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Investment Adviser Seeks Exclusion in Proposed UBTI Regs

JUN. 23, 2020

Investment Adviser Seeks Exclusion in Proposed UBTI Regs

DATED JUN. 23, 2020
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COMMENTS IN RESPONSE TO SECTION 512(A)(6) UBTI SILOING PROPOSED REGULATIONS

JUNE 23, 2020

This document has been prepared in response to the request for comments regarding the proposed regulations for unrelated business taxable income (“UBTI”) siloing under Section 512(a)(6), particularly with respect to investment partnerships. Global Endowment Management, LP (“GEM”) is an investment advisor (“RIA”) registered with the United States Securities and Exchange Commission (“SEC”) under the Investment Advisers Act of 1940, as amended. GEM offers an endowment-style investment program that invests with a long-term horizon, seeking varied and non-traditional investment opportunities in an effort to provide a diversified, single-portfolio investment strategy for its investors, the majority of which are tax-exempt. All of GEM's tax-exempt investors are limited partners in Delaware limited partnerships. These partnerships are structured as tiered “funds of funds,” investing in hundreds of underlying limited partnership alternative investments. GEM compiles Schedule K-1s from all of the underlying managers, prepares Form 1065 U.S. Return of Partnership Income for its partnerships, and distributes Schedule K-1s to its investors.

EXECUTIVE SUMMARY

1. Investment activity should not be treated as an unrelated trade or business subject to 512(a)(6).

2. If the IRS and Treasury treat investment activity as an unrelated trade or business, in order to make the regulations more administrable, we recommend that applicable accounting standards when a partnership is an investment or an operating business be used instead of the de minimis and control tests that are outlined in the proposed regulations. All UBTI generated from investment activity should then be classified as a single, separate trade or business for siloing purposes.

3. To the extent the above recommendations are not implemented (the IRS and Treasury treat investment activity as an unrelated trade or business and retain the de minimis and control tests), we recommend the following:

a. Tests for determining qualifying partnership interests should be based on actual control (as defined under applicable accounting standards), not ownership.

b. The look-through rule — if used  should apply more broadly.

c. Exempt organization ownership of partnership interests is not indicative of control and therefore should not be taken into account when determining ownership or control for purposes of the control test.

d. A reasonable efforts standard should be adopted that allows an exempt organization to rely on information provided by a partnership in determining its qualifying partnership interests in, and sources of UBTI from, that partnership.

BACKGROUND: GEM'S INVESTORS

The majority of GEM's assets under management are from our tax-exempt investors who seek to generate funding in perpetuity in order to further their exempt missions, which include assisting the underprivileged, providing healthcare to the indigent, educating the less fortunate, ending social injustice and safeguarding the environment. These tax-exempt investors are limited partners in various GEM limited partnerships to build their investment portfolios for capital appreciation. They have no interest in engaging in, or controlling, an unrelated trade or business. GEM's investors pay us a management fee and give us full discretion to invest their capital in a responsible manner based on applicable investment policies. These policies do not mention or contemplate controlling, engaging in, or operating an unrelated trade or business. These policies typically state that the investor is tasked with monitoring GEM, as investment manager, to help ensure their assets are invested prudently, according to their investment policy (e.g. allocation to asset classes, liquidity, volatility, investment performance, etc.). We do not believe that this investment activity should be treated as an unrelated trade or business subject to 512(a)(6).

PROPOSALS TO SIGNIFICANTLY REDUCE ADMINISTRATIVE BURDEN

We understand that Treasury and the IRS seek an administrable means to identify when a partnership interest is an investment, as opposed to an actively operated unrelated trade or business. We believe that the proposed regulations, particularly the de minimis and control tests for determining qualifying partnership interests (“QPIs”), would frustrate rather than promote administrability. These tests are overly complex, and would impose tremendous burdens on many exempt organizations with interests in investment partnerships that they do not control. To reduce this complexity while still relying on an objective third-party standard, we recommend using existing accounting standards and guidance that apply when preparing an organization's audited financial statements to determine if a partnership is an investment or an operating business.

Under the proposed regulations, investments in partnerships and other pass-through entities would be classified as a single, separate trade or business (“STB”) when they meet the “de minimis test” or the “control test.” However, these tests are underinclusive, failing to recognize other investments made by exempt organization investors as QPIs in which the investors have no actual control over partnership operations. GEM respectfully requests that the Treasury Department and the IRS expand the STB rule to include all investment activities made as part of investment portfolios of exempt organizations in which the organization has neither governance rights nor managerial control over the operations of the underlying investment activity. This approach would provide more of a bright-line test, consistent with current investment classification by exempt organization investors, that would promote compliance while reducing their costs and burdens.

