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Mezzanine Funds: Selected Tax Structuring Considerations

The number of mezzanine funds and the amount of committed mezzanine capital have increased significantly in recent years. A growing number of sponsors are also involved in forming these funds and structuring their investments. Debevoise & Plimpton takes a look at some of the tax issues to be aware of in this burgeoning corner of private equity.

Although mezzanine funds raise many of the same tax issues as leveraged buy-out (“LBO”) and venture capital (“VC”) funds, there are also a number of special tax issues implicated by the nature of mezzanine investing of which sponsors and investors should be aware. Most of these tax issues can be solved by careful (albeit complex) structuring, including in many cases the use of alternative investment vehicles or blockers. Recognizing the potential problems and baking the flexibility to solve them into the fund documentation can avoid nasty tax surprises.

Investing vs. Lending. The typical mezzanine fund investment consists of a debt security (paying both cash and “pay-in-kind” interest) and warrants to purchase equity in the borrower company (which warrants frequently have a strike price that is less than the value of the underlying shares). Less frequently, preferred stock is used to produce the desired mix of downside protection and upside participation.

Because mezzanine funds are in a sense “originating” debt securities, some tax practitioners have raised the question of whether mezzanine funds could be viewed as engaged in a lending business for U.S. tax purposes rather than merely investing in securities, with the result that foreign investors in the fund would be subject to net basis U.S. income tax (at the same rates as those applicable to U.S. residents) on their share of the fund's income. (By contrast, if the fund is viewed as investing in securities, foreign investors would generally not be subject to any U.S. tax on gains, and would generally be subject to 30% withholding tax on dividends and interest unless a treaty or the “portfolio interest” exemption applied.) Although the law in this area is scarce, the prevailing view in the market is that mezzanine funds should not be viewed as engaged in a lending business, but instead should be viewed as investors in securities. This is based on several factors: mezzanine funds engage in a relatively small number of transactions over a finite period of time; much of the expected investment return is derived from the “equity kicker” component of the security; mezzanine funds acquire their securities in a highly specialized market rather than from the public; and the subordinated position of the mezzanine debt exposes the fund to greater risks than are customarily assumed by commercial lenders. Thus, on balance, a mezzanine fund resembles an equity investor more than a commercial lender.

Phantom Income. Because mezzanine funds purchase most of their securities in “strips” (i.e., debt and warrants issued in a single transaction), mezzanine funds often realize significant amounts of “original issue discount” income on their debt securities. As an illustration, let's say that a mezzanine fund pays $100 for a bond with a face amount of $100 and a “penny warrant” to acquire $20 worth of stock for a nominal strike price. The U.S. tax rules would allocate the $100 purchase price between the two securities in the strip based on their respective values, in this case $80 to the bond and $20 to the warrant. The $20 difference between the price paid for the bond and its face amount is original issue discount (or “OID”) that is taxed to the bondholder on a constant yield basis over the term of the bond, without regard to when cash payments are received. The existence of a pay-in-kind feature would also give rise to OID.

As a result, mezzanine funds generate substantial “phantom income” (that is, taxable income without cash). Although mezzanine securities also typically provide for significant current cash interest, so that investors could use that cash to satisfy their tax liabilities, OID would generally continue to accrue on a bond even if the borrower defaulted on the cash interest. Of course, if the fund is not required to distribute the cash interest to investors (for example, because it uses the cash interest to provide leverage or make additional investments) the investors would have to fund payments of the tax on the “phantom income.”

