Panel: Update on tax issues impacting private equity real estate funds

1
Panel Update on tax issues impacting private
equity real estate funds

• Moderator Harry Shannon, Tax Principal, Global
• Real Estate Group, Ernst Young LLPPanel
  Members
• Erica Herberg, Principal, The Carlyle Group
• David S. Miller, Partner, Cadwalader,
• Wickersham Taft LLP

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Case Study
Managers
Investors
Real Estate Private Equity Fund
U.S. Investors
Offshore hedgefunds and CLOs

• Assume that the mezzanine loan will soon default
  and is probably worth about .50/1.00
• The PE fund would like to restructure the loan in
  a tax-efficient manner

Mezz Borrower LLC
Mezz Lenders
Mezzanine Loan
REMIC
PropertyOwnerLLC
Senior Lenders
Mortgage
USActive 17418885.1
Property
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Tax Considerations

• Tax Issues for the PE Fund and Its Investors
• Cancellation of Indebtedness (COD) Income if the
  Debt Is Cancelled
• Gain Upon Foreclosure (Difference between Face
  Amount of Debt and Basis in Property) if the
  Property is Foreclosed
• Tax Issues for Offshore Hedge Fund and CLO
  Investors
• Trade or Business Issues if Debt Is Restructured
• FIRPTA, Trade or Business, and Withholding Issues
  if Foreclosure
• Tax Issues for the REMIC
• Ensuring that its mortgages remain qualified
  mortgages

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Avoiding COD Income

• Modify the Debt in a Manner that Does Not Give
  Rise to a
• Taxable Exchange for Tax Purposes
• Temporary Forbearance
• Two years following the issuers initial failure
  to perform
• Any additional period during which the parties
  conduct good faith negotiations or during which
  the Issuer is in a title 11 or similar case
• Defer Payments Extend Maturity
• Scheduled payments may be deferred for a period
  that begins on the original due date and extends
  for a period equal to the lesser of five years or
  50 of the original term of the debt instrument
• Change the Yield
• The yield of the modified instrument may be
  changed so long as it varies by no more than the
  greater of
• ¼ of one percent (i.e., 25 basis points) or
• 5 of the annual yield (0.05 x annual yield)

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Avoiding COD Income (contd)

• Change the Collateral
• Recourse loan Collateral may be released,
  substituted, added, or altered, or a guarantee or
  other credit enhancement added, so long as the
  change does not change payment expectations
• Nonrecourse loan Cannot release, substitute,
  add or otherwise alter a substantial amount of
  the collateral for, or provide a guarantee or add
  credit enhancement, for a nonrecourse loan.
  However, collateral may be substituted if the
  collateral is fungible or otherwise of a type
  where there particular units pledged are
  unimportant

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Avoiding COD Income (contd)

• Rely on the Privately-Traded Debt Rules
• If the debt is not publicly traded, modify the
  terms of debt (i.e., extend maturity, provide for
  PIK interest, reduce interest rate to AFR), but
  do not change the principal amount
• To avoid being publicly traded, debt must not
• be listed on a national securities exchange,
• be listed on an interdealer quotation system,
• be listed on certain foreign exchanges or boards
  of exchange, or
• appear on a system of general circulation that
  provides a reasonable basis to determine fair
  market value by disseminating recent price
  quotations of one or more identified brokers,
  dealers or traders or actual prices of recent
  sales transactions
• Debt-for-tax issues
• If the modified loan does not constitute
  debt-for-tax purposes, then COD income will arise

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Avoiding COD Income (contd)
Have an Unrelated Party Acquire the Debt at a
Discount
Real Estate Private Equity Fund
Managers
Investors
REIT

• If the PE Fund were to buy the mezzanine loan for
  .50/1.00, the REIT would realize COD income
  under the related party rules of section
  108(e)(4)

Mezz Borrower LLC
Mezz Lenders
Mezzanine Loan
REMIC
PropertyOwnerLLC
Senior Lenders
Mortgage
Property
8
Avoiding COD Income (contd)
Have an Unrelated Party Acquire the Debt at a
Discount
Real Estate Private Equity Fund
Managers
Investors

• Two corporations are not treated as related
  parties so long as five or fewer individuals do
  not own 50 or more of the value of each
• An Irish section 110 company or Luxembourg
  securitization company that qualifies for U.S.
  treaty benefits is needed to avoid 30 U.S.
  withholding tax on interest. (The REIT and the
  Irish/Lux company are related for portfolio
  interest purposes.)

