Chipping away at the investor exception? Implications of the YA global case for foreign investors in US private funds

On November 15, 2023, the United States Tax Court held in YA Global v. Commissioner that a private fund specializing in Private Investment In Public Equity ("PIPE") transactions was engaged in a "United States trade or business" ("US trade or business") within the meaning of United States Internal Revenue Code ("Code") section 864(b) for the taxable years 2006 through 2008.  

The court held further that all of the fund's earnings during the relevant period—a combination of gains, interest, dividends, and fee income—were "effectively connected" with the fund's US trade or business, such that the earnings constituted "effectively connected income" or "ECI" for US tax purposes in the hands of the fund's offshore feeder corporation.  

The decision leaves the fund potentially facing more than $57 million in unpaid withholding tax, plus interest and penalties.  

This aim of this alert is to distil the key lessons and takeaways from the YA Global case from the perspective of a foreign high-net worth individual, trust, or family office investing in US-based alternative funds.    

The practical upshot of YA Global is that foreign investors in US-based private funds could face more serious US tax leakage than had previously been assumed.  In the wake of the decision, foreign investors in US alternative funds should consider negotiating at the subscription stage for covenants and indemnities against the specific tax risks and vulnerabilities that the YA Global opinion has brought to the fore.

It should be noted that the decision deals with a number of additional issues not addressed in this alert.

Background and Context

From a US federal tax perspective, non-US ("foreign") investors are treated very differently than their US counterparts.  Unlike a US investor, who is subject to US federal income tax on his or her worldwide income and gains regardless of source, a foreign investor is taxed only on: (i) certain passive US-source income; and (ii) ECI.  If a fund vehicle is structured as a partnership for US tax purposes, then the fund's partners are generally treated for US tax purposes as if they incur their pro rata share of the fund's earnings directly.   A foreign limited partner's allocable share of a fund's gain on the sale or exchange of its securities positions can, in certain instances, be "sourced" to the partner's foreign tax residence (even if the offices of the fund, general partner, and management company are all based in the United States).  Thus, if the fund is structured appropriately, a foreign limited partner may have zero direct or indirect US federal income tax on his or her share of the fund's portfolio exit gains (on the grounds that those gains are considered to be foreign-source income outside the scope of US federal income tax).

However, if the fund's earnings are regarded as "effectively connected income" or "ECI," the tax outcome for foreign investors is much less favourable.  A foreign limited partner who incurs a share of fund-level ECI is subject to US federal income tax at net rates ranging from 20% to 37% (or higher, where the investor is a foreign corporation subject to the so-called "branch profits tax," a dividend-like surtax which is intended to establish rough tax parity with domestic corporations engaged in similar activities).  Moreover, a foreign partner who is allocated even a single dollar of fund-level ECI during a particular taxable year is also required to file a non-resident US federal income tax return for that year.   

To guard against these outcomes, many funds try to insulate their foreign partners from incurring any direct ECI exposure by, for example, interposing a so-called "blocker corporation" as an intermediate feeder entity between the ECI-sensitive foreign limited partner and the main fund partnership (or by deploying the use of blocker corporations in other, more sophisticated ways).

The risk of ECI exposure at any level of a fund structure—whether at the foreign investor level or the blocker corporation level—turns on whether fund is considered to be engaged in a "US trade or business" in the first place.   Unhelpfully, neither the Code nor the Treasury Regulations offer any comprehensive guidance on what it means for a taxpayer to be engaged in a US trade or business.  The traditional test, derived from a line of older judicial decisions, asks whether the taxpayer's US-based activities are "continuous, regular, and engaged in for profit."  This nebulous standard is subject to a host of carveouts and per se rules, some of which operate in favor of the taxpayer and others in favor of the Internal Revenue Service (the "IRS").   

On the taxpayer-favourable side of the coin, courts have concluded previously that activities associated with selecting and managing a taxpayer's own financial investments cannot rise to the level of a "US trade or business" regardless of how much of that activity takes place in the United States (the "Investor Exception").    Private funds that acquire and hold portfolio equity positions on a long-term basis—such as private equity and venture funds—often maintain that they are mere "investors" in their target companies, relying on the Investor Exception to shield their foreign partners from ECI exposure in respect of the fund's exit gains.  Second, a Code-based safe harbor allows foreign entities to "trad[e]" securities or commodities positions for their own account on active and continuous basis without crossing the "US trade or business" threshold (the "Trading Safe Harbor").   Funds that turn over portfolio positions more frequently, such as hedge funds, typically rely heavily on the Trading Safe Harbour for the view that their foreign partners should not have to incur any ECI.