UBTI/ECI. As with LBO and VC funds, mezzanine funds may have U.S. tax-exempt entities as investors. Such tax-exempt investors are sensitive to the receipt of so-called “unrelated business taxable income” (or “UBTI”) because they are taxed on UBTI (but not on non-UBTI income). In the mezzanine fund context, UBTI typically arises in one of two ways. First, the mezzanine fund may use leverage in its investment strategy, in which case a portion of the fund's income allocable to the borrowing will be treated as UBTI. Some mezzanine funds address this by permitting tax-exempt investors to invest in an offshore feeder or parallel fund that is treated as a corporation for U.S. tax purposes (thus “blocking” any UBTI). However, such a “blocker” corporation would be subject to U.S. withholding tax on dividend income and interest income received from the portfolio company (subject to the discussion below of portfolio interest) and net basis income tax on U.S. trade or business income (see below). In some cases, the net tax cost incurred by tax-exempt investors that invest in the blocker would be greater than if such investors had invested directly in the mezzanine fund.

UBTI can also arise if the mezzanine fund acquires equity in an operating entity that is treated as a partnership for U.S. tax purposes (such as an LLC). Such investments can also give rise to income that is effectively connected with a U.S. trade or business (known as “ECI”), with the result that foreign partners in the fund will be subject to net basis U.S. income tax and return filing requirements with respect to their shares of the fund's ECI (and possibly even other income not derived from the fund). This is because a partner in a partnership is treated as carrying on the business activities of the partnership for purposes of determining whether such partner has income from an “unrelated trade or business” (for UBTI purposes) or a “U.S. trade or business” (for ECI purposes). As mentioned above, mezzanine funds often purchase warrants to acquire equity in borrowers for a nominal strike price. Tax practitioners often worry that such “penny warrants” issued by an LLC would be viewed as an actual equity interest in the LLC, giving rise to UBTI for tax-exempt investors and ECI for foreign investors. Although there are a number of structuring devices that can be utilized by mezzanine funds that invest in LLCs (including restructuring the form of the “equity kicker” or providing in the fund documents for the creation of a parallel fund structure to make the equity investment where the tax-exempt and foreign investors invest through a blocker corporation), all of these devices involve a fair amount of complexity and require careful structuring.

Portfolio Interest. As one might expect, mezzanine funds typically derive a significant portion of their income in the form of interest. In general, a foreign limited partner's share of any interest paid to the fund by U.S. borrowers is subject to 30% withholding tax (subject to reduction or elimination by treaty) unless the exception for “portfolio interest” applies.

In order to qualify as portfolio interest, the debt must generally be in “registered” form (meaning that transfers can only be evidenced by actual surrender and exchange or book-entry, as opposed to a bearer obligation), the amount of the interest cannot be based on revenues, income, profits, property value fluctuations or equity distributions, certificates of non-U.S. status must be obtained from foreign debtholders, and the person receiving the interest cannot be a 10% equity owner of the borrower.

While the other requirements are usually easy to satisfy, the last requirement is sometimes subject to question. Some tax practitioners are concerned that the exception will not apply where the fund owns 10% or more of the borrower's equity (or warrants to acquire such equity). However, the prevailing view appears to be that the 10% test should be applied at the partner level, treating each partner as owning its ratable share of the fund's equity stake, in which case it will be extremely unlikely that any particular partner in the fund will own 10% of the borrower's equity. (This latter view was endorsed by the IRS in a non-binding “field service advice” issued in 1994). As a result, if all the other requirements are met, the portfolio interest exemption generally can be used to avoid withholding on interest received by the fund that is allocable to foreign limited partners.

Investments in Foreign Issuers. As with LBO and VC funds, mezzanine funds may make equity investments in companies organized outside the U.S. This raises the possibility that certain U.S. anti-deferral rules, in particular the “controlled foreign corporation” (“CFC”) and “passive foreign investment company” (“PFIC”) rules, may apply to the fund's U.S. investors.

