United States: Final Noncompensatory Partnership Options Regulations Could Affect The Tax Treatment Of Penny Warrants And Other Arrangements

Last Updated: July 3 2014
Article by Lisa B. Petkun and Brian Allen

Investments in partnerships (and other pass-through entities such as limited liability companies treated as a partnership) often involve the acquisition of warrants, options or other rights to acquire securities. This is often because the investor either (i) does not want to be an actual partner in the partnership for tax purposes or (ii) wants the potential for an equity upside in connection with a debt financing transaction without currently being considered to be a partner for tax purposes. Whether the investment security achieves those goals depends on whether the security is respected as a separate instrument or is treated as exercised for tax purposes.

In 2013 the U.S. Treasury Department finalized regulations addressing when noncompensatory options (also called investment warrants1) will be treated as equity for federal tax purposes. Under the regulations, nominally priced investment warrants will be treated as equity for federal tax purposes if both (i) the investment warrant provides for rights that are similar to an owner of the underlying security and (ii) there is a strong likelihood that the failure to treat the investment warrant holder as the owner would result in a substantial reduction in the present value of the aggregate tax liabilities of the investment warrant holder and the owners. Penny warrants raise a significant risk that the warrants will be treated as equity. Equity treatment may cause: foreign investors to be liable for filing U.S. tax returns and paying U.S. taxes; tax-exempt investors to have "unrelated business taxable income" (UBTI); and taxable U.S. persons to have taxable income without the right to receive a tax distribution.

Federal Tax Consequences of Nominally Priced Investment Warrants in Partnerships that Are Treated as Equity

If the investment warrant is treated as an equity interest, the holder will be treated as a partner in the issuing partnership for all federal tax purposes.2 A holder that is treated as a partner in the issuing partnership will be allocated income, gain, loss, deduction or credit of the investment warrant issuer to the extent of its "interest in the partnership" (taking into account all facts and circumstances).3 While the rules determining a holder's "interest in a partnership" are quite complex, certain situations would clearly lead to the allocation of income, gain, loss, deduction or credit to the holder. For example, if the investment warrant is classified as equity under the tests described below and the terms of an investment warrant grant the holder a right not to only share in the future upside of the partnership but also to share in partnership capital in an amount that exceeds the exercise price of the warrant, the holder should be considered to have an "interest in the partnership." In this case, income, gain, loss, deductions and credits of the partnership would be allocated to the holder in accordance with its interest in the partnership. Therefore, depending on the holder's interest in the partnership, it is possible that a holder will be allocated taxable income even though the holder may not be entitled to any distributions (including tax distributions) under the issuer's operating agreement. The unexpected receipt of income without the right to receive a corresponding distribution is a possible consequence that should be considered when structuring investments.

Pepper Perspective

If it is determined that the investment warrant will be treated as an equity interest, the investment warrant agreement and the partnership agreement should state that the investment warrant holder will be treated as a partner for purposes of tax allocations and tax distributions.

Further, the possibility of a holder of an investment warrant being treated as a partner in the issuing partnership raises additional concerns for special types of holders. For example:

  • U.S. tax-exempt investors should consider whether the investment warrant would cause them to receive UBTI.
  • Regulated Investment Companies should consider whether the investment warrant would cause them to have income or assets that do not qualify under Section 851(b).
  • Foreign investors should consider whether the investment warrant causes them to be "engaged in a trade or business in the United States" or to have a "permanent establishment" in the United States, which could require such foreign investors to file U.S. tax returns and pay U.S. tax.

The investment warrant will be treated as an equity interest in the issuer if the two tests set forth under "Tests for Whether an Investment Warrant in a Partnership Is Treated as Equity" are met. These tests generally will be met when the investment warrant has a nominal exercise price and there is a strong likelihood that the failure to treat the warrant as the owner of the underlying security would result in a "substantial tax reduction."

Tests for Whether an Investment Warrant in a Partnership Is Treated as Equity An investment warrant to acquire an equity interest in a partnership (or other pass-through entity, including a limited liability company that is treated as a partnership for federal tax purposes) is treated as an equity interest if, on certain measuring dates (discussed further in "Measuring Dates" on page 11) both of two tests are met:

i. the investment warrant provides the holder with rights that are substantially similar to the rights afforded to the owner of an interest into which the investment warrant is exercisable, and

ii. there is a strong likelihood that the failure to treat the holder of the investment warrant as the owner of the underlying security would result in a substantial reduction in the present value of the aggregate tax liabilities of the other owners of the interests and holder of the investment warrant (a "Substantial Tax Reduction").

If these tests are met, then the investment warrant will be considered to be exercised, and therefore the holder will be considered to be a partner of the partnership for all U.S. tax purposes.

Pepper Perspective

If a partnership (or other pass-through entity) expects to issue or receive a substantial amount of nominally priced investment warrants, it should consider requiring its partners to provide information regarding the tax attributes of the partner's direct or indirect owners. This may allow the partnership to determine whether the investment warrants would not be required to be classified as an equity interest under the regulations because warrant treatment would not result in a Substantial Tax Reduction.

