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Firm Proposes Specified Service Business Standard

JUN. 18, 2018

Firm Proposes Specified Service Business Standard

DATED JUN. 18, 2018
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June 18, 2018

Thomas West
Tax Legislative Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Bryan Rimmke
Attorney-Advisor
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Re: Applicability of Section 199A to Certain Investment Management Businesses

Dear Messrs. West & Rimmke,

Thank you for your time meeting and discussing with us the application of Section 199A to certain investment management businesses. As discussed at our meeting, we are attaching a draft of proposed regulatory language providing a standard for determining when an investment management business should be considered a “specified service business.” As explained at the meeting and described below, for many pass-through entities engaged in the broad activity of managing investments, providing services in the form of specific investment advice to direct firm clients is not necessarily a large portion of the business. Instead, a significant amount of some pass-through managers' activities are related to the development and marketing of investment products, just like many of their corporate competitors. We believe that Congress intended that such pass-through businesses would be entitled to the benefits of Section 199A in the same manner as any other business that generates products to be sold — whether those products are tangible or intangible.

The business of investment management in 2018 is more diverse and multifaceted than at any time since the adoption of the Internal Revenue Code. While there are some investment management firms whose primary business is the provision of investment advice to clients by portfolio managers, other firms devote only a relatively small portion of their total activity to traditional “advising” activities. For those businesses in the latter category — the “product- oriented” diversified investment manager — a significant amount of activity is in development and marketing of what are better understood as investment “tools.” The tools employed by this type of diversified investment management business involve the design, testing, and marketing of products like investment strategies, asset allocation strategies, and quantitative models and investment capabilities. These tools are used not only (or even necessarily primarily) by the business's own clients, but by third parties who access these tools through financial advisors or other intermediaries, for example, these firms offer their mutual funds to the public at large through broker dealers, unaffiliated registered investment advisors and others who actually provide the investment management advice to individual clients. While these diversified investment management businesses may also provide advice directly to clients, that activity is not necessarily their predominant business.

A critical distinction between the traditional advisory type of investment management business and the more diversified product-oriented investment management business described above is in the use of capital. A traditional advisory investment manager's use of capital — to purchase computers, networking capability, office space, etc. — is incidental to its provision of investment advisory services to clients. In contrast, in order to develop the tools and strategic platforms described above, a diversified product-oriented investment manager must generate and deploy its own seed capital to test its asset allocation strategies and, importantly, to conduct research and collect data. The significant value derived from this use of seed capital is in the generation of valuable data which is used to build and refine the investment tools and capabilities that generate a significant amount of revenue of the diversified product-oriented investment management business.

While providing investment advice and designing investment products are both within the umbrella category of “investment management” as that term is commonly used, these businesses are fundamentally different. We do not believe that Congress intended “investment management” as used in Section 199A(d)(2)(B) of the Code to be so broad as to capture businesses whose predominant activity is not provision of services to customers but rather research, development, and marketing of investment products, platforms, and strategies. Therefore, in the attached draft of regulatory language, we have suggested factors that will identify investment management businesses as “specified service businesses” where, viewing all activities of the investment management business in the aggregate, specified services are the predominant activities of the business.

Several suggested factors that should be considered in making this determination are: whether capital is a material income-producing factor; whether the business employs individuals in sales, market, research, data analysis, or similar fields; whether the amount of business activity related to selling investment products to third parties is significant relative to other business activities; and whether the amount of business activity involving direct provision of services to clients is significant relative to other business activities. No single factor is determinative but all of the business activity should be viewed in the aggregate when making the determination as to whether providing specified services is predominant. Limiting the Section 199A(d)(1)(A) exclusion to investment management businesses that are specified service businesses is consistent with Congress's purpose in enacting this provision, and assures that that the exception does not exclude more businesses than Congress intended.

We appreciate your consideration of our recommendation. If you have any questions or comments regarding this letter, please feel free to contact us and we will be glad to discuss or assist in any way.

Sincerely,

Stuart L. Rosow, Partner
Richard M. Corn, Partner

Proskauer Rose LLP
New York, NY

/enclosure/


Proposed Regulatory Language

1.199A-x Treatment of Investment Management Businesses

(a) General Test. Investment management businesses may engage in multiple activities, including the provision of products, strategies, investment opportunities, platforms and access to investment managers, both to clients and to third parties through unrelated intermediaries. In addition, investment management businesses may also provide recommendations, advice, and other direct services to clients. An investment management business is considered a specified service trade or business under Section 199A(d)(1)(A) only if the provision of services directly to clients, and any other services specified in Section 199A(d)(1)(B) or Section 1202(e)(3)(A) (together with the provision of services directly to clients, “specified services”), are the predominant activities of the investment management business. In making this determination, all of the relevant facts and circumstances are taken into account, and all activities of the investment management business are considered in the aggregate with no specific factor being determinative. The determination is made by comparing the amount of activities constituting specified services to all other activities (including sales to third parties through unrelated intermediaries), and only if the specified services are the principal business activity of the investment management business in comparison to all other activities will such investment management business be determined to be a specified service trade or business.

