On May 2, 2017, the Small Business Administration (SBA) published a notice (the May 2 Notice),1 delaying the effective date of the final rule of the Passive Business Rule (the New Rule)2 under § 107.720 of the small business investment company (SBIC) regulations that, among other things, expands the permitted use of holding companies when investing in qualifying small businesses.3 The New Rule now will not go into effect until August 18, 2017.
The New Rule was initially scheduled to become effective on January 27, 2017. Nonetheless, on January 26, 2017, the SBA postponed the effective date until March 21, 2017 and invited additional public comment on the New Rule. The initial delay and request for public comment was in response to a memorandum, dated January 20, 2017, from the Assistant to the President and Chief of Staff, entitled “Regulatory Freeze Pending Review,” which called for agencies, like the SBA, to temporarily delay the effective date of rules not yet effective. The initial delay was a result of a standard practice that occurs when there is a change in presidential administration. On March 21, 2017, the SBA again delayed the effective date of the New Rule until May 20, 2017 to allow the new administration time to further consider the New Rule’s impact on the SBIC program and its participants and to make necessary determinations regarding the effects of the New Rule on the examination and liquidation functions of the SBA’s Office of Investment and Innovation. However, unlike the initial delay, the SBA’s second delay did not invite additional public comment.
What the Latest Delay of the New Rule Means for BDCs with SBIC Subsidiaries
In the May 2 Notice, the SBA delayed the effective date of the New Rule and requested comments regarding whether the SBA should remove the provision benefitting SBICs with investors that elect to be taxed as a regulated investment company (RIC). This provision of the New Rule allows wholly owned SBIC subsidiaries of business development companies (BDCs) to hold certain investment assets that are structured as pass-through tax entities (such as partnership interests or limited liability company interests) in order to block income from flowing up to the BDC through the SBIC, which may disqualify the BDC parent from continuing to qualify as a RIC and obtaining favorable tax treatment available to it under Subchapter M of the Internal Revenue Code.
The SBA noted that there are currently 31 SBICs with BDC investors (BDC-SBICs) holding over 23% of SBA’s outstanding guaranteed leverage and articulated that, if the New Rule were to become effective in its current form, many BDC-SBICs would structure a number of their investments through passive entities. The SBA expressed concern that, because BDC-SBICs represent such a large percentage of SBA’s portfolio and in light of the increased complexities of investments structured through passive entities, the SBIC program could be exposed to an unacceptable level of risk if these SBICs structured a significant number of investments through blocker entities, unless the SBA were to significantly increase its examination and monitoring resources. Therefore, the SBA is considering revising the Final Rule to remove this provision, and comments must be submitted no later than June 1, 2017.
Currently, SBICs are permitted, with SBA prior written approval, to use a blocker corporation to protect any of the SBIC’s investors from incurring “unrelated business taxable income” (UBTI). The New Rule extends the permitted use of blocker entities to protect any of the SBIC’s investors from incurring “effectively connected income” (ECI). In the May 2 Notice, SBA expressed its expectation that the number of blocker entities used to protect against UBTI and ECI would be relatively low when compared with the anticipated use of blocker entities by BDC-SBICs to preserve the BDC’s RIC status. Thus, it appears that UBTI and ECI exceptions will be preserved once the New Rule becomes effective.
1 Small Business Investment Companies: Passive Business Expansion and Technical Clarifications, 82 Fed. Reg. 83 (May 2, 2017).
2 Small Business Investment Companies: Passive Business Expansion and Technical Clarifications, 81 Fed. Reg. 249 (December 28, 2016).
3 See our previous legal alert for a summary of the New Rule.