purchase of Portfolio Entity Debt





Debt Investors












Debt Holder

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Holder Debt

Holder recognizes discount as income on annual basis over term of the debt

Income is generally non-cash income

Income treated as interest

Income flows through to investors


Interest = ordinary income

Non-cash income – timing issue

If acquisition is leveraged, blocker formed for tax-exempt investors may be subject to 30% U.S. withholding tax on interest

Cash from Fund for tax distributions to investors?

Related Party Flow-Through Purchase of Debt –Holder & Investor Tax Consequences

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Foreign Corporation Purchases Debt of Portfolio Corporate Entity




















Debt Holder




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Potential Effect Entity

Issuer may not have CODI and limitations on interest deductibility for U.S. tax purposes

Upon exit possible for income to be subject to the dividend\capital gain income rate (15% tax rate) for U.S. investors

Acquisition leverage minimizes foreign taxation

Potential Issues

Qualification for treaty benefits

Certainty that not “related” for CODI purposes

Manage passive foreign investment company (“PFIC”) income

Minimize interest expense limitations if Issuer is a U.S. corporation

AHYDO; earnings stripping rules

“Unrelated” – technical vs. actual

Foreign Corporation Purchases Debt of Portfolio Corporate Entity

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Voyage #2 EntityDistressed LPs

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First Steps Entity

  • Review LPA

  • “Defaulting LP”:

    • Historic approach: automatic upon failure to fund

    • More recent approach: only after notice from GP that LP is late

  • GP remedies can be one or more of:

    • Forfeiture of all or a portion of LP’s interest

    • Forced sale of LP’s interest

    • Withhold distributions from LP

    • Collect fees on LP’s interest

    • Other

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Forfeiture of Interest Entity

  • Forfeiture of LP’s interest

    • Tax implications

      • Capital shift: not taxable vs taxable (and if taxable, character issues)


      • “Force” capital accounts through disproportionate allocations of gains and losses

    • Impact on other LPs

      • Aggregate fund size may be reduced

      • Ownership levels may trigger adverse tax consequences. Examples:

        • 10%, for eligibility under portfolio debt exception to 30% US withholding tax on interest paid to a non US person

        • 20% (or possibly 35%), for private foundation ownership of “excess business holdings”

      • What if forfeited interest includes amounts through blocker corps?

  • Management fees

    • Assess fees in respect of forfeited interest?

    • Anti-deferral provisions: Sections 409A and 457A

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Sale of Interest Entity

  • Publicly Traded Partnerships

    • Applies if partnership interests are (i) traded on an established market or (ii) readily tradeable on a secondary market or substantial equivalent thereof

      • Disregarded transfers include:

        • Carryover basis transfers

        • Transfers at death

        • “Block” transfers (>2%)

        • Qualified Matching Service (not > 10%)

      • Lack of actual trading (transfers, other than disregarded transfers, not > 2%)

      • Private placement exception (not more than 100 partners)

    • A PTP is treated as a corporation unless 90% or more of gross income consists of “qualifying income”

  • “Involvement” of the partnership required

    • Use economic assignment in lieu of transfer

    • Risks for Fund, buyer and seller

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Sale of Interest Entity

  • Basis adjustment issues

    • General rule: if partnership has a “substantial built in loss” immediately after a a transfer of interest, then partnership must adjust basis

    • Exception: “Electing Investment Partnership”

      • Consequence: Loss deferral for transferee

  • Other considerations


    • AIVs

    • Non tax regulatory limitations on ownership interests

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Other Considerations Entity

  • Credit facility of Fund

    • Impact on existing facility

    • Ability to use facility for capital due from Defaulting LP

    • UBTI implications

  • LP relations

  • Fiduciary duty issues

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  • Any tax advice included in this written communication was not intended or written to be used, and it cannot be used by the taxpayer, for the purpose of avoiding any penalties that may be imposed by any governmental taxing authority or agency.

  • This memorandum is not binding on the Service or the courts and should not be considered a representation, warranty, or guarantee that the Service or the courts will concur with conclusions. This memorandum covers only the specific tax issues and tax consequences described herein. No other federal, state, or local laws of any kind were considered and are beyond the scope of this memorandum. This memorandum is not intended for the express or implied benefit of any party. No party is entitled to rely, in any manner or for any purposes, on this memorandum.