GEM utilizes “funds of one” for certain tax-exempt investors. In this case, the investor owns more than 20% of the entity but does not exercise control. Such investments serve the same purpose, and are made in the same manner, as an exempt organization's other investments. The goal is still to make an investment and to have someone else (GEM, the investment manager) make the investment decisions for the funds invested. While it is true in this situation that the exempt organization typically has the right to “fire” GEM, this ability is no different than the right of an investor in a publicly traded mutual fund who can “fire” the manager by withdrawing its funds. In the mutual fund arena, having the right to withdraw funds is not viewed as controlling that mutual fund, similarly, having the right to withdraw from a limited partnership (either directly or by replacing the manager  which is the same thing as withdrawing the funds and starting over with another manager) should not be viewed any differently.

Structural Challenges

The GEM investment partnerships are Delaware limited partnerships set up in a “master-feeder” structure. Investors invest through a top-tier entity (called a feeder fund) and that entity then invests into multiple lower-tier entities (called master funds). Using a structure such as this allows GEM to pool its investors, allowing for greater access to certain investments and shared cost savings. GEM's master funds then invest in hundreds of downstream alternative investments, including hedge funds, private equity funds, private real asset funds, etc. The downstream alternative investment managers in turn invest in hundreds of public and private companies.

The nature of such tiered partnership structures in which GEM's tax-exempt investors invest creates complexity and a substantial amount of investment information. However, GEM has little or no control over the specific reporting done by the downstream managers. There is no way to guarantee that our downstream managers will provide timely, complete, or accurate information that would enable GEM or our investors to separately classify and report the unrelated trade or business information.

The ability to get the information needed from the downstream investment managers is already challenging under the current regulations. In part, this is because a downstream fund (in GEM's fund-of-fund situation, for example) does not have the ability nor administrative heft to look through to the top-tier funds to determine who owns the limited partner interests. In addition, there is always an effort by funds to avoid unnecessary costs. Therefore, GEM is limited by the information it receives from these downstream fund managers, often only receiving a total UBTI number on Line 20V of the Schedule K-1. As it is, GEM does not receive detailed information for our tax-exempt investors regarding UBTI by line item, or state UBTI, resulting in incomplete information for our tax-exempt investors and requiring time consuming follow-up with the downstream managers.

Thus, if the regulations are finalized as proposed, general partners, fund managers, and investment firms such as GEM would be faced with substantial new reporting and K-1 footnote requirements without knowing which of their direct or indirect exempt organization investors really need the information, and at what level of detail. The potential variations on the types of information that could be needed under the currently proposed regulations is almost unlimited.

The look through of a top-tier fund into the direct, downstream holdings of a lower-tier fund would also be burdensome on funds that make numerous investments, including GEM and many of its underlying fund managers. For instance, if adopted as proposed, the regulations would require GEM to provide its

limited partners with a list of all of its investments and the exempt organization's investor ownership percentages in all of them, as averaged for the holding period during the year. Due to the sheer volume of investments, this would be extremely onerous to the investment fund industry as well as to exempt organizations. Further, GEM would have to provide its tax-exempt partners with the income and losses flowing through from each of the underlying partnership investments that generate UBTI, causing additional reporting burdens.

Investment funds like GEM and its tax-exempt investors already face the challenge of timely obtaining UBTI information needed from partnerships in which they invest, requiring significant, repetitious follow-up to obtain that information. GEM often has to use tax estimates from downstream managers in order to file the partnership's Form 1065 by the extended deadline, resulting in a very limited ability to estimate UBTI or obtain additional detailed information to be included in its Schedule K-1s. This impacts the exempt organization's ability to make timely and accurate estimated payments, determine in which states it needs to file extensions and/or returns, and to accurately calculate its true tax liability.

Control and De Minimis Test Issues

While the control and de minimis tests proposed in Notice 2018-67, and also included in the proposed regulations, allow for certain aggregation within investment partnerships, they create their own reporting and administrability challenges and do not correlate to a tax-exempt investor's level of control.

GEM allows for investors to make contributions quarterly; therefore, ownership percentages in GEM's feeder and master funds can change during the course of the year without the knowledge of the investors. GEM also has multiple tax-exempt organizations that are invested in funds-of-one, allowing for more investment customization of the underlying pooled master funds. Regardless of the capital ownership percentage of the tax-exempt investor in the limited partnership, the investor is always only a limited partner with no control over the partnership, its operations, or its downstream investments. GEM's investors sign a limited partnership agreement, allowing for GEM and the general partner to make all investment decisions. GEM's investors pay a management fee for this service, and all fiduciary duty and control is held by the general partner. The investors have no discretion over the investments GEM makes, and no control over the UBTI generating trades or businesses further downstream in lower-tier funds.