The CFC rules impute certain types of income earned by the foreign company to U.S. shareholders and convert gain on exit into ordinary income. A mezzanine fund that is organized as a Delaware limited partnership (as is common) would become subject to the CFC rules if it acquired a 10% or greater stake in a foreign company that was more than 50% owned by “10% U.S. shareholders” (meaning U.S. persons that each own 10% of the foreign company's voting power). If the fund instead held options (assuming such options are not in substance an actual stock interest), the options would be treated as exercised for purposes of determining whether the foreign company was a CFC, but the fund itself would not be subject to the CFC rules until exercise. If a mezzanine fund anticipates acquiring 10% or greater equity stakes in foreign companies, it can generally avoid CFC issues by organizing as a foreign (e.g., Cayman Islands) limited partnership instead of in Delaware, or, for funds already formed in the U.S., by making the foreign investment through a parallel “alternative investment vehicle” organized offshore.

The PFIC rules apply to U.S. persons that acquire equity in foreign corporations with “passive” income (such as dividends, interest, rents, royalties, etc.) or assets that produce passive income exceeding certain thresholds, and could apply to U.S. partners of a mezzanine fund whether the fund is organized in Delaware or offshore and regardless of how small a percentage of the PFIC the fund owns. Although the PFIC rules were originally intended to apply to U.S. shareholders of offshore mutual funds and similar investment companies, they have a much broader reach and can apply in unexpected places. For example, start-up companies that have not begun to receive operating revenues may have interest income that, even though relatively insignificant in amount, constitutes a sufficiently high percentage of the start-up's overall gross income so that the start-up satisfies the PFIC “income test.”

The PFIC rules treat all gain derived on a sale of PFIC shares as ordinary income and impose an interest charge (calculated as if the gain had been taxable on a ratable basis over the entire holding period of the PFIC shares, a potentially onerous result). These rules can be avoided if a “qualified electing fund” (“QEF”) election is made, in which case the U.S. investor would instead be taxed currently on its pro rata share of the PFIC's ordinary income and capital gains (and would preserve the opportunity for capital gains on a sale of PFIC shares).

Because mezzanine funds often acquire their “equity kickers” in the form of options (such as warrants), the PFIC rules can present a potentially disastrous trap for the unwary. This is because the PFIC rules do not generally permit QEF elections for options, but nonetheless apply the disadvantageous ordinary income and interest charge treatment to a sale of the option. In addition, for purposes of determining the application of the interest charge to a sale of the PFIC stock acquired on exercise of the option, the holding period of the stock is deemed to include the period the option was held. Mezzanine funds that make investments in foreign companies should carefully consider the application of the PFIC rules. In the event that a mezzanine fund invests in a foreign company that is or might be a PFIC, fund sponsors would generally be well advised to structure the equity kicker as an actual issuance of stock (perhaps with vesting or forfeiture provisions to parallel the proposed economics) thereby allowing the QEF election to be made, as opposed to structuring that investment with warrants or options.

It should be noted that a QEF election can only be made if the issuer agrees to provide certain financial information to the fund on an annual basis, which some foreign companies may be unwilling to do, particularly if the mezzanine fund is a minority investor. If the mezzanine fund wants to be able to make the QEF election, it will be advisable to discuss this with the issuer before committing to invest, and to include in the investment documentation contractual provisions requiring the issuer to provide the necessary information.

In conclusion, mezzanine funds offer sponsors and investors the potential for attractive returns with a more conservative risk profile than LBO or VC funds. However, mezzanine investing raises a number of tax issues that will often require careful planning in order to maximize the after-tax return to investors.

Reprinted with permission from The Debevoise & Plimpton Private Equity Report.  © 2002 Debevoise & Plimpton.  All rights reserved.  No portion of this article may be reproduced without the express consent of the authors.

Adele M Karig (akarig@debevoise.com) is a partner and member of Debevoise & Plimpton's Tax Department.  Peter A Furci (pafurci@debevoise.com), also a member of the Tax Department, is an associate.

Debevoise & Plimpton, an international law firm, was founded in 1931. The firm, which now has more than 500 lawyers, provides international services in corporate, litigation, tax, and trusts and estates law. Debevoise & Plimpton offices are located in New York, Washington, DC, London, Paris, Frankfurt, Moscow, Hong Kong and Shanghai.