Presentation on theme: "Panel: Update on tax issues impacting private equity real estate funds"— Presentation transcript:
1 Panel: Update on tax issues impacting private equity real estate funds Moderator: Harry Shannon, Tax Principal, Global Real Estate Group, Ernst & Young LLP Panel Members: Erica Herberg, Principal, The Carlyle Group David S. Miller, Partner, Cadwalader, Wickersham & Taft LLP
2 Real Estate Private Equity Fund Case StudyManagersInvestorsReal Estate Private Equity FundU.S. InvestorsOffshore hedge funds and CLOsAssume that the mezzanine loan will soon default and is probably worth about $.50/$1.00The PE fund would like to restructure the loan in a tax-efficient mannerMezz Borrower LLCMezz LendersMezzanine LoanREMICProperty Owner LLCSenior LendersMortgageUSActiveProperty
3 Tax Considerations Tax Issues for the PE Fund and Its Investors Cancellation of Indebtedness (COD) Income if the Debt Is CancelledGain Upon Foreclosure (Difference between Face Amount of Debt and Basis in Property) if the Property is ForeclosedTax Issues for Offshore Hedge Fund and CLO InvestorsTrade or Business Issues if Debt Is RestructuredFIRPTA, Trade or Business, and Withholding Issues if ForeclosureTax Issues for the REMICEnsuring that its mortgages remain “qualified mortgages”
4 Avoiding COD IncomeModify the Debt in a Manner that Does Not Give Rise to aTaxable Exchange for Tax PurposesTemporary ForbearanceTwo years following the issuer’s initial failure to performAny additional period during which the parties conduct good faith negotiations or during which the Issuer is in a title 11 or similar caseDefer Payments; Extend MaturityScheduled payments may be deferred for a period that begins on the original due date and extends for a period equal to the lesser of five years or 50% of the original term of the debt instrumentChange the YieldThe yield of the modified instrument may be changed so long as it varies by no more than the greater of:¼ of one percent (i.e., 25 basis points) or5% of the annual yield (0.05 x annual yield)
5 Avoiding COD Income (cont’d) Change the CollateralRecourse loan: Collateral may be released, substituted, added, or altered, or a guarantee or other credit enhancement added, so long as the change does not change payment expectationsNonrecourse loan: Cannot release, substitute, add or otherwise alter a “substantial amount” of the collateral for, or provide a guarantee or add credit enhancement, for a nonrecourse loan. However, collateral may be substituted if the collateral is fungible or otherwise of a type where there particular units pledged are unimportant
6 Avoiding COD Income (cont’d) Rely on the “Privately-Traded” Debt RulesIf the debt is not publicly traded, modify the terms of debt (i.e., extend maturity, provide for PIK interest, reduce interest rate to AFR), but do not change the principal amountTo avoid being publicly traded, debt must notbe listed on a national securities exchange,be listed on an “interdealer quotation system,”be listed on certain foreign exchanges or boards of exchange, orappear on a “system of general circulation” that provides a reasonable basis to determine fair market value by disseminating recent price quotations of one or more identified brokers, dealers or traders or actual prices of recent sales transactionsDebt-for-tax issuesIf the modified loan does not constitute debt-for-tax purposes, then COD income will arise
7 Real Estate Private Equity Fund Avoiding COD Income (cont’d)Have an “Unrelated Party” Acquire the Debt at a DiscountReal Estate Private Equity FundManagersInvestorsU.S. InvestorsOffshore hedge funds and CLOsREITIf the PE Fund were to buy the mezzanine loan for $.50/$1.00, the REIT would realize COD income under the “related party” rules of section 108(e)(4)Mezz Borrower LLCMezz LendersMezzanine LoanREMICProperty Owner LLCSenior LendersMortgageProperty
8 Real Estate Private Equity Fund Avoiding COD Income (cont’d)Have an “Unrelated Party” Acquire the Debt at a DiscountReal Estate Private Equity FundManagersInvestorsTwo corporations are not treated as “related parties” so long as five or fewer individuals do not own 50% or more of the value of eachAn Irish section 110 company or Luxembourg securitization company that qualifies for U.S. treaty benefits is needed to avoid 30% U.S. withholding tax on interest. (The REIT and the Irish/Lux company are related for portfolio interest purposes.)Irish section 110 companyREITInterestMezz Borrower LLCMezzanine LoanREMICProperty Owner LLCSenior LendersMortgageProperty
