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.


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.

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