Irish section 110 company
REIT
Interest
Mezz Borrower LLC
Mezzanine Loan
REMIC
PropertyOwnerLLC
Senior Lenders
Mortgage
Property
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Avoiding COD Income (contd)
Have an Unrelated Party Acquire the Debt at a
Discount and Enter Into a Total Return Swap with
the Owner of the Borrower
Real Estate Private Equity Fund
Managers
Investors
InvestmentBank
Total Return Swap
REIT
Interest
Mezz Borrower LLC
Mezzanine Loan
REMIC
PropertyOwnerLLC
Senior Lenders

• Risk that PE fund is treated as the tax owner
  of the mezzanine loan (which would cause the REIT
  to realized COD income).

Mortgage
Property
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Section 108(i)

• For debt cancelled in 2009 or 2010
• COD income is deferred until 2014 and
• Then included ratably in each year from 2014 to
  2018

Section 108(a)

• If a taxpayer is insolvent or bankrupt, COD is
  not recognized, but tax attributes (NOLs, basis)
  are reduced on a dollar-for-dollar basis. (But
  if a partnership is the borrower, section 108(a)
  is applied at the partner level (i.e., the
  partners have to be insolvent or bankrupt).)

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COD Versus Realization for Nonrecourse Debt

• A foreclosure on nonrecourse debt is treated as a
  sale of the property for the face amount of the
  debt.
• Assume that the debtor has 100 basis in property
  that is subject to 90 of debt and the property
  is now worth 50
• If 40 of debt is cancelled, the taxpayer
  realizes 40 of COD income
• If the creditor forecloses on the property, the
  taxpayer has a 10 capital loss and no COD, even
  though the foreclosure is the economic equivalent
  of the cancellation of 40 of debt and a sale of
  the property for 50 (i.e., 40 COD and 50
  capital loss)

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Tax Issues For Offshore Hedge Funds and CLOs

• Workout Activity
• The IRS takes the position that origination
  activities cause an offshore fund or CLO that has
  a U.S. manager to be engaged in a trade or
  business in the United States and subject to
  U.S. corporate income tax. IRS Office of
  Chief Counsel Memorandum (September 22, 2009)
• A workout that gives rise to a taxable event
  under section 1001 is treated as a redemption of
  the original loan and an origination of the
  modified loan.
• Working out a nonperforming loan will generally
  increase its value the increase in value is
  entirely attributable to services performed in
  the United States (as opposed to changes in the
  credit of the borrower or changes in market
  conditions).

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Tax Issues For Offshore Hedge Funds and CLOs
(contd)

• Risk for offshore hedge fund or CLO
• Least risk if the fund purchased a performing
  loan that was not expected to default, the debtor
  subsequently defaulted, and the U.S. manager is
  negotiating or agreeing to a workout to preserve
  its investment
• Most risk if the fund purchases the loan when it
  is distressed in order to work it out and sell it
  at a profit.

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Tax Issues For Offshore Funds and CLOs Owning
Real Estate

• Income from the real estate subject to a 30
  withholding tax or 35 net income tax
• Gain on the sale of the real estate (measured
  from its value on the date of foreclosure)
  subject to 35 net income tax
• Many offshore funds are prohibited from directly
  owning real estate
• If an offshore fund owns an interest in U.S. real
  estate, the real estate will often be held in a
  U.S. blocker corporation (and the fund may, in
  turn, hold this U.S. corporation through a
  foreign blocker corporation)

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Tax Issues For Offshore Funds and CLOs Owning
Real Estate (contd)
Foreign Fund
Cayman blocker corporation
U.S. blocker corporation
Interest inU.S. real property
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Tax Issues For REMICs That Hold Distressed Real
Estate Loans

• If a REMIC agrees to a significant modification
  of a mortgage loan when the loan is not in
  default or default is not reasonably
  foreseeable, the mortgage may fail to be a
  qualified mortgage, which could jeopardize the
  REMICs status as a REMIC. A REMICs governing
  documents may have other (non-tax) limitations on
  modifications.
• Revenue Procedure 2009-45 (September 15, 2009)
  expands the definition of reasonably
  foreseeable default and provides that a mortgage
  may be modified without losing its status as a
  qualified mortgage if there is a significant
  risk of default upon maturity or before based on
  a diligent contemporaneous determination
  (including credible written representations from
  the borrower). The risk of default may be a
  year (or possibly later) in the future.