Investment structures designed for private equity fund investments generally should permit tax efficient operations of the acquisition target and tax efficient partial, or full, exits. It is important both to minimize taxes payable on the cash-on-cash return and also to minimize dry (or phantom) income (i.e., taxable income without cash to pay the tax) for the fund investors. This article discusses the use of pre-acquisition check-the-box elections to accomplish these important tax planning goals in connection with investments by US private equity funds (or other funds with US investors) outside the US.
Some of these goals may be achieved by causing the fund's acquisition vehicle to make an election to treat the acquisition of stock of a target corporation as a purchase of assets pursuant to Section 338 of the Internal Revenue Code. A 338 Election is available to a corporation that makes a ?qualified stock purchase (or ?QSP?) of the stock of another corporation. Generally, a QSP is the acquisition by ?purchase of at least 80 percent of the stock of the target corporation (determined by vote and value) within a 12-month period by the acquiring corporation (and certain affiliates). ?Purchase means a transaction, other than one in which the acquirer's basis in the stock of the target corporation is determined, in whole or in part, by reference to the basis of the selling shareholder. In other words, the purchaser corporation generally must acquire at least 80 percent of the stock of the target corporation in a taxable transaction. Thus, the fund's historic ownership of more than 20 percent of the stock of the target, the retention of stock by a significant minority of target investors, or the rollover of management or other existing investors' interests' in the company in a manner that would be tax-free under US tax principles, may preclude the making of a 338 Election.
The US ?check-the-box regulatory regime may make it possible to achieve nearly the same results that a 338 Election would when the 338 Election is not available. Except for certain listed entities that are always treated as corporations, most non-US entities may elect to be characterized as either corporations or partnerships (or, in the case of single member entities, disregarded entities) for US federal income tax purposes. The election is made on a form which, aside from certain identifying information, requires only two boxes to be checked (hence the nickname ?check-the-box regulations? ). Since US corporations may not elect to be treated as disregarded entities or partnerships for US tax purposes, this article focuses on acquisitions of foreign corporations.
The technique involves making an election to treat the target corporation as a disregarded entity (in the case of a single-member entity) or a partnership (in the case of an entity with more than one member) for US federal tax purposes, effective as of the closing date. If such an election is made, the regulations provide that the target corporation will be deemed to have liquidated immediately prior to the close of business on the previous day. The election is effective only for US federal tax purposes. Accordingly, it should have no effect on the target corporation other than for US tax purposes. If the seller is not a US person, the election should have no effect on the seller. In fact, even if there are one or more US sellers, the effect on these sellers, other than those rolling over or retaining an interest in the company or the acquisition vehicle, may be limited.
If the fund's acquisition vehicle acquires 100 percent of the target corporation's shares in a taxable transaction, then the transaction will be treated as the purchase of the assets of the target corporation, and the target will be treated as a disregarded entity (i.e., like a branch of the acquisition vehicle) for US federal tax purposes. If the purchase involves management's or existing investors' rolling their interest in the target into the acquisition vehicle, or retaining an interest in the target corporation, such that the acquisition vehicle does not purchase all of the shares of the target, the transaction may be viewed as the purchase of an interest in a partnership. The check-the-box election may be combined with a Section 754 election to step up the basis of the assets related to the acquired portion of the target corporation (other with respect to the portion of the assets acquired in a tax-free rollover). Using this strategy, basis step-up in the assets may be obtained automatically so long as the seller is not a corporation that owned at least 80 percent of the stock of the target corporation since the deemed liquidation would be considered a taxable event for US tax purposes. If the seller is a corporation that owns at least 80 percent of the target, the liquidation would be tax-free under US tax principles and, thus, there would be no resulting basis step up unless the acquisition vehicle acquires all of the shares of the target in a taxable transaction, or causes a Section 754 election to be made.
