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Irish Intermediation for Private Equity Debt Repurchases

Posted on Apr. 13, 2020

Let the recriminations begin.

Songwriter John Prine knew a little something about recriminations. An Illinois mailman who was sent to Stuttgart, Germany, in the Vietnam draft, his first song, “Sam Stone,” was about a heroin-addicted veteran (of which there were quite a few after Vietnam, where the drug was cheap and available). “There’s a hole in daddy’s arm where all the money goes, Jesus Christ died for nothin’ I suppose,” he wrote. A two-time cancer survivor, Prine died at age 73, after being admitted to hospital with coronavirus on March 26.

Rock fetishizes the singer-songwriter, but in Nashville there’s a separation. Prine was both, but spent most of his career on the songwriter side of that divide, writing songs covered by many prominent singers, including Johnny Cash (“Sam Stone”), Bonnie Raitt (“Angel From Montgomery”), Miranda Lambert (“That’s the Way That the World Goes Round”), and even Bette Midler (“Hello in There”). He was noted for his wry sense of humor, which Raitt compared to Mark Twain. Bob Dylan compared him to Marcel Proust.

Discovered in Chicago by Kris Kristofferson, Prine was also famous for bucking the recording contract system of indenture. “You could go to a bank and do the same thing for less money and put a loan behind your career instead of a major label throwing parties for you and charging you,” he said.

He asked Ahmet Ertegun to be released from his Atlantic Records contract four years in, and then went to Asylum, home of the Eagles. He started his own record label, Oh Boy Records, in 1982. It was primitive — fans literally mailed paper checks to him — but it worked. The first song he released was “I Saw Mommy Kissing Santa Claus.” Prine loved Christmas — Oh Boy gave an annual Christmas party, and he kept a tree up in his house year round. He turned down a Sony offer to buy the label seven years later. Prine became a successful recording artist in his own right after that point. He won four Grammys and other honors.

A great storyteller, Prine even wrote his own obituary in “When I Get to Heaven,” the final song on his final album: “When I get to heaven, I’m gonna shake God’s hand. Thank him for more blessings than one man can stand. Then I’m gonna get a guitar and start a rock-and-roll band. Check into a swell hotel — ain’t the afterlife grand?”

Prine died at Vanderbilt University hospital. There are three types of hospitals: public hospitals, not-for-profit hospitals, and for-profit hospitals. All of them are expected to cover their own costs, which is impossible.

Now, the dirty little secret of hospitals is that they sit around empty most of the time, which is why they're always on the lookout for high-paying patients with elective surgeries and frivolous medicalized problems. That is why, once elective procedures were banned, overflow facilities in New York have not been filled with non-coronavirus patients. There aren't that many such patients at any given time.

Moreover, hospital capacity and licensing are controlled by the states. Now, state and local governments are putting shut-down hospitals back into service. In recent years, hospital capacity has been reduced, as insurers including Medicare stopped paying for longer stays. U.S. hospital capacity has been reduced from 1.5 million beds to 931,000 beds over the last 50 years, even though the population has grown by more than 50 percent in that period. New York City’s hospital beds were reduced from 74,000 to 53,000 over the last two decades. So there is little surge capacity in the system to handle unforeseen emergencies.

Private equity owns a lot of hospitals. Private equity has bought up some charitable hospitals and converted them to for-profit hospitals, which have no impetus to stay in business if paying patients aren't coming in the door. And often hospital buildings are in REITs, which lease them to operators.

 John Prine, country/folk singer-songwriter
John Prine knew a thing or two about recriminations. (David Seelig/Polaris/Newscom)

Private equity divided the hospitals from their staffs, which are employed by outside staffing firms. This division has been blamed for surprise billing, in which patients whose hospital costs were insured suddenly find that other costs are not. Roughly a third of hospital emergency rooms are staffed by just two private-equity-owned staffing companies, TeamHealth, owned by Blackstone, and Envision Healthcare, owned by Kohlberg Kravis Roberts.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) expanded the Small Business Administration section 7(a) loan program, which has an affiliation rule that prevents private-equity-owned firms from qualifying for SBA payroll protection loans even if they have fewer than 500 employees (section 1102 of the act).

