A Tax Planning “Hat Trick” for Funds Acquiring Portfolio Company Debt
As a result of the COVID-19 pandemic, many companies are having difficulty meeting payment obligations on their outstanding debt. However, thanks to a combination of the U.S.-Irish income tax treaty and Section 108 of the Internal Revenue Code of 1986, as amended (the “Code”), private equity funds (and other funds) may be able to find a silver lining and seize the opportunity to purchase debt of one or more of their portfolio companies at a substantial discount without incurring (i) cancellation of debt income (“CODI”), (ii) withholding tax on interest payments, or (iii) income tax on interest payments. How can a fund achieve this hat trick?
Generally under Section 108(e)(4) of the Code, acquisition of indebtedness by a person related to the debtor results in CODI to the debtor. The term “related” is used throughout the Code but with different attribution rules depending on the specific Code section. For purposes of Section 108(e) of the Code, two corporations are considered related if, very generally, they are brother-sister corporations (meaning that five or fewer individuals, estates, or trusts own at least 50% of the stock of each corporation) or they share a common parent corporation that owns at least 50% of each corporation’s stock).
As a result of the narrow definition of brother-sister corporation described above, a private equity fund with more than five owners may be able to use a wholly-owned Irish Collective Asset-management Vehicle (“ICAV”) (treated as a corporation for U.S. tax purposes) to purchase debt of a wholly-owned U.S. portfolio company at a discount without triggering CODI.
Using an ICAV that Qualifies for Treaty Benefits
Generally, unless an exception applies, interest paid by a U.S. borrower to a foreign person is subject to 30% withholding tax. However, in the case of an Irish entity (such as an ICAV) qualifying for the benefits of the U.S.-Irish income tax treaty, this rate is reduced to 0%.
A fund-owned ICAV would typically qualify for this treaty under an ownership/base erosion test, if 50% or more of the ICAV is owned by U.S. or Irish residents. The base erosion prong of this test is typically not an issue because ICAVs are exempt from Irish income tax.
The Hat Trick in Action
For purposes of this example, let’s assume a private equity fund which is more than 50% owned by U.S. persons (“Fund”) wholly owns Lipsticks Inc., a Delaware corporation (“Portfolio Company”). Fund purchased Portfolio Company several years ago with a mix of debt and equity. However, due to COVID-19, Portfolio Company has experienced a severe decline in revenue as people realized they will all be wearing masks for the next 12-18 months. Thus, Portfolio Company has been struggling to service its debt which has become distressed. Seeing this as a restructuring opportunity, Fund sets up a new wholly-owned ICAV which acquires outstanding debt of Portfolio Company at a substantial discount. Assuming that Portfolio Company and ICAV are not related for purposes of Section 108 of the Code (as discussed above), no CODI is created by reason of the acquisition. The ICAV should be able to benefit from the U.S.-Irish income tax treaty, and thus not be subject to U.S. tax on interest paid on the debt, and should not be subject to tax in Ireland on interest income and, to the extent there is full payment on the debt, on the purchase discount.
As simple as this sounds, there are many issues and nuances that need to be considered to properly implement this structure. To learn more, please reach out to your primary Kleinberg Kaplan contact or a member of our tax department.
Further, Kleinberg Kaplan, in partnership with two other firms, plans to have a webinar on this topic in the near future. Please let us know if you are interested in receiving an invitation to the webinar.