ETB or not ETB?

US mezzanine firms fear being labeled as lenders, which can mean a tax of as much as 35 percent.

Are mezzanine firms engaged in lending or investing?

It’s a rather annoying question, but with potentially significant implications for foreign LPs of US mezzanine debt funds. According to US tax law, non-US people and entities tied to financial activities in the US can be taxed under two circumstances: first, if they have income from the US in the form of interest and/or dividends, and second, if they are deemed to be engaged in trade or business (ETB) in the US.

An important safe harbor has been created for foreign entities that exempts them from the definition of ETB. According to the US tax code, trade or business is not “effecting, through a resident broker, commission agent, or custodian, of transactions in the United States in commodities… or in stocks or securities.”

Traditionally, the IRS and the US Treasury Department have viewed investing as not a “trade or business,” while lending – the primary business of banks – is indeed ETB.

In recent years however, non-bank institutions have become important sources of debt finance to the US market, and the legal community serving these groups have struggled to include them in the tax code’s safe harbor. Hedge funds, for example, frequently will buy syndicated debt, but because they have not originated the loan, these transactions are generally not seen as ETB.

Other non-bank entities, however, do indeed frequently originate loans, and as such run the risk of being labeled lenders, which would expose their foreign investors to “effectively connected income” (ECI).

Then there are mezzanine debt firms, which provide subordinated financing to many private equity deals. Are their mezzanine funds, hence limited partners, engaged in lending, or are they investing in securities? According to a recent report on this topic put out by the New York City Bar Association, many forms of debt instruments are already defined as “securities” for the purposes of this safe harbor.

But mezzanine investment activity is not clearly defined by the code. “The law is simply not settled,” says Daniel Dunn, a partner in the tax practice of law firm Dechert. “While the markets have developed guidelines for practice in the area, there is little guidance from the government to provide any real certainty.” Dunn notes that the IRS and possibly the Treasury Department are currently weighing whether or not to further define the line between lending and investing, given the shifts in the market.

The stakes are high for non-US limited partners. Being tagged with ETB can mean a tax of as much as 35 percent – enough, perhaps, to make an LP think twice before backing a US mezzanine fund.

Japan ups registration requirements for funds
In the country’s biggest change in financial regulations in 20 years, Japan has introduced new laws that expand the scope of regulated instruments to include products like derivatives, hedge funds and private equity funds; enhance disclosure by publicly listed firms; outline provisions affecting the operation of self-regulation in exchanges; and increase criminal penalties for securities violations. The reconstituted Japanese Securities and Exchange Law, now known as the Financial Instruments and Exchange Law, will bring the country’s regulations closer to international standards and will enhance transparency in the sector. Financial statements must now be certified, and companies will be required to report earnings quarterly, as do their US and European counterparts. Private equity or venture capital partnerships that invest more than 50 percent of their assets in securities will not be exempt from the disclosure requirements, unless they use the newly created private placement exemption to avoid the registration requirement. Under the new law, the maximum penalty for illegal securities transactions has been raised to 10 years, from three years before.

Congress puts brake on PE tax hike
US Senate Majority Leader Harry Reid has admitted that the various proposals to increase taxes on private equity firms will not pass before the end of 2007 due to the tight schedule on Capitol Hill. The industry has spent no small amount of money on lobbyists to defeat the hikes. Blackstone alone spent $3.74 million on lobbyists as of June 30 of this year, up 3,000 percent from the same period last year. Reid’s spokesman, Jim Manley, said in an e-mailed response to the Washington Post: “Given the difficulty in getting any legislation through the Senate and the little time left this year for moving other issues important to the American public, it is unclear whether there is sufficient time to address the appropriate tax treatment of private equity firms.” Regardless of the reasons, if the legislation doesn’t pass this year, there’s a slim chance for the proposal to pass in 2008, as lawmakers and lobbyists agree that Congress is always wary of passing tax increases during election years.