The affiliation rule treats multiple businesses controlled by a single firm as one entity. It basically says that businesses owned by large investors don’t qualify on the theory that they can borrow from their sugar daddies rather than banks (13 C.F.R. sections 121.103 and 121.310). The CARES Act permits some private-equity-controlled businesses to qualify for SBA loans, like food services, restaurants, and hotels (NAICS code beginning with the number 72) and franchisees (SBA franchise identifier code) (SBA-2020-0015).

But doesn’t the private equity business model involve mass firings? Yes, but private-equity-controlled businesses still employ nearly 9 million people. Private equity firms are busy lobbying both sides of the aisle to be further excused from the SBA affiliation rule. Apollo Global Management lobbied Jared Kushner for an exemption. House Speaker Nancy Pelosi, D-Calif., Sen. Jerry Moran, R-Kan., Rep. Ro Khanna, D-Calif., and others wrote to Treasury and the SBA asking for an exemption for venture capital (The Washington Post, Apr. 6, 2020).

It’s wrong to blame the entire downturn on the coronavirus lockdown. Some businesses and areas were going down the tubes before the pandemic was declared. In Italy, which has been slammed by coronavirus, a new designation for beaten-down debt was created — “unlikely to pay,” a notch above nonperforming. The medical emergency provides cover for decisions that would have to have been made anyway.

So while we’re revisiting long-standing bankruptcy and insolvency issues, let’s look at what private equity is about to get up to. Advisers are reporting the private equity funds will be looking for ways to purchase the beaten-down debt of their portfolio companies that may be suffering from the shutdown or may have been in bad shape beforehand. This article looks at a common technique for avoiding COD income on discount purchases of portfolio company debt.

Loan Markets

Bank lenders don’t hold onto loans anymore, so this debt is likely to be traded and available for purchase in the secondary market.

There is $400 billion of junk-rated leveraged loans currently trading, much of it packaged into collateralized loan obligation. Some of the borrowers are household names like Staples, Dell, Cirque du Soleil, and Hilton — all private equity victims. Leveraged loans are trading at discounts, especially for the hospitality business issuers. Financially repressed investors love the high yields but may not be prepared for defaults (The Wall Street Journal, Sept. 24, 2017).

The wrinkle in this private equity plan to repurchase portfolio company debt is the COD income, which reduces net operating losses and other tax attributes. A private equity fund cannot repurchase portfolio company debt at a discount without the latter incurring COD income. A price that differs from the stated principal amount at maturity can create COD income for the issuer (section 108(e)(10)(A)).

A debt interest issued by a CLO is a security. A loan may be a security if it is traded. Even if the debt is bank debt, it is probably a security because bank debt is usually priced and traded. When debt is publicly traded, its price is the fair market value of the property exchanged for it (section 1273(b)(3)). A debt instrument is publicly traded if it is listed on an exchange, has an available sales price, has a firm quote, or has a believable soft quote (reg. section 1.1273-2(f)(1) through (5)).

So funds and their advisers are looking to create intermediaries to do the purchasing, skating around the tax law’s related-party rules. The tax law’s debt forgiveness rules ought to have affiliation rules like the SBA has to prevent avoidance of recognition of COD income. Or Congress, if it chooses, could grant a holiday for debt repurchases, like it did after the 2008 meltdown.

Private equity funds were turning to intermediaries to repurchase their own bank debt during the aftermath of the 2008 financial meltdown. In 2009 Apollo used a total return swap with Citigroup to effectively repurchase debt that its portfolio company Harrah’s owed to the bank. The swap was the economic equivalent of a cash repurchase of that debt, although there were circumstances when Citi would reassume risk. The debt that was the subject of the swap was not Harrah’s but other private equity loans Citi wanted to be rid of. (Prior analysis: Tax Notes, Feb. 16, 2009, p. 823.)