While the de minimis test allows for look-through ownership thresholds of 2% for certain partnerships that fail to meet the control test, it presents its own challenges and burdens. GEM's master funds invest in hundreds of downstream limited partnerships, and the ownership of these downstream funds can change throughout each year, as well. These ownership percentages do not necessarily indicate the ownership of the underlying trades or businesses that would generate UBTI. For example, the ownership of portfolio companies in a private equity partnership fund would not be known to GEM or its investors. Compiling, tracking, and maintaining these tiered, look-through ownership percentages for each of GEM's tax-exempt investors would be a significant administrative burden. Exempt organizations also have varying fiscal year-ends, which could result in confusion as to what period of time the ownership percentages should or could even be determined.

Rather than looking at an exempt organization's profits or capital interests in a partnership to determine QPI status, its classification and treatment for financial reporting purposes should determine whether the partnership qualifies as a QPI. Under generally accepted accounting principles (“GAAP”), a partnership interest is accounted for in one of three ways, depending on the level of control and influence the exempt organization has over the partnership:

1. Consolidation accounting (in accordance with ASC paragraph 958-810-15-4 or ASC paragraph 958-810-25-2 through 25-4)

2. Equity method accounting (in accordance with ASC paragraph 958-810-15-4)

3. Fair value accounting (in accordance with ASC paragraph 958-321-15-2)

We believe that partnership interests accounted for at fair value under GAAP should be treated as QPIs, whereas partnership interests accounted for under the consolidation or equity accounting method (or that would be accounted for under the consolidation or equity accounting method, if the organization were to apply GAAP) should be treated as operating activities (rather than as investment activities) of the exempt organization and classified based on the appropriate two-digit NAICS code (subject to the applicability of the look-through rule for downstream holdings of that partnership). This proposed method of identifying QPIs would accomplish the following:

  • Provide a bright-line test whose result is easily determined by examination of the exempt organization's balance sheet.

  • More closely align with Form 990, Part X, line 12 - investment reporting.

  • Enable the exempt organization investor to more easily determine and manage its separate unrelated trades or businesses.

  • Require no additional analysis or reporting by fund managers who may not be able to identify UBTI from separate trades or businesses without significant administrative burden.

  • Better identify an exempt organization's true investments (i.e. partnership interests that are part of its investment portfolio), versus partnerships that are extensions of its operating activities.

This method of distinguishing investments from operating partnerships would provide a more accurate reflection of control over partnerships than would the percentage ownership standards in the proposed regulations. It is inaccurate to equate ownership percentage with control for a limited partner, particularly in the investment world. As noted above, for investment partnerships, exempt organization investors generally do not want control and do not have the expertise to exercise any control  that is why such investors hire professional investment advisors to make the investing decisions for them. They invest in partnerships that have appropriate parameters on investments (e.g. types of investments, domestic or international, whether the partnership can incur debt and the limits thereof) that they are comfortable with and that fit within the exempt organizations' investment policy statements. The actual investment decisions by the investment partnerships are left to the professionals that have teams of researchers and analysts who can make sound investment decisions.

The 20% capital interest threshold was described in the proposed regulations as being consistent with one other administrative exception created for certain investment activities: IRC 731(c)(3)(C)(i). This provision, however, relates to gain recognition on the transfer of securities between investment partnerships, and is not as relevant or administrable as the accounting standards described above for distinguishing between investments and operating partnerships.

As explained above, it is common for exempt organization investors to hold a greater than 20% capital interest in a partnership, yet have no control over the partnership (e.g., fund-of-one partnerships, master-feeder structures). To comport with the IRS and Treasury's intention to allow exempt organizations to aggregate as qualifying investments those partnerships through which they do not actively carry on any trades or businesses, we recommend that Treasury and the IRS (i) replace its de minimis and control tests with the fair value accounting method standard for determining investment partnerships, as described above; or, (ii) if the IRS and Treasury are not willing to abandon the de minimis and control tests, that they instead eliminate the ownership percentage prong of the control test and modify the control prong of that test to comport with the more familiar and administrable ASC standards for consolidated and equity method accounting treatment (ASC paragraphs 958-810-15-4 and 958-810-25-2, as described above), which set forth the criteria below for determining control. This would be consistent with the language and intent of 512(a)(6), while significantly minimizing burden for exempt organization investors and their investment managers and downstream general partners.

  • The exempt investor has a 20% or greater voting interest in the partnership;

  • The exempt investor has substantive kick-out rights (i.e., to dissolve the limited partnership or otherwise remove the general partners without cause) in the partnership; or

  • The exempt investor has substantive participating rights (i.e., to block or participate in significant financial and operating decisionsof the partnership that are made in the ordinary course of business).