BVCA plans radical overhaul
Private equity’s public image in the UK is set for an overhaul to be led by its new chief lobbyist Simon Walker. Walker will be taking over as chief executive of The British Private Equity and Venture Capital Association from Peter Linthwaite, who resigned after failing to defend the industry in front of the UK Treasury Select Committee this summer. Hopes are high for Walker, who was most recently senior advisor to the chairman and CEO of the Reuters Group, to stave off criticisms of the industry as politicians increase private equity’s tax bill.

Wol Kolade, BVCA chairman, said: “With his background in campaigning, journalism, Whitehall and Brussels and his broad experience of communications at some of the highest profile institutions and companies in Britain, he has got just the mix of skills that we are looking for.” One of Walker’s first tasks will be to increase BVCA’s membership fees to fund its organizational overhaul. Some buyout firms have said they will support the move to raise fees by as much as three times if it means that the trade group will be better equipped to defend the industry.

New classification system for venture trusts
The UK’s Association of Investment Companies has introduced a new classification system for venture capital trusts (VCT). Six new sub-sectors have been created to expand on the current “specialist” and “generalist” categories. The new sectors are VCT Generalist; VCT AIM Quoted; VCT Specialist: Healthcare and Biotechnology; VCT Specialist: Environmental; VCT Specialist: Media, Leisure and Events; and VCT Specialist: Technology. The new system also distinguishes between VCTs according to the three year investment requirement rule, namely that investors must have at least 70 percent of their investments in qualifying investments, which must be invested within three years of a VCT’s launch. “This will allow investors to distinguish more easily between VCTs that are fully invested and avoid the distortions that VCTs that have not yet met the investment criteria can have on performance averages,” said Daniel Godfrey, director general of AIC, in a statement.

Schumer plans US carry tax proposal
US Senator Charles Schumer, an influential member of the Senate Finance Committee, has said he will introduce legislation that will raise taxes on carried interest. But unlike an existing proposal from Sander Levin, a Michigan member of the US House of Representatives, Schumer’s proposal would raise tax on carried interest for all partnerships, including private equity, hedge funds, oil and gas, timber, real estate and agriculture. Schumer, a Democrat who represents New York City, is viewed as an opponent to additional tax on carried interest, given his finance-industry constituents and Wall Street campaign donors. By introducing legislation that affects a broader set of partnerships, Schumer may in fact be attempting to kill enthusiasm for the tax raise among lawmakers whose constituents include energy industry, agricultural and other powerful business interests. “My intent is to raise the most revenue and do it in a fair way,” Schumer said in an interview with Bloomberg.

Bain’s 3Com deal draws US scrutiny
A deal that pairs Chinese telecommunications firm Huawei Technologies with Bain Capital in the acquisition of publicly traded 3Com is drawing scrutiny from the US government over worries that the impending transaction comes with a risk to national security. Bain Capital has agreed to a national security review of the $2.2 billion buyout. The deal would give a minority stake in 3Com to Huawei, which reportedly has close ties to the Chinese government. In a statement, Bain Capital said: “We believe the US government review in this matter will conclude that the company will be firmly controlled by an American firm, have only a small minority foreign shareholders, and the deal presents no risks to national security.” Huawei has not received good press in the past – the company has fought allegations that it once breached UN Iraq sanctions. 3Com has previously pursued transactions with Huawei.

New US-Canada protocol eases burdens
Cross-border deals between the US and Canada should be made less painful thanks to a newly signed tax treaty, made effective in late September. The new treaty, the culmination of 10 years of negotiations, was signed by Henry Paulson, the US Treasury Secretary, and Jim Flaherty, Canada’s Finance Minister. Among the enhancements to US-Canada trade are: the elimination of withholding taxes on cross-border interest payments; the extension of treaty benefits to limited liability companies; a requirement that certain key double tax issues, such as transfer pricing, be settled through arbitration; a recognition of certain tax issues surrounding pension contributions; and a clarification on how stock options are taxed. Nancy Hughes Anthony, president and chief executive of the Canadian Bankers Association, said in a statement that the new protocol would “result in increased investment, reduced cost of capital, and more efficient North American capital markets.”