Nonetheless, some lawyers even suggest swaps over a portfolio company’s own debt. That would seem to elevate form over substance. This article looks at a more straightforward strategy — Irish intermediaries.

Irish Eyes

And a decade later, our Irish friends are here to help, again offering section 110 companies to accommodate debt repurchases.

“We expect a wave of debt restructurings and buybacks, as has happened in most downward cycles in the past. Ireland is well positioned to be the jurisdiction where funds will look to hold repurchased portfolio debt,” said a leading Dublin lawyer. “Speed is often the key consideration in this environment, as managers want to lock in market discounts and manage debt exposures in portfolios.”

The Apollo parties could have tried to avoid the COD income problem by using an Irish section 110 company (an investment vehicle eligible for treaty benefits) to effectuate the repurchase. The point would be to create a vehicle deemed unrelated to the borrower for COD income purposes. The private equity fund partnership would clearly be related to the portfolio company borrower.

Section 110 is a special Irish taxation scheme for securitizations. A section 110 company is a separate taxpayer and a treaty resident. It is only permitted to hold financial assets, of which it must acquire €10 million, at arm’s-length prices, on its first day of existence. It doesn’t have a banking license and arguably doesn’t have a trade or business in the United States (section 864). A section 110 company is not considered to have a regular trade or business in Ireland; rather, it is on its own schedule. It is unlikely to have economic substance in Ireland, and it is not a regulated investment fund.

An Irish section 110 company would be just a vehicle for the fund to acquire its portfolio company’s debt without U.S. tax on COD income. It is not necessary to bring in outside investors. Investors in the fund own the section 110 company. The fund sponsor capitalizes it with a capital call to get the cash. Alternatively, the sponsor could borrow from a bank. That bank could even be the original lender because it probably would have sold the original loan.

Therefore the section 110 company would be related, but the question is, how related under what set of rules? There are different sets of rules for different purposes, and the set applicable to COD income is lenient.

As long as five or fewer individuals or trusts do not own more than 50 percent of the vote and value of the borrower and the Irish company, it would not be considered related to the borrower for purposes of creating COD income (section 108(e)(4)). The statute works off more generous related-party definitions (section 267(b) and section 707(b)(1)). The Irish company would nonetheless be a controlled foreign corporation related to the borrower for U.S. purposes (section 958(b)). But tax would not be withheld on interest payments under the Irish treaty, which provides for zero withholding on interest.

Here we’re thinking of a simple model of a single private equity fund with a single portfolio company borrower. But fund sponsors often foster many funds that own many portfolio companies. One fund can hold several portfolio companies. It can be part of a group of funds with the same sponsor and run by the same managers. Funds with the same sponsor can buy each other’s portfolio company debt without running into related-party issues because they are related to the borrowers not by ownership but by management.

Because banks don’t hold onto loans, and because many loans are traded, the section 110 company may be acquiring portfolio company debt in the market. The section 110 company itself is a taxpayer and could have its own issues when it buys the debt of a borrower that Irish law treats as related. Ireland has related-party debt rules, but a discount purchase of debt does not automatically trigger COD income. Market discount on a discount purchase of portfolio company debt would be taken into account rateably over the remaining term of the debt, as in the U.S. system (section 1286).

Capitalizing the section 110 company with debt would create interest deductions to offset market discount inclusions. Section 110 companies are typically capitalized with hybrid securities, while a trust holds the equity interests. The hybrids are profit participating notes whose yield exactly matches the market discount on the target debt. The picture is improved if the section 110 company holds other securities whose yield can be paid out as profit participation on the notes. A section 110 company would have to look out for the Irish interest barrier rules by ensuring that interest deductions did not exceed interest income.

