Updates for hedge funds and private equity funds

ERISA exposure increases for private equity funds: The Sun Capital decision

On July 24, 2013, the US Court of Appeals for the First Circuit endorsed the view of the Pension Benefit Guaranty Corporation that a private equity fund can be held jointly and severally liable for the unfunded pension obligations of its portfolio companies. On Aug. 8, 2013, the First Circuit denied a petition for a rehearing filed by private equity funds associated with Sun Capital.

The active role that the management company of the fund (the general partner) had in the portfolio company (Scott Brass Inc., aka SBI) was attributed to the fund itself. The court found that both the general partner and the fund were engaged in a trade or business for ERISA purposes. The court gave significant weight to the fact that the fees paid to the general partner by SBI partially reduced the two percent annual management fees that the fund would otherwise have to pay the management company. The court was careful to note that the analysis it followed was limited to ERISA purposes and that the analysis to determine whether a fund is a trade or business for tax purposes may be different.

The importance of this case goes beyond the specific ERISA pension liability issue and raises the question of whether there may be unrelated business income of tax-exempt pension plans and/or effective connected income for foreign investors. Further, the court’s interpretation that the funds were engaged in a trade or business opens the door for the income the fund receives on its "carried interest" to be considered ordinary income rather than capital gains.

The implications of Sun Capital are being hotly debated in the tax practitioner community and we are continuing to analyze the decision.

New temporary identified mixed straddle regulations

On Aug. 1, 2013, the IRS issued temporary and proposed Treasury regulations addressing identified mixed straddle transactions.

An identified mixed straddle involves a section 1256 contract and a non-section 1256 contract. The previous rule required the recognition of a built-in gain or loss of any position included in an identified mixed straddle on the day prior to its establishment. Often taxpayers with capital loss carry-forwards that were ready to expire would enter into an identified mixed straddle to generate capital gains for the purpose of offsetting their capital loss carry-forward.

The new temporary regulations state that the built-in gain or loss is not recognized. Instead, the taxpayer must determine the amount of built-in gain or loss at the time the transaction is executed and the built-gain or loss will be recognized when realized. However, the other Internal Revenue Code provisions that require the recognition of gain or loss were not changed.

The temporary regulations are prospective on their face. Previous transactions would not be challenged if the taxpayer complied with the mixed straddle provisions.

FATCA news

On Aug. 14, 2013, the Cayman Islands government agreed to sign a Model 1 intergovernmental agreement (IGA) and entered into a new tax information exchange agreement (TIEA) with the US government. The IGA and TIEA should be signed formally in September or October this year.

It is good news for investment funds located in the Cayman Islands as the US government will treat the territory as having an IGA in place for FATCA purposes. Therefore, compliance with FATCA will be greatly reduced, and there will be no need for Cayman foreign financial institutions (FFIs) to enter into an agreement with the IRS, although they will still need to register with the IRS.