The pre-acquisition check-the-box technique presents several possible benefits. The tax basis in the assets is marked to market value as a result of the deemed asset purchase. The historic earnings and profits of the target are eliminated. Additionally, earnings and profits of the target are reduced in future periods by increased depreciation and amortization, including, importantly (and subject to certain ?anti-churning rules), amortization of goodwill and going concern value. If the target corporation is foreign (which is the focus of this article) a fund with US investors nearly always should consider whether a Section 338 election or the alternative pre-acquisition check the box election is desirable.
Assume that private equity fund creates a non-US Newco to acquire a target corporation. Due to the rollover of management shareholders, who will acquire over 20 percent of Newco in a manner that would be tax free under US tax principles, no 338 Election is available. However, Target elects to be treated as a flow-through vehicle immediately before the acquisition with the results described in the previous paragraph. In this case, any income and deductions of Target will be treated as income and deductions of Newco. Distributions by Newco to the fund will be treated as dividends to the extent of earnings and profits of Newco, and thereafter, return of capital and capital gain. As mentioned, the check-the-box election would have eliminated any historic earnings and profits. Moreover, the check-the box election would have resulted in a deemed taxable liquidation of Target, giving acquisition vehicle a fair market value basis in the assets. Thus, higher depreciation and amortization deductions (coupled with interest deductions if Newco has leveraged its investment) would have reduced current earnings and profits, perhaps to zero so that any distribution would be treated as a tax-free return of capital.
Additionally, if Newco were a controlled foreign corporation (i.e., generally, a non-US corporation more than 50 percent of the stock of which, determined by vote or value, is owned by US persons, each of whom own at least 10 percent of the voting stock), then 10 percent US shareholders of Newco would be required to include in income their proportionate share of certain of the income of Newco whether or not such income is distributed. However, the amount required to be included under these rules is limited to Newco's current earnings and profits. Accordingly, the pre-acquisition check-the-box elections could limit any inclusions pursuant to these rules applicable to US shareholders of CFCs. Similarly, if Newco were a passive foreign investment company (?PFIC, which, generally speaking, is a non-US corporation if more than 75 percent of the gross income is passive, or more than 50 percent of the average assets of the corporation generate passive income or no income), the pre-acquisition check-the-box election could reduce earnings and profits and, thus, reduce the amount to be included in income by US persons who elect to include their proportionate share of the income of Newco in order to avoid the adverse rules applicable to owners of PFICs at the time of extraordinary distributions or disposition of shares. Finally, if Newco sells Target, it would be treated as a sale of assets. A sale of stock would be treated as Subpart F income if Newco were a CFC. However, the deemed asset sale would give rise to Subpart F income only if the assets give rise to passive income (or, except in the case of business assets, no income).
Check-the-box elections can be made effective up to 75 days prior to the date of filing. Pre-acquisition check-the-box elections necessitate sellers' cooperation. Generally, the entity classification election form can be signed by any officer, manager or member of the electing entity who is authorized (under local law or the entity's organizational documents) to make the election. However, the regulations provide that every person who was a member on the date that the liquidation is deemed to occur, but who is not an owner at the time that the election is filed must sign the election. Similarly, in the case of a retroactive election, each person who was an owner between the date the election is effective and the date it is filed, and who is not an owner at the time the election is filed, must also sign the election. Accordingly, if an authorized officer or member does not sign and file the election by the date of closing, then the private equity fund may have the unwieldy task of getting signatures from all sellers. (As a practical matter, this should be done the day before closing, as it is note ntirely clear that the sellers' will be considered to be owners for the entire closing date for this purpose). Accordingly, in order to take advantage of the benefits described herein, itis wise to discuss the intention to use this technique with sellers well in advance of closing and to have the election be a pre-closing condition in order to ensure that the check the box elections are filed the day before closing.
Steven D. Bortnick is a counsel in the tax and private equity groups of international law firm Dechert. Mr. Bortnick devotes a significant portion of his time structuring cross-border private equity transactions, and holds a masters in tax law from New York University.