The profit participating notes are hybrid securities that the United States treats as equity, but other countries treat as debt. And the ultimate fund investors may not be taxable. Why isn’t there a problem under the Irish hybrid rules? As an EU member, Ireland is required to comply with the EU’s second anti-tax-avoidance directive, 2017/952/EU. Because it is only allowed to hold financial assets acquired at arm’s-length prices, a section 110 company would be eligible for the “financial trader” (broker/dealer) exemption from the Irish hybrid rules, which became effective in January of this year (section 835AH(e), part 35C of the Taxes Consolidation Act 1997).

Alternatively, planners could put an ICAV between the section 110 company and the investors. Formed under the Irish Collective Asset-Management Vehicle Act of 2015, an ICAV is an alternative investment management fund, so it is regulated, unlike a section 110 company. The point of using an ICAV is that non-U.S. investors or other outside investors could be brought in. An ICAV takes a while to set up, so a section 110 company may be quickly put in place to buy debt before the former is established. The ICAV would issue plain debt to the section 110 company, which would deduct interest on it, but the ICAV would be capitalized with equity interests held by the investors, to which it would pay dividends. If time is not of the essence, the ICAV could be directly owned by investors.

The ICAV itself would be exempt from tax in Ireland, but it would nonetheless qualify as a treaty resident provided it was controlled by U.S. investors, including U.S. corporations owned by non-U.S. investors. Although exempt from tax, the ICAV would be subject to Irish tax jurisdiction, and would not be base eroding with interest deductions because it doesn’t deduct anything.

If the fund has both U.S. and foreign investors, as most do, different classes of profit participating notes issued by a section 110 company or equity interests in an ICAV would be issued to the U.S. and foreign feeders. There is no withholding tax on interest payments if the vehicle is 50 percent owned by U.S. investors. Interest payments by the section 110 company would have to satisfy the U.S. treaty’s base erosion test, so that no more than 50 percent of its gross income can be paid out as deductible payments in the current year or the previous four years (article 23(2)(c)).

Lawyers point out that if the repurchased debt was acquired in the market and not canceled (so that it would be deemed reissued at a big discount), it may cease to be fungible with the portfolio company’s remaining debt in the market. So if the new holder doesn’t plan on canceling the debt, it may have to plan on holding it forever and not being able to sell it readily. The tax law is not responsible for ensuring that your tradable debt remains fungible if you go around conducting big transactions in it.

There may be corporate law constraints. A portfolio company may not have the cash to buy its own debt, but the opportunity to purchase it at a discount could be a corporate opportunity that belongs to it. So it might have to formally forsake that opportunity so that the fund, fund sponsor, or specially created section 110 company could pick it up. Even then, the purchaser may become a creditor of the portfolio company, because purchase does not usually involve cancellation. As an affiliated creditor, its claim in a bankruptcy of the portfolio company may be equitably subordinated if there was inequitable conduct (11 U.S.C. section 510(c); Pepper v. Litton, 308 U.S. 295 (1939)).

Legislative Fix?

Congress could ensure that COD income is taxed on repurchases by using a different standard for relatedness.

Congress could tighten the related-party rule for COD income. We said back in 2009: Congress might want to reexamine the section 108(e)(4) related-party rules so that COD income is not avoided in the future. The practical control concept of section 482 might make a more suitable standard. This rule encompasses “any kind of control, direct or indirect, whether legally enforceable, and however exercisable or exercised” (reg. section 1.482-1A(a)(3); DHL Corp. v. Commissioner, 285 F.3d 1210 (9th Cir. 2002)).

Indeed, the control relationship standard of section 482 is sufficiently broad that it might cover a situation when a private equity fund buys the debt of a portfolio company owned by another fund with the same fund sponsor. Common management and common purpose could constitute “any kind of control” that binds together the purchasing fund and the portfolio company borrower.