On the other hand, an entity carrying out an active "banking, financing, or similar business in the United States" will generally be deemed to be engaged in a US trade or business on that basis alone.   For that reason, credit, workout, and distressed debt funds tends to be especially careful when it comes to insulating their foreign partners from any ECI because these kinds of activities create an enhanced risk of creating a US trade or business by reason of the active banking or financing rule.  By way of illustration, credit funds will sometimes arrange their activities such that a separately owned affiliate of the fund or the general partner conducts all material loan negotiation, structuring, and/or origination activities with target issuers, subsequently proceeding to sell the "seasoned" debt interest to the main fund once these loan origination and structuring activities have been fully completed (the "season and sell" strategy).   Funds with a heavy credit emphasis will also sometimes require their investors to be resident in countries which have a double tax treaty in effect with the United States because treaty-resident investors generally have an ability to claim that they should not be subject to tax on any ECI unless and until the fund has a so-called "Permanent Establishment" in the United States (a presence threshold which is different to, and generally more taxpayer-favourable than, the US trade or business test).  Separately, the Code states that the "performance of personal services" at any time during the year by a foreign person or entity is generally a per se US trade or business.  Partly in cognizance of this rule, in cases where a fund's general partner or management company earns advisory, consulting, underwriting, execution, or similar fees from its underlying portfolio companies, the fund's organizational documents are often set up such that these fees accrue directly to an affiliate of the fund sponsor rather than to the main fund vehicle, in order to avoid tainting the main fund vehicle with any bad services income.   Management fees owed from the fund to the fund sponsor are then typically "offset" by any fees earned by lower-tier portfolio companies so that the fund's investors are not paying for the same services twice.

The Case and Implications

The fund at issue in the recent Tax Court case was YA Global Investments LP ("YA Global"), a Cayman master fund that focused on bespoke financing for low-priced public companies traded in the over-the-counter public markets.   YA Global had two affiliated feeder entities—a Cayman corporation established for the benefit of its foreign investors (the "Offshore Feeder") as well as a US partnership feeder for its US investors (the "Onshore Feeder").   YA Global's investment advisor and principal sponsor entity was Yorkville Advisors ("Yorkville"), based in Jersey City, New Jersey.  

During the period at issue, YA Global acquired a host of different securities in its portfolio companies, including convertible debentures, standby equity distribution agreements ("SEDAs"), and other similar securities straddling the debt/equity borderline.   A typical SEDA required YA Global to commit to purchasing up to a specified dollar value of a portfolio company's stock over a given time period, with the fund ultimately receiving shares at a discounted price.   Under the terms of the SEDAs, the fund was often required to advance capital to the portfolio company before purchasing its equity securities.  The convertible debenture instruments also generally gave YA Global the ability to convert to equity in the target at a discounted price.  Portfolio companies were frequently obligated to pay Yorkville and/or YA Global various commitment, execution, and other fees.  YA Global would often re-sell any portfolio company stock it acquired under the terms of a convertible debenture to other market participants, often waiting to exercise the conversion feature in the convertible debentures until it was confident that it had secured a market for the stock.  Likewise, YA Global would typically sell any stock it received under a SEDA shortly after acquiring it.

The court concluded that YA Global had been engaged in a US trade or business for the period under scrutiny.  Crucially, the court did not specify precisely what kind of trade or business YA Global had carried out; it suggested that there was no need to attach any particular label to YA Global's activities in order to reach that conclusion given that the fund could not prove that its activities were fully protected under the Investor Exception or Trading Safe Harbor.  While the court intimated that YA Global was involved in some combination of an underwriting services business and/or an active lending business, it refrained from stating that explicitly in the opinion.  The court placed special emphasis on the various fees earning by the fund as part of the SEDA and convertible debenture transactions, suggesting that these fees were received in exchange for what amount in substance to underwriting and other financial services furnished to the fund's portfolio companies (and hence a US trade or business under the per se rule for services income).  YA Global refuted this contention by arguing that these activities should fall within the umbrella of the Investor Exception and/or Trading Safe Harbor because they were in substance part of the portfolio companies' cost of capital—the economic equivalent of interest and/or option premium payments despite being labelled as fee income.  In this vein, many of the fund's expert witnesses contended that these payment streams were part of the embedded economics of the financial instruments themselves rather than separate fees for services.   The court was ultimately unpersuaded by these arguments and ruled in the IRS's favor.

Some of the broad-brush language in the court's opinion suggests that if any part of the fund's economic return on its portfolio investments can plausibly be attributed to services provided to the portfolio company by the fund, then some or all of that return might be treated as ECI solely on that basis.  In perhaps the most ominous passage of the court's opinion, the court remarked that "when the purchaser of a security goes beyond simply deciding whether to purchase a security on the terms offered and arranges and structures the transaction in which the security is issued, the issuer realizes a benefit beyond the receipt of capital."  This sentence should trouble private equity funds that actively structure and manage the companies in their investment portfolio and which up to now will have relied on the Investor Exception to shield their foreign partners from ECI leakage.

Having decided that YA Global was engaged in a US trade or business for the relevant period, the court went on to conclude that all of YA Global's earnings during the relevant years were effectively connected with that trade or business.