Conversely, the following are means of being able to monitor and protect an exempt organization investor's interest in its partnership investment rather than controlling that partnership, and therefore should not be deemed to constitute control over a partnership:

  • The ability to remove or replace a fund manager who manages the investment(s)

  • The ability to appoint a member of an advisory board of the partnership

  • The ability to withdraw from a partnership

The proposed regulations provide a “look-through rule” that allows an exempt organization investor in partnerships in which it has a greater than 20% capital interest, but for which it fails the control prong of the control test, to treat as QPIs any downstream partnerships in which it has no greater than a 2% profits and capital interest. However, the proposed regulations would not allow exempt organization investors to apply this rule within partnerships that they control.

As a practical matter, an exempt organization that is deemed to exercise “control” over a partnership, however control is defined in the final regulations, is very unlikely to exert any actual control over a downstream partnership in which it has no more than a 2% capital or profits interest, or even a 20% capital interest. Instead, such control would be exercised by the general partners and investment managers of those downstream partnerships. Preventing a look-through exception that allows for looking through all of the ownership layers down to the operating business, regardless of the exempt organization investor's level of ownership or control of the upper-tier fund, would impose an undue burden and tax cost to the exempt organization, because the investment would not qualify as a QPI under the proposed regulations. However, the rationale for applying the look-through rule applies equally to such lower-tier partnerships regardless of whether the lower-tier partnership sits below an upper-tier partnership that the exempt organization investor does or does not control. Accordingly, if the IRS and Treasury were to retain the de minimis and control tests, the final regulations should allow exempt organizations to apply the look-through rule to any of their downstream partnership interests that qualify as a “qualifying investment interest” on their own merits, however that term is defined in the final regulations.

If Treasury and the IRS were to finalize regulations that include some version of the de minimis and/or control test, we recommend that the final regulations provide that exempt organizations are required only to make a reasonable effort to determine what types of unrelated trade or business activities were engaged in by partnerships in which the organizations had ownership interests, and which did not meet the definition of “qualifying partnership interests,” for purposes of determining the NAICS codes used to classify such unrelated trades or businesses. Such reasonable efforts could include, but not be limited to, distributing a questionnaire to the general partner of the partnership in which it directly invests to request such information.

If an exempt organization is not able to determine whether UBTI is derived from a qualifying partnership interest or a particular unrelated trade or business, after making a reasonable effort to obtain information on such UBTI source(s), then we recommend that an exempt organization be permitted to report UBTI derived from its partnership interests as being from “other services” (NAICS code 81).

This reasonable effort standard would significantly reduce burden because, as explained above, certain partnerships in which an exempt organization has a capital interest above 20% have multiple (sometimes hundreds of) downstream partnership investments that generate different types of UBTI. Even if the exempt organization participates in the management or business operations of the partnership or exercises some degree of control over the partnership, it generally has little or no ability to ascertain all downstream sources of UBTI that it ultimately derives from the downstream partnerships. Even if the exempt organization were successful in negotiating an agreement with the general partner of the partnership to provide what information on such UBTI the general partner is able to obtain, it generally would be very difficult, if not impossible, for that general partner to obtain information on (i) all downstream sources of UBTI and (ii) what amount of total UBTI from each downstream partnership is attributable to each UBTI source. The less a partnership's interests are in a downstream partnership, the less likely it is that the partnership will have the leverage or ability to obtain that information.

CONCLUSION

As investment activities are not described as, and do not fit the definition of, unrelated trade or business activities in Sections 511-513 or elsewhere in the Code, we believe that investment activity should not be treated as an unrelated business subject to 512(a)(6). Tax-exempt organizations make investments to generate funding to further their exempt missions; therefore, investment income should not be considered as income from the “sale of goods” or the “performance of services” that are unrelated to the organization's mission — the definition of unrelated business activities.

If, however, the IRS and Treasury treat investment activity as an unrelated business, an absolute requirement that such organizations obtain the proposed necessary information on UBTI sources from its partnership investments would either be impossible to meet or impose a very heavy, costly burden on many exempt organizations and investment funds, such as GEM. To make such a requirement more administrable, we recommend that the final regulations remove the control and de minimis tests in determining qualified partnership interests, and instead use applicable accounting standards.

To the extent the final regulations maintain some version of the de minimis or control tests, we recommend they permit an exempt organization to report UBTI derived from its partnership interests as being from “other services” (NAICS code 81) if it is not able to determine whether the UBTI is derived from a qualifying partnership interest or a particular trade or business, after making a reasonable effort to obtain information on such UBTI source(s).

Yours truly,

Richard S. Abraham
Chief Financial Officer
Global Endowment Management, LP
Charlotte, NC

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