Test I - Rights Similar to Owners

An investment warrant provides its holder with rights that are substantially similar to the rights afforded to an owner of an equity interest in the issuer if either (i) the investment warrant is "reasonably certain to be exercised," or (ii) the investment warrant holder possesses owner attributes.

Whether an investment warrant is reasonably certain to be exercised at the time of a measurement event is determined based on all the facts and circumstances. While these facts and circumstances include a variety of factors, if the value of the partnership interest is equal to or higher than the exercise price, an investment warrant with a nominal exercise price would generally be considered "reasonably certain to be exercised" unless a safe harbor applies.

Test I -Safe Harbors

The final regulations provide two objective safe harbors. These safe harbors only apply, however, if the holder of the investment warrant does not have as a principal purpose achieving a Substantial Tax Reduction on the measuring date. If the holder of the investment warrant has such a purpose, then the holder of the investment warrant cannot rely on the safe harbors and the determination must be made based on all of the facts and circumstances.

An investment warrant will fall into a safe harbor and will therefore not be considered "reasonably certain to be exercised," if, as of the measurement event, either of the following is applicable:

i. the warrant may be exercised no more than 24 months after the measurement event and the strike price is equal to or greater than 110 percent of the fair market value of the underlying interest in the issuer on the date of the measurement event; or

ii. the warrant's terms provide that the strike price is equal to or greater than the fair market value of the underlying interest in the issuer on the warrant's exercise date.

While the failure to satisfy either of the safe harbors is not determinative of whether an investment warrant is treated as reasonably certain to be exercised, in the absence of a safe harbor, an investment warrant with a nominal exercise price may have a substantial risk of being treated as "reasonably certain to be exercised" under the general facts and circumstances test.

Therefore, unless there is support that the fair market value of an investment warrant with a nominal strike price is almost worthless (i.e., less than such nominal amount) on the date of issuance or other relevant measuring date, or an investment warrant provides for an exercise price equal to or greater than the fair market value of the interest on the date of exercise, the investment warrant may be treated as an equity interest unless there is not a strong likelihood of a Substantial Tax Reduction.

Example 1

100,000 investment warrants in a partnership are granted to Holder with a restriction that the warrants must be exercised within 24 months of their issuance. Using the Discounted Cash Flow method, it is determined that at the time of issuance the underlying partnership interest has a fair market value of $910. Therefore, if the combined exercise price of the warrants is $1,000 (1 cent per warrant), the investment warrant will meet the first safe harbor. If the warrants are exercisable more than 24 months after the issuance, then they would not meet the safe harbor and likely would be considered reasonably certain to be exercised.

Example 2

100,000 investment warrants in a partnership are granted to Holder. There is no restriction on the timing of the exercise of the warrants. However, instead of a fixed exercise price, the warrants provide that the exercise price will be equal to the fair market value of the partnership interest granted as of the date of exercise.

Using the Discounted Cash Flow method, it is determined that at the time of issuance the underlying partnership interest has a total value of $910. In Year Five, the fair market value of the partnership interest has increased to $100,000. By the terms of the investment warrant, the exercise price of the warrants will be $100,000 in Year Five. Therefore, the warrants will meet the second safe harbor. However, the investment warrant holder does not share in either the initial $910 value or in any of the increase of the value of the partnership interest from $910 to $100,000.

Test II - Substantial Tax Reduction

If the investment warrant does not fall into one of the safe harbors and is considered to provide the holder with rights similar to an owner, then it will be treated as an equity interest if there is also a strong likelihood that the failure to treat the holder of the investment warrant as the owner of the underlying security would result in a Substantial Tax Reduction.

Whether there is a strong likelihood that the failure to treat an investment warrant holder as an owner would result in a Substantial Tax Reduction is a facts and circumstances test. It takes into account:

i. the interaction of the allocations of the issuer and the tax attributes of the owners and the investment warrant holder (including tax consequences that result from such interaction that is unrelated to the issuer)

ii. the absolute amount of the federal tax reduction

ii. the amount of the reduction relative to the overall federal tax liability, and

iv. the timing of items of income and deductions.

In general, if it can be determined that all of the owners (or at least owners that hold a large majority of the existing equity interests) are taxed at the highest marginal tax rate at which the investment warrant holder would be taxed, then treating the investment warrant holder as an owner would not result in a Substantial Tax Reduction. However, the determination of whether a Substantial Tax Reduction would result will depend on the specific tax attributes of the owners. For instance, if the existing owners had net operating losses that would offset any partnership income allocable to them and the investment warrant holder did not, then there may be a Substantial Tax Reduction if in the same situation it was expected that the issuing partnership would generate taxable income. Conversely, if the partnership is expected to generate tax losses, then the allocation of those losses to the holder may not result in a Substantial Tax Reduction, as the holder would receive a present tax deduction while the owner would only receive further net operating losses. Therefore, in practice it may be difficult for an investment warrant holder or issuing partnership to have sufficient information regarding the tax attributes specific to each owner to determine whether there is a strong likelihood that the failure to treat the investment warrant holder as an owner would result in a Substantial Tax Reduction.

