If there is one thing that readers should take away from Monte Jackel’s analysis of the relevant tax law in Sun Capital, it is that business and deal professionals should consult with their M&A tax advisors to discuss the international tax structuring and M&A transaction traps and opportunities that may arise when private equity funds set up parallel partnerships that may share the same business objectives or ownership interests. Unlike most other countries, the United States may treat two legally separate partnerships as a single partnership for US federal income tax purposes in certain situations in which those partnerships share the same business objectives and owners. These “Deemed partnerships” may create many new and unforeseen U.S. taxation issues and administrative complexities. This can be a particularly shocking result for non-U.S. individuals and entities that do not consider such a business arrangement to be a deemed partnership. As Monte Jackel will describe in greater detail, the holding in Sun Capital has far-reaching implications for the US partnership tax issues in structuring of private equity funds. This article stresses the importance of discussing international tax structuring with an M&A tax consultant.
Note that this letter is reprinted from the letter first published in Tax Notes, Tax Analysts, Fairfax, VA, on April 25, 2015. See DOC 2016-8225. The letter has not been updated since that publication. Note that certain laws may have changed since the initial posting, and the analysis provided herein has not been updated for such changes.
To the Editor:
I read with interest both the news story (Marie Sapirie, “Business Test Met, Common Control Found in Sun Capital,” Tax Notes, Apr. 4, 2016, p. 23 ) and the underlying case (Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, No. 10-10921, D.C. Mass. (2016) ), which recently held that two private equity funds could be aggregated for purposes of finding liability under ERISA.
In so holding, the district court found that there was a “deemed partnership” between two private equity funds despite the fact that the funds were formally independent entities with separate owners. The court’s holding was based principally on the fact that it found that the investment and business decisions of the two funds were made ultimately under the direction of the same individuals. This was so even though the two funds at issue did not formally act as so-called “parallel funds”; that is, a group of funds that invest together at a fixed proportion (with U.S. and other taxable investors in one fund and foreign or other exempt investors in the other fund).
The key points made by the district court were:
Organizational formalities do not resolve the question of joint operation that tax law emphasizes in recognizing partnerships, whether those formalities delineate separate parallel or [separate] non-parallel funds.
Of course, individuals may create multiple businesses, using the same strategy, without necessarily putting all their enterprises into partnership with each other.
The two funds at issue “have separate financial statements, separate reports to their partners, separate bank accounts, largely non-overlapping sets of limited partners, and largely non-overlapping portfolios of companies in which they have invested. . . . The conventional theories of a general partnership — those that on the face reflect operational and institutional overlap between the funds — are not evident here.”
“A more limited form [of] partnership or joint venture . . . is nevertheless to be found, based on the present record. . . . Prior to entity formation and purchase, joint activity took place in order for the two Funds to decide to co-invest, and that activity was plainly intended to constitute a partnership-in-fact.”
“The Funds have not indicated . . . that they sometimes co-invested with each other but sometimes co-invested with other outside entities. Neither has evidence been adduced of disagreement [between the two funds] as might be expected from independent members actively managing and restructuring an industrial concern. The smooth coordination is indicative of a partnership-in-fact . . . of joining together and forming [a] community of interest.”
The court deemed to be highly significant that the two funds invested in the subject entity in a 70-30 ratio to avoid either fund from owning 80 percent of the subject investment and being in formal control, and that this pattern of behavior was repeated multiple times by the ultimate owners for other investments not at issue in the case.
When this case first came out several weeks ago, it struck me that the case could have important implications beyond ERISA. For example, U.S. law firms that want to combine or “merge” with foreign law firms frequently maintain a separate organizational structure of separate legal entities with certain common overall business objectives. The broadness of this case may implicate these international “virtual merger” law firm combinations by treating all or a portion of the combined business as one single global partnership for U.S. tax purposes. This would create U.S. tax issues for foreign partners and could also create foreign tax issues for U.S. partners. It is hard to tell exactly what impact this case will have on those structures. My point here is that caution is clearly warranted because the case at issue is clearly broad in its finding of a “deemed partnership.”
Similar issues may also arise with international groupings of accounting firms such as, for example, the so-called Big Four. Does this case mean that there is an increased risk of there being one worldwide global partnership for U.S. tax purposes for these firms even though great care is taken to keep the legal entities separate in their daily operations due to the overall joint global business objectives? Time will tell.
Monte A. Jackel
As Monte Jackel astutely notes, the implications of Sun Capital have the potential to reach far beyond ERISA liability claims. It is concerning that any joint activities between separate entities or individuals —not just those of an international law or accounting firm—may be vulnerable to characterization as a deemed partnership. Make sure to consult with a M&A tax advisor to ensure your business is not inadvertently characterized as a deemed partnership, and to learn how a deemed partnership may affect FIRPTA implications, withholding taxes, tax due diligence, tax basis step-ups, and interest expense limitations.