(b) Factors. In making the determination as to the predominant activities of an investment management business, the following factors (without limitation) will be considered:

(i) Whether capital is a material income-producing factor in the investment management business. For example, if capital is used to develop and test investment strategies, models or other products, to create investment options for clients and for third parties through unrelated-intermediaries, including the use of regulatory capital, and if such capital contributes materially to the production of income for the investment management business, this tends to establish that the predominant activity is not the provision of specified services.

(ii) Whether the business employs employees or service providers in the fields of sales, marketing, research, analysis, IT, or related fields, for the creation and preservation of goodwill or other intangible assets for use by the business independent of the reputation or expertise of any particular service provider or employee. For example, if a substantial number of employees or other service providers of the business are engaged in such activities, this tends to establish that the predominant activity of the business is not the provision of specified services.

(iii) Whether the amount of business activity related to the selling of products, funds, investment opportunities, strategies, or platforms to unrelated intermediaries is significant in comparison with other business activities. For example, if a substantial amount of revenue of the business is attributable to sales of investment products and strategies to unrelated intermediaries that ultimately perform services described in Section 1202(e)(3)(A) for third parties by selling such products and strategies, this tends to establish that the predominant activity of the business in selling investment products and strategies to unrelated intermediaries is not the provision of specified services. As another example, if a substantial number of employees or service providers of the business are engaged in activities related to sales of investment products and strategies to unrelated intermediaries, this tends to establish that the predominant activity of the business is not the provision of specified services.

(iv) Whether the amount of business activity involving a portfolio manager's or other service provider's direct provision of services to clients or involving such portfolio manager's or other service provider's personal relationship with clients (in each case, excluding any activities described in subparagraph (ii)) is significant in comparison with other business activities. For example, if most of the activities of the business involve one or more service provider's direct provision of services to, or personal relationships with, clients, this tends to establish that the predominant activity of the business is the provision of specified services.

(c) Examples. The following examples illustrate the application of 1.199A-x(a)-(b).

Example 7: (a) IM is an entity taxable as a partnership under U.S. federal income tax law, owned by individuals A, B and C. IM is engaged in the business of advising clients on investing in stocks, securities, and other financial instruments. A, B and C provide services for IM, where they recommend investment strategies to clients of IM. In particular, A, B and C recommend specific stocks, securities and financial instruments to clients, as well as arranging meetings with other investment managers, mutual funds, and other persons for such clients. IM does not own a material amount of invested capital, and does not hold stocks, securities or financial instruments for sale to others, whether clients or other investment managers. Further, IM does not engage in underwriting, margin loans to clients, lending generally, or proprietary trading. The clients of IM have direct personal relationships with one or more of A, B and C. IM employs four other individuals — a researcher who investigates third party products, funds, and investment opportunities and provides the information to A, B and C for their transmittal to clients, and three back-office employees who provide administrative and technical support for IM. IM leases real property for use as an office for its employees and owners, and owns miscellaneous office equipment (such as computers, copiers, etc.) to assist the employees in their activities.

(b) Under the principles of 1.199A-x(a)-(b), IM is a specified service trade or business under Section 199A(d)(1)(A). Substantially all of IM's activities are involved in the provision of specified services. IM's capital is only incidentally involved in the production of IM's income.

Example 2: (a) IB is an entity taxable as a partnership under U.S. federal income tax law, owned by multiple individuals who provide services to IB. IB engages in multiple investment management activities, including the provision of advice directly to clients, but also the establishment of investment funds, the entering into of arrangements with investment managers and other provider of alternative investment opportunities, and the provision of regulatory and investment capital (“seed capital”) to create investment options and platforms for clients and for third party investment advisors. IB employs a large number of employees for marketing, back-office, research, product creation, IT, and similar activities. Although some of IB's service providers engage in direct advising of clients, most of IB's service providers and most of IB's business activity are engaged either in (i) marketing, back-office, research, product creation, IT, and similar activities or (ii) provision of products, funds, opportunities, and platforms to third-party investment advisors (i.e., not direct clients). At least 30 percent of IB's net equity is used for seed capital.

(b) Under the principles of 1.199A-x(a)-(b), IB is not a specified service trade or business under Section 199A(d)(1)(A). Given the material amount of capital used in the production of income, the proportion of business activity engaged in marketing, back-office, research, product creation, IT, and similar activities or provision of products, funds, opportunities, and platforms to third-party investment advisors, and the large number of employees engaged in marketing, back-office, research, product creation, IT, and similar activities, the factors listed in 1.199A-x(b) strongly establish that the predominant activity of IB is not the provision of specified services.

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