Example 1

Assume that a partnership has three partners, each of which is a tax-exempt entity and that none of the income earned by the partnership would be considered to be UBTI (because, for example, it is all interest and dividends). Therefore, none of the income of the partnership is taxable to those partners. The partnership earns a substantial amount of income and has very few losses.

Assume that the partnership issues investment warrants to Holder, and the warrants provide for an exercise price of 110 percent of the current fair market value of the underlying partnership interest and a 24-month limitation on the exercise of the warrants. Holder is a taxable U.S. corporation and does not have any tax attributes, such as net operating losses, which would allow it to offset income of the Partnership.

The failure to treat Holder as a partner in the partnership likely will result in a Substantial Tax Reduction, as none of the income will be taxable if the Holder is not treated as a partner, while Holder's allocable share of income would be taxable if it were treated as a partner. Therefore, if a principal purpose of the issuance of the investment warrants was to reduce the aggregate tax liability of the three partners and Holder, then notwithstanding the fact that the investment warrants otherwise meet the safe harbor, the warrants may be treated as an equity interest.

Example 2

The facts are the same as Example 1, except the partnership earns a substantial amount of losses and has very little income. The failure to treat the Holder as a partner in the partnership likely will not result in a Substantial Tax Reduction, as the losses would not be able to be used by the tax-exempt entities, but allocating the losses to the Holder may reduce the Holder's taxable income.

Example 3

The facts are the same as Example 1, except that the investment warrants do not contain the 24-month limitation. As the warrants do not meet the safe harbor and the failure to treat the warrants as equity interests would result in a strong likelihood of a Substantial Tax Reduction, the warrants likely will be treated as an equity interest.

Example 4

The facts are the same as Example 1, except that (i) the investment warrants do not contain the 24-month limitation and (ii) Holder is a tax-exempt entity that would not be taxable on income attributable to it from the partnership if the warrants were treated as an equity interest. As there is not a strong likelihood of a Substantial Tax Reduction (because Holder is a tax-exempt entity), the investment warrants would likely be respected as investment warrants and would likely not be treated as an equity interest.

If the investment warrant holder or owner of the partnership is a pass-through entity, the determination of whether there is a strong likelihood of a Substantial Tax Reduction must take into account the tax attributes of the direct and indirect owners of the pass-through entity. In this case, it may be difficult for either the issuer or the investment warrant holder to determine whether there is a strong likelihood of a Substantial Tax Reduction, as this determination would require tax information from persons who are not a party to the partnership agreement.

Example 5

Assume that a partnership has three partners, all of which are themselves partnerships. Each of the three partners has a variety of taxable corporate owners. Holder is a taxable U.S. corporation and does not have any tax attributes, such as net operating losses, which would allow it to offset income of the issuing partnership. Holder is issued investment warrants from the issuing partnership. In order to determine whether the warrants would be able to meet one of the safe harbors or otherwise establish that there is no substantial tax reduction, information would be needed regarding the tax attributes of each of the indirect corporate owners to determine whether there is a strong likelihood of a Substantial Tax Reduction. If, for instance, the indirect corporate owners had substantial net operating losses, which would offset the income attributable to them from the issuing partnership, not treating the investment warrants as an equity interest may result in a Substantial Tax Reduction. If this were the case, the warrants could avoid being treated as an equity interest by meeting one of the safe harbors. Note that the issuing partnership may have difficulty obtaining from its three partnership owners adequate tax information regarding their corporate owners to permit the issuing partnership to make the determination.

Measuring Dates

The characterization test applies at any of the following times (so-called measurement events):

i. issuance of the investment warrant

ii. an adjustment of the terms of the investment warrant or of the underlying interest in the partnership (including an adjustment pursuant to the terms of the investment warrant), and

iii. transfer of the investment warrant, if either

  • the investment warrant may be exercised (or settled) more than 12 months after issuance, or
  • the transfer is pursuant to a plan in existence at the time of issuance or modification of the investment warrant that has as a principal purpose the substantial reduction of the present value of the aggregate federal tax liabilities of the other owners of the interests in the partnership and the investment warrant holder.

Continued Application of General Tax Principles

The final regulations clarify that the characterization rules discussed above do not override any general tax principles that would characterize an investment warrant as a partnership interest. Therefore, the IRS may assert that notwithstanding the fact that an investment warrant meets the requirements of the characterization rules to avoid being treated as an equity interest (for instance, treating the holder as a partner would not result in a Substantial Tax Reduction), the investment warrant should nonetheless be treated as an equity interest.

Footnotes

1. For the purpose of the regulations, an investment warrant includes any contractual right to acquire an interest in the issuer (or to cash or property having a value equal to the value of such an interest) that is not issued in connection with the performance of services. Warrants, options, convertible debt (debt that is convertible into an interest in the issuer) and convertible equity (an equity interest in an issuer that is convertible into a different equity interest of the issuer) are considered noncompensatory options under this regulation.

2. See Treas. Reg. 1.761-3 for the rules.

3. See Treas. Reg. 1.761-1(b)(4) for the rules determining a partner's "interest in a partnership."

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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