Deferment across the fund

New provisions to the IRS code will likely mean more work and communication between the partners to US private equity funds where there is the option to defer cancellation of indebtedness income.

Section 108(i) of the IRS Code grants temporary relief from COD income to certain taxpayers who restructure or repurchase debt in 2009 and 2010, as is the case with many private equity firms. Those who do repurchase or restructure an “eligible debt instrument” during those two years can generally elect to defer any COD income that the taxpayer would otherwise recognise for five years, according to a client memorandum released by Clifford Chance.

In addition, recently issued IRS Revenue Procedure 2009-37 allows partnerships such as private equity funds to apply Section 108(i) selectively on a partner-by-partner basis, as well as being able to defer either zero, part or all of a given liability. “For partner A they can elect zero deferral, partner B they can elect 100 percent deferral and for partner C they can elect 60 percent deferral, and those elections can be made on a liability-by-liability basis,” says Noel Brock, partner and partnership tax practice leader for Grant Thornton.

The ability to make the deferral election might apply in situations where certain partners qualify for other exclusions from Section 108(i) – such if they are insolvent or are in a Chapter 11 bankruptcy case – but where other partners do not. But while the election to defer has to be made at the partnership level, this can be complicated if a partner already qualifies for another exception or exclusion.

“Since the statue came out we’ve been scratching our heads wondering about the disconnect,” Brock says. “If you have already qualified for one of these exclusions – you have a partner who is in Chapter 11, a partner that is insolvent – they may not want to make the 108(i) election, they may want to use their other exclusion. But if you have some partners who are in Chapter 11 or are insolvent and some who are not, then the partnership is caught between a rock and a hard place: how can it make everyone happy?”

By allowing elections to be made for part or all of a liability, on a liability-by-liability basis and on a partner-by-partner basis, the revenue procedure alleviated this concern, he says. But at the same time it has also created additional issues of its own.

For example, Rev. Proc. 2009-37 will likely mean extra burdens for many private equity fund managers. “If they have cancellation of indebtedness income and they are considering making a 108(i) election, they should have a policy regarding how to deal with the flexible nature of the section 108(i) election,” he says. “This might mean asking each partner to verify whether it does or does not want an election pursuant to section 108(i) to be made on its behalf and, if so, in what amount. And although this revenue procedure doesn’t really require it, I would want that verification in writing to protect me. This would put the onus on the manager to really understand his or her partners’ individual tax situations and understand whether any of them qualify for other exclusions prior to making a section 108(i) election.”

The revenue procedure also states that if a foreign partnership is not required to file a US federal income tax return, the partnership can still make a Section 108(i) election for its COD income if so desired by its US partners, according to Clifford Chance. This could come up for a fund that owns a portfolio company and it has a CFC (Controlled Foreign Corporation) in Luxembourg, and that Luxembourg entity forms a partnership with a French company, but there is no requirement to file a US tax return because there is no US trader interest.

“Even those entities have the ability make elections under 108(i) to exclude COD income, and if so there are reporting requirements for those entities,” Brock said. “In my mind if I were a manager of a fund or any partnership I would not want to the 1089(i) election without talking to the partners first.”