Private Equity Alert

Private Equity Alert July 2007 Congress Turns its Attention to the Taxation of Weil News Investment Funds and Sponsors n Weil Gotshal advised the investor By Keith Cooper ([email protected]) group comprised of Providence Equity Partners, the Ontario Teachers’ Pension Plan Private Two pieces of legislation have been introduced in Congress over the course of Capital Group, Madison Dearborn the past few weeks that, if enacted in proposed form, would affect the taxation of Partners and other Canadian investment funds and/or the sponsors of such funds. The first piece of legislation investors in the C$51.7 billion was introduced by Senator Baucus (D-Mont.) and Senator Grassley (R-Iowa) on June leveraged buyout of Bell Canada, the largest leveraged buyout 3, and provides that the “qualifying income exception” applicable to publicly in history according to The Wall traded partnerships does not apply to partnerships that directly or indirectly Street Journal derive income from providing investment advisory and related asset management n Weil Gotshal advised Lehman services. The second piece of legislation was introduced by Representative Sander Brothers in connection with the Levin (D-Mich.) on June 22, and provides, in part, that net income and gain $22.2 billion acquisition Archstone- associated with an “investment services partnership interest” is treated as ordinary Smith Trust by Tishman Speyer Properties and Lehman Brothers income from the performance of services. n Weil Gotshal advised Avaya Inc., Baucus & Grassley Legislation a leader in web-based corporate phone equipment, in its $8.2 billion Under current law, a “publicly traded partnership” is generally taxable as a corpo- sale to Silver Lake Partners and ration. However, if 90% or more of the gross income of the partnership for each TPG Capital taxable year is “qualifying income” (generally passive investment income, such n Weil Gotshal advised an investor as dividends, interest, real property rents and natural resources royalties) and group led by Macquarie Infra- certain other conditions are met, the partnership is not taxed as a corporation, but structure Partners and Macquarie Communications Infrastructure instead is taxed as a partnership. The foregoing exception to the publicly traded Group in the $1.4 billion acquisition partnership rules is often referred to as the “qualifying income exception.” of Global Tower Partners, the leading US wireless tower operator The entities subject to the recent Fortress and Blackstone public offerings purport to satisfy the qualifying income exception, and, as such, each of those publicly n Weil Gotshal advised Providence 2 Equity Partners in connection traded entities is expected to be taxable as a partnership under current law. with its acquisition of a majority Concerns have been raised in the press and among various members of Congress equity interest in NexTag Inc. that such tax treatment is inequitable and/or has the potential to erode the for $830 million corporate tax base. The legislation introduced by Senator Baucus and Senator n Weil Gotshal advised Lee Equity Grassley is intended to address those concerns. Partners and Union Square Partners in connection with their The legislation introduced by Senator Baucus and Senator Grassley makes the participation in the equity financing qualifying income exception unavailable for any partnership that directly or of the $630 million acquisition by Universal American Financial Corp. indirectly has any item of income or gain (including capital gains and dividends), of Member Health Inc. the rights to which are derived from services provided by any person acting as n Weil Gotshal advised TPG Capital an “investment adviser” or as a “person associated with an investment adviser” and TPG-Axon Capital in their sale (in each case, as defined in the Investment Advisers Act of 940 and determined of a 12.45% stake in German without regard to whether the person is required to register as an investment telecommunications provider adviser). A similar prohibition would apply to any partnership deriving income freenet AG to Berlin-based private investment firm Vatas from “asset management services” where such services are provided by a person of Private Equity Alert July 2007 the type described in the preceding If the proposed legislation were for purposes of determining whether sentence. If enacted in its proposed enacted in its current form, the the publicly traded partnership form, the legislation would apply distributive share of partnership net satisfies the qualifying income to all taxable years of a partnership income allocable to an “investment exception. Consequently, a publicly beginning on or after June 4, 2007, services partnership interest” for traded partnership would be taxable except that a five-year transition rule any partnership taxable year would as a corporation if (i) the publicly would apply to certain partnerships generally be treated as ordinary traded partnership held an interest that are either publicly traded or have income for the performance of in a partnership, (ii) the interest a registration statement filed with the services, and the distributive share constituted an “investment services SEC on or before such date.3 of partnership net loss allocable to partnership interest” (e.g., because an “investment services partnership the publicly traded partnership Levin Legislation interest” for any partnership taxable provided a “substantial quantity” of The legislation introduced by Repre- year would generally be treated as investment-related advisory services sentative Levin focuses on the tax an ordinary loss (subject to certain to the lower-tier partnership), and treatment of the “carried interest” limitations, carryforward rules, and (iii), for any taxable year, income received by the sponsors of investment basis adjustment rules). Similarly, or gain attributable to such interest funds taxable as partnerships.4 Specifi- any gain on the disposition of an (together with any other “bad” cally, it provides that net income and “investment services partnership income) equaled or exceeded ten gain associated with an “investment interest” would generally be treated percent of the publicly traded services partnership interest” is treated as ordinary income for the perfor- partnership’s gross income. as ordinary income from the performance of services, and any loss on the The legislation introduced by Repre- mance of services. Income so treated disposition of such an interest would sentative Levin does not provide is subject to a maximum federal rate generally be treated as ordinary loss for an effective date and would not of tax of 35% and is subject to taxes (again, subject to certain limitations apply for purposes of determining imposed on self-employment income, and basis adjustment rules). whether a REIT satisfies the asset and regardless of the character of the income tests of Section 856 of the income at the partnership level. To the extent the distributive share of net income or net loss attrib- Internal Revenue Code. In addition, The proposed legislation defines an utable to an “investment services the proposed legislation does not “investment services partnership partnership interest” is reasonably address whether the mere receipt of an “investment services partnership interest” as any interest in any allocable to invested capital, the interest” is a taxable event, and, partnership if the person holding such rules described immediately above thus, the issuance and receipt of such interest directly or indirectly provides would not apply. In that case, the an interest would continue to be to the partnership a “substantial character of the holder’s distributive governed by the applicable authorities quantity” of certain specified share of partnership items would be under current law (e.g., Sections 6 & investment-related advisory and determined at the partnership level 83 of the Internal Revenue Code and managerial services, but only if such (i.e., the character of partnership Rev. Proc. 93-27 & Rev. Proc. 200-43). services are provided “in the active items would “flow through”). The conduct of a trade or business.” The purpose of this exception is to permit a Going Forward types of services designated in the service provider to enjoy capital gains There are two levels of uncertainty proposed legislation are () advising treatment, like other investors, to the with respect to both pieces of proposed as to the value of specified assets, (2) extent of his pro rata capital contri- advising as to investment decisions legislation. On one level, there is butions. A similar exception would with respect to specified assets, (3) uncertainty as to how the legislation apply to gain or loss realized on the managing, acquiring, disposing of, would be applied if it were enacted in disposition of an “investment services or arranging financing for specified its proposed form. For example, with partnership interest” where a portion assets, and (4) “any activity in support respect to the legislation introduced by of such gain or loss is reasonably of” such services . For purposes of Senator Grassley and Senator Baucus, allocable to invested capital. the foregoing, “specified assets” are what types of services constitute generally defined as securities, real Where a publicly traded partnership “asset management services” and estate, commodities, and options or holds an interest in another will even a de minimis amount of derivative contracts thereon. partnership, such rules

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