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 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 of Bell Canada, the largest 13, 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 1 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 n Weil Gotshal advised Providence to satisfy the qualifying income exception, and, as such, each of those publicly 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 1940 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 14, 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 perfor- mance 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 61 & 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. 2001-43). 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 (1) 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 would apply income from such services preclude

Weil, Gotshal & Manges llp  Private Equity Alert July 2007 application of the qualifying income [fund] managers are doing to earn be at least one more Senate Finance exception? Similarly, the legislation their income,” but Senator Baucus Committee hearing on the topics of introduced by Representative Levin similarly stopped short of advocating carried interest and publicly traded gives no indication as to what quantity one view over the others. partnerships, but any legislation of designated services constitutes a regarding the carried interest issue n Senators from both sides of the aisle “substantial quantity,” nor does it would likely move forward only after expressed concerns regarding not elaborate on when services will be the publicly traded partnership bill only the proposed legislation, but also deemed to be provided “in the active has moved out of committee. changing the current tax treatment conduct of a trade or business.” On a of carried interest in general. Senator With respect to the legislation intro- second level, there is uncertainty as to Charles Schumer (D-N.Y.) noted that duced by Representative Levin and whether either piece of proposed legis- while some changes to the current consideration of the carried interest lation will ever be enacted, either in its tax treatment of carried interest may issue by the members of the House current form or in a modified form. be warranted, he “will not stand for of Representatives, Chairman Rangel The proposal of legislation is only treating financial services partner- (D-N.Y.) has previously announced the first step in the legislative ships one way while all the other that the House Ways and Means process, and that process is often partnership are treated another Committee will conduct a hearing times a dynamic and unpredictable way.” Senator John Kerry (D-Mass.) “on the important issues surrounding one. On July 11, the Senate Finance expressed concerns that changes to private equity carried interest and Committee conducted a hearing titled the current tax treatment of carried publicly traded partnerships” after the “Carried Interest, Part I.” As part of interest would have some serious July 4 recess. “downstream” problems, although that hearing several interested parties 1. Entities taxable as partnerships do not pay issued statements and provided he would like to see clarification of U.S. federal income tax. Rather, the character exactly what would be considered and amount of a partnership’s items of remarks regarding not only the Baucus income, loss, deduction and credit “flow & Grassley proposed legislation, but services income versus investment through” to its partners, and each partner is income from capital gains. Senator subject to tax on its distributive share of such also their positions with respect to the items, irrespective of whether such partner proper tax treatment of income from Orin Hatch (R-Utah) noted that he receives distributions from the partnership. carried interest in general. Portions of believes changing the current taxation 2. In February 2007, Fortress Investment Group of carried interest would have the LLC raised approximately $634 million from some of those statements and remarks its public offering. On June 21, Blackstone effect of making investments seem Group LP raised $4.13 billion in the biggest are noted below. U.S. IPO in five years. less desirable and could eventually 3. On June 20, Representative Peter Welch (D- n The statement issued by Senator hurt efforts to encourage innovation Vt.) introduced legislation almost identical to Grassley reiterated that the legis- and new business, and Senators John the legislation introduced by Senator Baucus and Senator Grassley, except that the legis- lation proposed by him and Senator Ensign (R-Nev.) and Mike Crapo (R- lation introduced by Representative Welch Baucus is “about closing a loophole” Idaho) noted that any such changes contains no such transition rule. and would prevent “the long-term would be a threat to U.S. competi- 4. “Carried interest” refers to the dispropor- tionate percentage of fund profits to which the erosion of the corporate tax base.” tiveness in the financial sector. sponsor of the fund is entitled. For example, For the most part, Senator Grassley’s if a fund agreement provides that investors n Eric Solomon, Assistant Secretary will receive a return of their invested capital statement was focused on “private and, thereafter, profits will be shared 80/20 for Tax Policy, told the committee equity and managers that between the investors and the sponsor, respec- during his testimony that he views tively, the sponsor’s “carried interest” is 20% go public.” However, the statement of fund profits. the current tax treatment of carried did touch upon the tax treatment 5. E.g., On June 27, Treasury Secretary Henry interest as “consistent with our Paulson voiced objections to the legislation of carried interest in general, and introduced by Senator Grassley and Senator goals” of encouraging investment Senator Grassley noted that “[e]ven if Baucus. and reducing distortions in the current law is relatively clear, I would economic system, and that the Bush not call it a no-brainer that all of administration has “concerns and those [carried interest] profits should cautions about making significant and be treated as a return on investment potentially unsettling changes to the rather than a return on labor.” In treatment of carried interest.”5 his opening remarks to the hearing, Senator Baucus acknowledged that In comments to reporters after the “there are many views of what … hearing, Senator Baucus said there will

