Group Seeks Interest Expense Guidance for Tiered-Fund Partnerships

Limitation on Deducting Interest Expenses

As we discussed at our meeting, in addition to some of our broader concerns with the application of section 163(j), the limitations on deducting interest expenses raise particular concerns in the context of tiered fund partnerships, which we believe should be addressed in further guidance. One issue that we believe should be addressed through guidance is whether disallowed interest at lower-tier partnerships flows up to an upper-tier partnership in a manner similar to excess earnings in tiered partnership structures.

Below are two examples of why we believe further guidance is needed in the context of alternative funds with respect to this issue.

Example 1:

Master fund A is an alternative fund engaged in trading assets. In connection with its trading activities, it incurs interest expenses and enters into counterparty relationships with prime brokers. Master fund A is a partnership for U.S. tax purposes. Master fund B is also an alternative fund engaged in trading assets. In connection with its trading activities, it has income but no interest expenses. Master fund B is a partnership for U.S. tax purposes.

Feeder fund A also is an alternative fund partnership that has invested substantially all of its assets in Master fund A and Master fund B, owning 80% of each master fund. For various business reasons, such as reducing the master funds' counterparty risk, the investment manager chooses to keep some cash and cash equivalent securities at the Feeder fund A level. Feeder fund A does not directly engage in any trading activities.

Master fund A incurs interest expenses and, after adjustments for Master fund A's income, has excess business interest expense. Master fund B has excess taxable income as it has income but no interest expense from its trading activities. Feeder fund A earns interest income but has no interest expenses.

For purposes of applying the limitation on the deductibility of interest expense, we believe that Master fund A, Master fund B, and Feeder fund A should be treated similarly as a consolidated group, which would permit the excess taxable income earned by Master fund B and the interest income earned by Feeder fund A, to be used to offset the excess interest expenses incurred by Master fund A, which would flow up to Feeder fund A.

Example 2:

Master fund A and Master fund B are both alternative funds engaged in trading assets. Feeder fund A invests 50% of its assets into Master fund A and 50% of its assets in Master fund B. Feeder fund B invests 50% of its assets into Master fund A and 50% of its assets in Master fund B. Feeder funds A and B together own 100% of each master fund. Master funds A and B and Feeder funds A and B are all partnerships for U.S. tax purposes.

Master fund A has gains from its trading activities, but no interest expenses. Master fund B has no trading gains, but does have interest expenses.

Similar to example 1 above, we believe that, for purposes of applying the limitation on the deductibility of interest expenses, any excess taxable income earned by Master fund A and any disallowed interest expenses from Master fund B both should flow up to Feeder fund A and Feeder fund B based on the partnership allocation of such income and expenses.