In a recently released Internal Revenue Service (“IRS”) Chief Counsel Advice, CCA 201501013 (Sept. 5, 2014) (the “CCA”), the IRS concluded that the activities of a fund manager (“Fund Manager”) to originate loans on behalf of an offshore private fund (the “Fund”) should be attributed to the Fund, and that, as a result, the Fund was engaged in a lending business that constituted a U.S. trade or business (“USTB”). The IRS further concluded that this lending activity was not eligible for the trading safe harbors (“Trading Safe Harbors”) in Section 864(b)(2)(A)(i) of the Internal Revenue Code, which prevent certain trading income from constituting a USTB. The net impact of these conclusions was that any direct foreign investor in the Fund, which was classified a partnership for U.S. federal tax purposes, and the foreign feeder entity (“Foreign Feeder”), which was presumably established as a blocker corporation for foreign investors and U.S. tax-exempt entities, would be subject to U.S. federal income tax (possibly on a gross basis if no income U.S. federal income tax returns were filed) on any income that was effectively connected with the lending business, and in the case of any corporate investor, including the Foreign Feeder, possibly a 30% branch profits tax on such income.
The CCA addresses what appears to be a typical offshore master feeder fund structure. The Fund, which was located in a non-treaty jurisdiction, engaged the Fund Manager as an investment manager pursuant to a management agreement. The management agreement “appointed Fund Manager as Fund’s agent and irrevocable attorney-in-fact with full power to buy, sell, and otherwise deal in securities and related contracts for Fund’s account.” The Fund’s investments included convertible debt instruments, promissory notes and stock. The IRS characterized the activities engaged in by the Fund Manager relating to Fund’s investments in convertible debt and promissory notes as “lending” activities, and noted that:
On behalf of Fund, Fund Manager negotiated directly with borrowers concerning all key terms of the loans. Before agreeing to make a loan, Fund conducted extensive due diligence on a potential borrower. Often, Fund lent borrowers money in return for debt instruments that were convertible into the borrowers’ stock at a future date. Typically, the conversion prices were discounted from the trading prices of the borrowers’ stock, determined at the time of conversion. After converting a debt instrument into stock at a discount, Fund sought to earn a spread by quickly disposing of the stock. Fund often received other property in connection with its lending agreements, including warrants to purchase additional shares of borrowers’ stock. Borrowers also paid Fund various fees. Aside from Fund Manager, no other entity participated in Fund’s lending activities.
Based on these facts, the IRS easily concluded that the Fund was engaged in a lending business in the U.S. It further concluded that the Fund was not a “trader” because it did not seek to profit from buying and selling the securities acquired from borrowers, but rather sought to profit from fees, spreads, and interest. The IRS’s conclusion on these issues in the CCA is not surprising in light of its previous position in A.M. 2009-10 (Sept. 22, 2009), which concluded that the loan origination activities of an agent of a foreign corporation (presumably a foreign bank or other financial institution) should be attributed to the foreign corporation even though the agent was not authorized to conclude contracts on behalf of the foreign corporation. Nonetheless, this CCA is significant because it is the first guidance in which the IRS has concluded that a fund manager’s activities on behalf of a fund were sufficient to conclude that the fund was engaged in a lending business in the U.S.
Interestingly, in addition to its loan origination activities, the Fund also entered into distribution agreements with unrelated issuers that entitled the issuer to periodically issue and sell shares of stock to the Fund. The Fund would acquire the shares at a discount and immediately resell them, often in pre-arranged sales. The IRS characterized this as an “underwriting” business and concluded that it also constituted a U.S. trade or business. It further concluded that these activities resulted in the Fund becoming a dealer for purposes of the Trading Safe Harbors. This conclusion was significant because a dealer, unlike a non-dealer, is not eligible for the Trading Safe Harbors if it conducts its activities in the U.S. through a “dependent” agent. The IRS concluded that the Fund Manager was a dependent agent because it had discretionary investment powers on behalf of the Fund. As a result, any income effectively connected with this underwriting business would also be subject to U.S. income and other taxes in the same manner as the income from the lending business.
Although this CCA is interesting for the reasons discussed above, it leaves open a number of important issues that are relevant to private funds that invest in U.S. debt and their investment managers. For example, the CCA fails to provide any guidance as to how many loans a Fund may originate each year or over its investment horizon without becoming engaged in a lending business. In this respect, the number of loans originated each year by the Fund has been deleted from the CCA. In addition, the ruling is not clear as to which activities of the Fund were essential to the conclusion that it was a lender. Most of the facts are set forth in a conclusory manner and there is no discussion as to which activities the Fund could have engaged in without crossing this line to become a lender. Further, the CCA provides no guidance to private funds that invest in loan syndication arrangements that are negotiated by unrelated third parties rather than their investment managers. Finally, because the CCA involved a Fund established in a non-treaty jurisdiction, it provides no guidance as to whether a treaty might prevent a fund manager’s activities from being attributed to a private fund.