Weil, Gotshal & Manges llp  Private Equity Alert July 2007

Boston James Westra Back Issues of Private Equity Alert are available online at www.weil.com 617-772-8377

Recent Articles: Budapest David Dederick Going Semi-Private 011-361-302-9100 The Great Pushback Dallas Winning Management’s Vote – Alternative Approaches to Equity Compensation Glenn West 214-746-7780 FTC Heightens Antitrust Scrutiny of Private Equity Investments in Overlapping Companies Frankfurt Private Equity in Brazil: Opportunities and Challenges for Foreign Investors Gerhard Schmidt 011-49-69-21659-700 Lessons from the Front London Private Equity Market – The Best of Times Michael Francies SEC Proposes New Rules Affecting Private Equity Sponsors 011-44-20-7903-1170 Marco Compagnoni Fortress IPO – Start of the New New Thing? 011-44-20-7903-1547 Go-Shops: Are Sponsors Giving Away the Store? Munich Warning Shots Gerhard Schmidt 011-49-89-242430 The Art of Syndicating Your Deal Private Equity Firms Face Shareholder Class Action After Announcement of DOJ New York Antitrust Investigation Barry Wolf 212-310-8209 Canadian Income Trusts – Opportunity for Private Equity Sponsors? Doug Warner Debunking the Myth of the Sandbagging Buyer: When Sellers Ask Buyers to Agree to 212-310-8751 Anti-Sandbagging Clauses, Who Is Sandbagging Whom? Paris David Aknin 011-331-44-21-9797

Prague Karel Muzikar 011-420-2-2140-7300

Providence David Duffell 401-278-4700

Shanghai Steven Xiang 011-86-21-6288-1855

Silicon Valley Private Equity Alert is published by the Private Equity Group of Weil, Gotshal & Manges LLP, Craig Adas 767 Fifth Avenue, New York, NY 10153, 212-310-8000. The Private Equity Group’s practice includes 650-802-3020 the formation of private equity funds and the execution of domestic and cross-border acquisition and investment transactions. Our fund formation practice includes the representation of private equity Warsaw fund sponsors in organizing a wide variety of private equity funds, including buyout, , Pawel Rymarz distressed debt and real estate opportunity funds and the representation of large institutional 011-48-22-520-4000 investors making investments in those funds. Our transaction execution practice includes the representation of private equity fund sponsors and their portfolio companies in a broad range of Washington, DC transactions, including leveraged , merger and acquisition transactions, strategic investments, Robert Odle recapitalizations, minority equity investments, venture capital investments and restructurings. 202-682-7180 Editor: Douglas Warner ([email protected]), 212-310-8751 Deputy Editor: Michael Weisser ([email protected]), 212-310-8249

©2007. All rights reserved. Quotation with attribution is permitted. This publication provides general information and should not be used or taken as legal advice for specific situations that depend on the evaluation of precise factual circumstances. The views expressed in these articles reflect those of the authors and not necessarily the views of Weil, Gotshal & Manges LLP. If you would like to add a colleague to our mailing list or if you need to change or remove your name from our mailing list, please email [email protected], or call 646-728-4056. www.weil.com

Weil, Gotshal & Manges llp