9 Real Estate Private Equity Fund Avoiding COD Income (cont’d)Have an Unrelated Party Acquire the Debt at a Discount and Enter Into a Total Return Swap with the Owner of the BorrowerReal Estate Private Equity FundManagersInvestorsInvestment BankTotal Return SwapREITInterestMezz Borrower LLCMezzanine LoanREMICProperty Owner LLCSenior LendersRisk that PE fund is treated as the “tax owner” of the mezzanine loan (which would cause the REIT to realized COD income).MortgageProperty
10 Section 108(i) Section 108(a) For debt cancelled in 2009 or 2010: COD income is deferred until 2014 andThen included ratably in each year from 2014 to 2018Section 108(a)If a taxpayer is insolvent or bankrupt, COD is not recognized, but tax attributes (NOLs, basis) are reduced on a dollar-for-dollar basis. (But if a partnership is the borrower, section 108(a) is applied at the partner level (i.e., the partners have to be insolvent or bankrupt).)
11 COD Versus Realization for Nonrecourse Debt A foreclosure on nonrecourse debt is treated as a sale of the property for the face amount of the debt.Assume that the debtor has $100 basis in property that is subject to $90 of debt and the property is now worth $50If $40 of debt is cancelled, the taxpayer realizes $40 of COD incomeIf the creditor forecloses on the property, the taxpayer has a $10 capital loss and no COD, even though the foreclosure is the economic equivalent of the cancellation of $40 of debt and a sale of the property for $50 (i.e., $40 COD and $50 capital loss)
12 Tax Issues For Offshore Hedge Funds and CLOs Workout ActivityThe IRS takes the position that origination activities cause an offshore fund or CLO that has a U.S. manager to be engaged in a “trade or business” in the United States and subject to U.S. corporate income tax IRS Office of Chief Counsel Memorandum (September 22, 2009)A workout that gives rise to a taxable event under section 1001 is treated as a redemption of the original loan and an origination of the modified loan.Working out a nonperforming loan will generally increase its value; the increase in value is entirely attributable to services performed in the United States (as opposed to changes in the credit of the borrower or changes in market conditions).
13 Tax Issues For Offshore Hedge Funds and CLOs (cont’d) Risk for offshore hedge fund or CLOLeast risk if the fund purchased a performing loan that was not expected to default, the debtor subsequently defaulted, and the U.S. manager is negotiating or agreeing to a workout to preserve its investmentMost risk if the fund purchases the loan when it is distressed in order to work it out and sell it at a profit.
14 Tax Issues For Offshore Funds and CLOs Owning Real Estate Income from the real estate subject to a 30% withholding tax or 35% net income taxGain on the sale of the real estate (measured from its value on the date of foreclosure) subject to 35% net income taxMany offshore funds are prohibited from directly owning real estateIf an offshore fund owns an interest in U.S. real estate, the real estate will often be held in a U.S. “blocker” corporation (and the fund may, in turn, hold this U.S. corporation through a foreign “blocker” corporation)
15 Tax Issues For Offshore Funds and CLOs Owning Real Estate (cont’d) Foreign FundCayman “blocker” corporationU.S. “blocker” corporationInterest in U.S. real property
16 Tax Issues For REMICs That Hold Distressed Real Estate Loans If a REMIC agrees to a “significant modification” of a mortgage loan when the loan is not in default or default is not “reasonably foreseeable,” the mortgage may fail to be a qualified mortgage, which could jeopardize the REMIC’s status as a REMIC. A REMIC’s governing documents may have other (non-tax) limitations on modifications.Revenue Procedure (September 15, 2009) expands the definition of “reasonably foreseeable” default and provides that a mortgage may be modified without losing its status as a qualified mortgage if there is a “significant risk of default” upon maturity or before based on a “diligent contemporaneous determination (including credible written representations from the borrower).” The risk of default may be a year (or possibly later) in the future.