In DHL, the requisite control for purposes of section 482 was litigated and held to exist at the trial level. The subject of the reallocation was the sale of the DHL trademark and the performance of services for affiliated corporations. DHL Corp., the domestic entity, and its international sister, DHL International, were commonly controlled by four individuals, though they operated separately. MNV, a Netherlands Antilles affiliate owned by two of the four controlling shareholders, controlled most of the foreign operating companies. The issue was whether the trio were commonly controlled when valuable trademarks were optioned to foreign investors.

The Tax Court agreed with the government that common control was present, focusing on the existing shareholders’ continued operating control and influence on board actions. DHL argued to the Ninth Circuit that section 482 control had to be “complete.” The Justice Department argued that the requisite control need only exist at the time the examined transaction took place. The Ninth Circuit reversed the Tax Court on the amount of the section 482 reallocation, but affirmed the finding of common control when the option was priced. That is, the court accepted the department’s transactional view of common control (Rooney v. United States, 305 F.2d 681 (9th Cir. 1962)).

“This transactional approach for determining common control under section 482 comports with common sense, and the regulations, which state that ‘[i]t is the reality of the control which is decisive, not its form or the mode of its exercise,’” Ninth Circuit Judge William A. Fletcher wrote.

Control for purposes of section 482 means practical control. In a private equity setting, a handful of managers and institutional investors have control of a portfolio of companies. These companies and the funds that own them are housed in separate entities. But the fact that the fund sponsor uses a separate partnership for each acquisition, or each group of acquisitions, should not obscure the fact of control. Congress should recognize this and change the control relationship required for section 108(e)(4) to the section 482 standard.

Again, the debt forgiveness rules ought to have affiliation rules like the SBA section 7(a) loan program has. Certainly taxpayers might complain that the section 482 related-party rules are too onerous or uncertain in application. The code has another set of affiliation rules that were revived for the BEAT — the single employer test. This rule aggregates all entities considered a single employer, using a 50 percent threshold, as a single taxpayer (sections 52, 1563(a)). The single employer rule for partnerships looks for common control of a trade or business (section 52(b)).

Legislative Indulgence?

Or Congress could give people a temporary reprieve for debt repurchases. In 2009 some legislators proposed outright exemption for debt reacquisition. Congress opted for temporary deferral instead.

In the American Recovery and Reinvestment Act of 2009 (P.L. 111-5), Congress temporarily permitted taxpayers to defer tax on COD income created on acquisitions of their own debt for as long as five years (section 108(i)). Acquisition of the debt could be by the debtor or a related person. There was no interest charge on the deferral, which was available for acquisition of any debt issued by a corporation or a related person in connection with its trade or business. Deferral of the issuer’s original issue discount deduction was required for any new debt created in an actual or deemed exchange in which COD income was incurred. This nice gesture expired in January 2011.

It was unusual that section 108(i) had no interest charge. An interest charge is customary for deferral provisions used by large and well-advised taxpayers. When large taxpayers were found to be abusing installment sales, an interest charge was added (section 453A). Large corporate taxpayers face a higher tax deficiency interest bill for aggressive but not penalized positions they take on returns (section 6621(c)). Sophisticated taxpayers well understand that they are borrowing from the government and can analyze the price for themselves.

Congress also turned off the applicable high-yield discount obligation (AHYDO) rules for obligations issued between September 1, 2008, and December 31, 2009. Why was that necessary? Portfolio company loans acquired at a deep discount and not canceled are deemed reissued with a high yield that may not be deductible to the borrower but would be taxable to the purchaser cum holder (section 163(i)). If the acquirer is offshore, there would be withholding on interest, unless a treaty like the Irish treaty applies, because the portfolio interest exemption would not apply (section 881(c)(3)(B)).

We’re monetizing all the coronavirus stimulus, so even though section 108(i) was considered an expensive provision in its day, that wouldn’t much matter now. The drafters of the CARES Act recognized that some tax forgiveness and deferral is appropriate for a coronavirus-engineered recession. Just as the CARES Act pulled off the SBA affiliation rule for some private-equity-controlled businesses, so Congress might want to temporarily encourage debt buybacks.

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