Takeaways for Foreign Investors:

• Increased US ECI Tax Risk.  For foreign investors in US-based private funds, the risk of serious ECI tax leakage is materially greater now than before the YA Global decision came down.  The IRS may view the opinion as giving it a license to pursue US-connected funds and/or their foreign partners more aggressively on US trade or business or ECI theories.  In addition, funds may now take more conservative stances on the issue from the outset, changing how portfolio company investments are structured and/or self-reporting a greater quantum of ECI tax liability than before.
• Beyond the "Blocker".  The case also illuminates the important distinction between simply "blocking" a foreign limited partner from direct ECI and/or US return filing exposure, on the one hand, versus going the extra distance of sheltering that investor from indirect ECI exposure at all levels of a fund structure.   The vast majority of YA Global's foreign investors during the period at issue were corporate shareholders in the fund's Offshore Feeder vehicle.  The ultimate foreign investors therefore would have been protected from direct ECI exposure and a return-filing requirement regardless of the outcome of the case.   The precise issue was whether the master fund had failed to comply with the foreign partner ECI withholding requirements under Code section 1446 (and by implication whether the Offshore Feeder itself had ECI liability for the years at issue) – there had never been any suggestion that the fund's foreign limited partners should be directly liable to the IRS for any unpaid ECI tax.   Nonetheless, most private fund limited partnership agreements are drafted such that the equityholders of any foreign blocker entity in the fund structure must bear the economic cost of any ECI liability suffered at the blocker level.  This, in turn, means that any blocker-level ECI liability will significantly affect the foreign investors' after-tax yield in much the same way as if it had been incurred directly, in an "unblocked" fund structure.  
• Bad Fact Make Bad Law?  While the facts in YA Global were fairly unique, it is unclear whether the Tax Court intended to limit its holding to these unique facts or whether the decision may spell trouble for more conventional private equity funds.  As a matter of market practice, most private equity and venture fund vehicles do not earn fee income directly from the fund's portfolio companies.  To the extent the fund's management company or sponsor earns fees from target companies, there is usually a "management fee offset" provision in the fund's limited partnership agreement to ensure that the sponsor does not receive a double economic benefit—once from the portfolio companies and then again from the fund in the form of fund-level management fees.  While that arrangement is not completely risk-free—a 2013 Federal Court of Appeals case called Sun Capital suggests that the IRS might recharacterize these formal arrangements to treat the fund as earning funds directly from the portfolio companies—it at least give private funds a robust reporting position that this incidental fee income should not trip them into US trade or business territory.   YA Global's business model was apparently very different—in that fund structure, the master fund ostensibly did receive significant streams of fee income either directly from its portfolio companies or indirectly from Yorkville.  Plain-vanilla private equity or venture funds might maintain that the decision should not affect them because YA Global's business model was anomalous and uniquely difficult to shoehorn into the Investor Exception or Trading Safe Harbor concepts.   Yet a close reading of the Tax Court's rhetoric suggests that it may place little weight on distinctions of this kind.   The court seemed to indicate in certain passages of the decision that it would have reached the same or similar conclusions regardless of whether YA Global had received actual fees for these services or instead had embedded these returns within the terms of the securities it acquired from its portfolio companies.  The IRS might marshal some of these far-reaching opinion passages to argue that much of the advisory, consulting, and management activities carried out by traditional private equity funds are enough to tip the fund into "US trade or business" territory;  in support of this view, the IRS might claim that the economic returns on portfolio company exits in these kinds of fund structures will invariably come down to some combination of invested capital as well as management, structuring, consulting, and similar services rendered in the runup to the exit transaction.  
• The ECI "Cliff Effect".  Once the Tax Court had decided that YA Global was indeed engaged in a US trade or business during the relevant period, it proceeded to conclude that all of the fund's earnings during that period were taxable ECI, not simply the portions which were labelled as fee income.  This illustrates the potential for an ECI "cliff effect" in cases where a US-based fund is found to have crossed the US trade or business threshold.  Accordingly, getting the threshold "US trade or business" question wrong can have dramatic and outsize effects on its foreign partners' after-tax yield on invested capital.
• Subscription Process.   It remains to be seen whether most US-based private funds will adapt their subscription materials to account for the YA Global decision—for example, whether the tax matters sections of Private Placement Memorandums ("PPMs") will evolve to include more circumspect language on the US trade or business issue or seek to insert pro-fund exculpation clauses, pared-back tax representations, or indemnity carveouts in their limited partnership agreements.   Foreign investors must be vigilant against the possibility that funds may attempt to foist the increased ECI risk onto them and should be prepared to push back with proposed limited partnership agreement markups, markups to the subscription materials, or side letter requests.

Withers LLP has an established track record in advising and protecting the legal and tax interests of foreign investors subscribing for interests in US private funds.