Canada: Appellate Ruling Against Sun Capital Presents Challenge To Foreign Investors In U.S. Private Equity Funds

In a recent court decision involving Sun Capital Partners IV, LP ("Fund IV"), a private equity fund managed by the Florida-based Sun Capital investment advisor group (the "Investment Advisor"), the First Circuit Court of Appeals held that Fund IV may be liable for unfunded benefits of a multiemployer pension fund of a bankrupt company in which Fund IV had invested. Although the liability at issue in Sun Capital was not a tax liability, the case could potentially be relevant to the U.S. federal tax treatment of foreign investors in U.S. private equity funds. The statute at issue in Sun Capital, 29 USC §1301(b)(1), provides that trades or businesses under common control are treated as a single employer upon which the pension withdrawal liability can be imposed. The court concluded that Fund IV's activities as a private equity fund were sufficient for Fund IV to be treated as a "trade or business" for this purpose. This designation is potentially significant to foreign investors in private equity funds because the test for determining the taxability of a foreign investor on its share of the gains recognized by a private equity fund is whether or not the fund is engaged in a trade or business in the United States Although the court did indicate that its holding did not require it to conclude that Fund IV's activities were sufficient for it to be treated as engaged in a trade or business for tax purposes, the court nevertheless insisted that its conclusions were consistent with the longstanding case law in the tax area holding that passive investors in stocks and securities are not engaged in a trade or business.1 The Sun Capital case thus represents a challenge to foreign investors in private equity funds who rely on those authorities (or on the Internal Revenue Code's statutory securities trading exemption) for the position that they are not engaged in a U.S. trade or business.

The Sun Capital court referred to several factors that supported the conclusion that Fund IV was a trade or business. These factors included: (1) statements made in the Sun Capital funds' private placement memos to the effect that it would be actively involved in the management and operation of the companies in which it invests; (2) similar statements appearing in the Sun Capital funds' partnership agreements, which also empowered the general partner of Fund IV to make decisions about hiring, terminating and compensating agents and employees of the funds and their portfolio companies; and (3) actions taken by the Sun Capital funds to replace directors and provide consultants who were immersed in details involving its management and operation of the bankrupt portfolio company. However, the fact to which the court seems to have attached the most weight was that management fees paid by Fund IV's portfolio companies to its general partner entitled Fund IV to an offset against the management fees Fund IV otherwise would have been obligated to pay its general partner. The court considered this factor to be so significant that it declined to hold that a second Sun Capital fund that had invested in the same portfolio company was a trade or business absent a finding that the other fund received a similar benefit from an offset of the management fees paid to its general partner by the bankrupt portfolio company, and the court remanded the case to the lower court for a resolution of that factual point. In addition, the court found that this fee offset represented a significant difference between the facts in the case before it and those addressed by the tax cases on the trade or business issue. In the court's view, the fact that Fund IV derived an economic benefit from the management activities of its general partner in the form of the fee offset meant that the general partner was performing those management activities as an agent of the private equity fund.

Sun Capital is troubling in part because most private equity funds provide for an offset of fees the manager earns from the portfolio companies against their proportionate share of the general partner's management fee. As a technical matter, reimbursed fees should not cause recognition of gross income at all, so the attribution of the management fees to the fund seems questionable. Moreover, since Fund IV itself was not providing the services to the portfolio company, it would seem that if there was a gross income item includible by the fund, it should have been dividend income.

Sun Capital is also relevant to foreign governmental investors who rely on the section 892 governmental exemption.2 The section 892 exemption is not available for income derived from a partnership that is engaged in a commercial activity. In addition, an exempt controlled entity of a foreign government may be disqualified entirely from the section 892 exemption if it is viewed as indirectly engaged in a commercial activity through a partnership. We suspect that the Sun Capital case will not cause any changes in operation of the industry, but if Sun Capital were viewed as changing the legal landscape, then consideration should be given to the use of special purpose blocker corporations for investments in private equity funds, especially if the fund features a general partner management fee offset like the one present in Sun Capital. Proposed regulations under section 892 would protect a governmental entity from being disqualified by reason of engaging in a commercial activity inadvertently or as a result of an investment in a partnership as a limited partner if the governmental entity does not have rights to participate in the management and conduct of the partnership's business. However, the income earned from such an investment is still not eligible for the section 892 exemption.

Footnotes

1. Higgens v. Commissioner of Internal Revenue, 312 U.S. 212 (1941); Whipple v. Commissioner of Internal Revenue, 373 U.S. 193 (1963).

2. IRC §892.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions