Congress recently enacted additional legislation in its continuing effort to crack down on abusive tax shelter transactions. Although the new rules are designed to target tax-exempt entities serving as “accommodation parties” in tax shelter transactions, the rules have a potentially much greater scope and could be read to apply to fairly standard investments. The rules impose stiff penalty taxes on most types of tax-exempt entities that participate (whether knowingly or unknowingly) in what are referred to as “prohibited tax shelter transactions.” In addition, the new rules impose an excise tax (of $20,000) on “entity managers” (broadly defined) of tax-exempt entities who approve the entity as a party or otherwise cause the entity to be a party to a transaction that the manager knows or has reason to know is a prohibited tax shelter transaction.
How do the new rules work?
What is a “prohibited tax shelter transaction?”— Prohibited tax shelter transactions (“PTSTs”) consist of what are known as “listed transactions”—transactions that are, or are substantially similar to, transactions the IRS has specifically identified as tax avoidance transactions and are listed on the IRS website—as well as two other categories of transactions that are already subject to reporting requirements, “confidential transactions” and “transactions with contractual protection.” Although listed transactions are generally aggressive tax shelter transactions, questions may arise as to whether a legitimate transaction could be found to be substantially similar to a listed transaction (for a time, there was a concern that certain swap transactions could be found to be substantially similar to a listed transaction involving notional principal contracts). A confidential transaction is a transaction offered under conditions of confidentiality and for which a taxpayer has paid an advisor a minimum fee. A transaction with contractual protection is a transaction for which a taxpayer has the right to a full or partial refund of fees if the intended tax consequences from the transaction are not sustained or for which fees are contingent on the taxpayer’s realization of tax benefits.
Who does the tax apply to?—All tax-exempt entities, other than qualified pension plans, IRAs, and similar taxfavored savings arrangements (“Pension Plans”), are potentially subject to the basic tax, including public charities,
churches, hospitals and schools, private foundations, and government entities such as state retirement plans and Indian tribal governments. In addition, “entity managers” of tax-exempt entities, including entity managers of Pension
Plans, are potentially subject to the $20,000 excise tax. When is a tax-exempt entity a “party to the transaction?”— The tax may be imposed on a tax-exempt entity, or the entity manager, only if the entity becomes a “party” to a PTST. Neither the statute itself nor a subsequently issued IRS Notice addresses when indirect involvement in a PTST (such as through another entity) will result in the entity being a party to the transaction (although as discussed below, the legislative history provides a helpful discussion).
Who is an entity manager?—In the case of entities other than Pension Plans, the term “entity manager” means the person with authority or responsibility similar to that exercised by an officer, director or trustee and, with respect to any act, the person having the authority or responsibility over the act in question. In the case of Pension Plans, the term means the person who approves or otherwise causes the Pension Plan to be a party to the PTST. (An individual beneficiary or owner can only be liable as an entity manager if it has broad investment authority under the arrangement.) This clearly covers in-house managers, and has been read as covering external managers and advisors as well.
How is the tax computed?—A tax-exempt entity that is a party to a PTST will have to pay a tax equal to 35% of the greater of (a) 100% of its net income attributable to the transaction and (b) 75% of the proceeds received by the entity that are attributable to the transaction, for the year in which the entity becomes a party to the PTST and each subsequent year. (The term “proceeds” is not defined, and could even be read as including every dollar received in a
transaction, even those representing a return of capital.)
However, if the tax-exempt entity knew or had reason to know that the transaction constituted a PTST at the time it entered into the transaction, the excise tax will equal 100% of the greater of (i) 100% of its net income attributable to the transaction and (ii) 75% of the proceeds received by the entity that are attributable to the transaction. In addition, a tax of $20,000 can be imposed on each entity manager of a tax-exempt entity who approved the entity’s becoming a party to the transaction and knew, or had reason to know, that the transaction was a PTST.
Additional reporting requirements—A tax-exempt entity must report to the IRS its participation in a PTST and the identity of any other parties known by the tax-exempt entity to be participating in each such transaction. A taxable party to a PTST must report to each tax-exempt entity which is a party to the transaction that the transaction is a PTST.
How does all of this apply to private equity funds?
Could an investment by a tax-exempt entity in a private equity fund itself be a PTST? Some tax lawyers have expressed concern that the confidential nature of a private equity fund’s documents could cause the fund itself to be a confidential transaction. We do not believe this should be the case. A number of funds have chosen to foreclose any concern by adding “tax exception” language (which gives investors the right to disclose the tax treatment and tax aspects of the fund) to the confidentiality provisions in the fund’s private placement memo and partnership agreement. (Many funds had already included this language when confidential transactions were merely subject to disclosure.) The influential New York State Bar Association Tax Section report (the “NYSBA Report”) calls such “magic language” unnecessary, and many funds refuse to include it.
Could a private equity fund be a transaction with contractual protection? The American Bar Association’s comments to the legislation when it was in proposed form note that customary agreements by investment managers not to expose exempt organizations to the tax on unrelated business taxable income could be construed to involve contractual protection. (The NYSBA Report believes such treatment is not appropriate and recommends that guidance be issued to that effect.) This raises the question, what about a private equity fund that agrees to use commercially reasonable efforts to avoid certain transactions that may generate unrelated business taxable income? We think it would be a stretch to view such a covenant as constituting contractual protection.
What if a private equity fund invests in a PTST? The conference report to the new rules states that certain indirect involvement in a PTST would not result in an entity being considered to be a party. Giving as an example an investment in a mutual fund that in turn invests in a PTST, the report says that the tax-exempt entity would not be a party to the PTST “absent facts or circumstances that indicate that the purpose of the tax-exempt entity’s investment
in the mutual fund was specifically to participate in such a transaction.” The report goes on to say that the determination will be informed by whether the entity or entity manager “knew or had reason to know” that investment of the entity would be used in a PTST. In the case of a typical private equity fund, the limited partners are investors in a blind pool whose offering documents give no indication that the fund will invest in a PTST. It is hard to see how the fund’s tax-exempt investors would be found to be parties to any investment in a PTST to be made by the fund under this reasoning. We note that listed transactions in particular seem to be unlikely investments for typical private equity funds, which have a variety of investors with widely varying tax profiles. Nonetheless, the NYSBA Report notes that well-advised tax exempts already routinely are asking for side letter agreements with funds in which the fund represents that the tax-exempt investor will not be a party to a PTST by reason of an investment in the fund.
Could the fund’s general partner or manager be viewed as an “entity manager” of a limited partner that is a tax-exempt entity? Although the language of the statute seems broad enough to cover this, because the limited partner would have to be viewed as a party to the transaction undertaken by the fund in order for the entity manager to be subject to tax, we think is generally unlikely that a fund general partner or manager would have any liability as an “entity manager” under these rules.
Status of the New Rules
The new rules are fully effective. On July 11, 2006, the IRS issued a Notice explaining the new rules to tax-exempt entities and requesting public comments on the new provisions in anticipation of additional guidance. Over 90 comment letters were received. On September 19, Treasury announced that they are reviewing the comments and expect that they will provide guidance “soon.” Many commentators have criticized the law as overbroad. For the meantime, until further clarification is forthcoming, taxexempt investors and fund managers should consult their tax advisors as to the applicability of these rules to their specific investments and funds.
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