The economy has often wreaked havoc with business plans and projections of the portfolio companies of venture capital funds, resulting in devaluations, recapitalizations and fewer realizations. Additional pressures have been created for funds to borrow to protect and preserve their investments and to enhance the returns of their investors. For funds with tax-exempt investors, the pressure to borrow raises the prospect of unrelated business taxable income (UBTI).
The tolerance of a venture capital fund for UBTI depends upon its investors. Some tax-exempt organizations and pension funds will accept UBTI on the basis that it is better to have the income and pay the tax than to miss out on the extra income. Other investors pride themselves on never having recognized even the smallest amount of UBTI. A fund’s governing documentation dealing with UBTI generally represents its most conservative investors’ tolerance for UBTI. No fund whose investors include tax-exempts desires to recognize UBTI where it can be avoided.
Avoiding UBTI has generally meant that a fund formed as a pass-through vehicle, such as a limited partnership or limited liability company, must avoid borrowing to make investments. That is because Sections 512(b)(4) and 514 of the Internal Revenue Code of 1986, as amended, treat dividends, interest and capital gain from debt-financed property as UBTI. Moreover, because these rules are broadly phrased-applying not only to debt incurred to purchase property, but also incurred as a result of an investment made before or after the time the debt was incurred-they often provide a chilling effect on borrowing by the fund for any purpose. In this market of slow realizations and devalued portfolios, the inability to borrow places a real crimp in the fund manager’s ability to maximize the return of an investment.
Fund managers must report income or gain to their tax exempt investors as UBTI to the extent that there is “acquisition indebtedness,” with respect to the investment that generated such income or gain. Acquisition indebtedness means indebtedness incurred (i) in acquiring the property, (ii) before the acquisition of the property if such indebtedness would not have been incurred but for the acquisition, or (iii) after the acquisition of the property if such indebtedness would not have been incurred but for such acquisition and the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition. Gain will not be UBTI if the debt is paid off more than 12 months before the investment is sold. Income, such as dividends, derived from debt-financed property will not be UBTI if the indebtedness is not outstanding during the taxable year in which the income was earned.
Here are some of the circumstances that make borrowing an attractive option:
Dry Funds. It is common for venture capital funds to have fixed periods over which they can continue to call capital from investors to make investments. After this period, or after all commitments have been contributed, a fund may have the ability to make further investments in portfolio companies (follow-on investments). The inability of a fund to make a follow-on investment may cause the fund’s investment in a portfolio company to be significantly diluted or to fail altogether. Follow-on investments may be financed through realizations from the sale of other investments. Unfortunately, in the current market, realizations on existing investments have slowed considerably. In such a case, it may be tempting for the fund to borrow the funds necessary to make the investment. That borrowing would certainly constitute acquisition indebtedness.
In order to avoid UBTI with respect to the follow-on investment, the fund would have to hold on to the investment for more than 12 months, and not derive any income with respect to the investment during any taxable year in which the debt is outstanding. In this case, the fund must be mindful of the fact that the Code imputes income in some cases. For example, interest accrues over time-it is not possible to simply defer interest to a tax year after the debt is repaid. Similarly, the fund may be required to report redemption premium on redeemable preferred as deemed dividends currently, generating income despite the absence of cash payments.
One question that may arise is whether the indebtedness could be considered acquisition indebtedness with respect to other investments. It appears that because the debt incurred to make the follow-on investment clearly is acquisition indebtedness with respect to such investment, it should not also be treated as acquisition indebtedness with respect to other investment property. Support for this proposition is found in at least one private letter ruling.1 In that ruling, debt secured by, and incurred to acquire, a new headquarters property did not constitute acquisition indebtedness with respect to the old headquarters property (which was expected to be sold at a gain) because the new debt did not satisfy the “but for” test with respect to the old headquarters property. In other words, it could not be said that the debt would not have been incurred but for the investment in the organization’s old headquarters property. The IRS held that because the new headquarters property debt bore a direct “but for” relationship to the new headquarters property and was equal to 100% of the cost, the debt could not be deemed to bear the same relationship to any other property.
Bridging Calls. A fund does not earn an optimal return by tying up its investors’ money in a money market account waiting to make investments. The desire to enhance the investors’ return and to avoid a manager’s embarrassment in making a capital call for a transaction that doesn’t close provides significant incentive to borrow on a short-term basis and repay the indebtedness with the proceeds of a capital call. Such borrowing would, without some exception, appear to constitute acquisition indebtedness. Fortunately, and intelligently, the Internal Revenue Service has recognized the existence of an exception for the debt-financed property rules for short-term borrowings.
Based on a 1978 ruling addressing issues raised by securities lending activities of a tax exempt organization2, the Internal Revenue Service has privately held that transitory indebtedness incurred for administrative convenience and to avoid having to retain large cash reserves or sell securities on an inefficient basis does not constitute acquisition indebtedness. The rulings reason that short-term borrowing of this type is not leverage, but is rather a management tool to enable the organization to perform its daily investment activities in an efficient manner, without concern for cash-flow issues. Venture capital funds have relied on this exception in bridging calls, although some caution is in order. First, private letter rulings cannot be relied on as precedent. Accordingly, the existence of this exception relies on the IRS’s continued belief that it exists. Second, the rulings do not present significant guidance as to the breadth of the exception. There is no indication as to the permitted term of the borrowing: Certain of the rulings indicated that the borrowings would be for “several days” or “several weeks.” Thirty days seemed to be the outside limit, although this should not be viewed as a safe harbor. Thus, the shorter and more isolated the borrowing, the better.
Borrowing to pay expenses. Sometimes a fund will wish to borrow to pay expenses to avoid having to make a call or use proceeds of the disposition of other investments. Done occasionally, this should not be a problem, assuming that the money is used to pay fund expenses, and the debt is repaid before any further investments are made. However, the facts have to be examined carefully. For example, if an investment is sold and immediately rolled into a new investment, and shortly thereafter money is borrowed to pay an expense (such as the management fee) that was reasonably foreseeable at the time that the investment was made, the IRS may argue that the second investment is debt financed. Treasury regulations indicate that whether indebtedness is reasonably foreseeable depends upon the facts and circumstances of each situation.
Neither the regulations nor other authority in the area provide significant guidance as to when the “but for” or “reasonably foreseeable” standards will be satisfied. The regulations do, however, provide that, although the need for the incurrence of indebtedness may not have been actually foreseen by the organization, a subsequent incurrence of indebtedness may have been reasonably foreseeable. In one example in the regulations, mortgage indebtedness incurred in the tax year following a sale of a real property in exchange for a note was deemed to constitute acquisition indebtedness with respect to the note. The facts indicated that the seller realized that it would have to borrow in order to replace the property. Accordingly, interest on the note was treated as UBTI even though the property actually purchased with the borrowed funds would not have generated UBTI if it had been debt financed.
Accelerating realizations. Sometimes a fund will enter into a sales agreement which provides for a deferred payment of the consideration, and will want to borrow money to distribute to investors to boost their return. The example in the regulations described in the preceding paragraph poses concern that the borrowing may give rise to UBTI if there is actual or imputed interest on the deferred payment, or if a portion of the consideration consists of stock or securities of the purchaser.
Although the rules pertaining to UBTI have limited planning opportunities of managers of venture capital funds for many years, these rules create an increased impediment on the efficient operation of venture capital funds in the current economic climate. While opportunities are still available, recognizing pitfalls is critical, and careful planning is needed to minimize the risks of recognition of UBTI created by the apparent breath of the rules regarding debt-financed property.
Steven D. Bortnick is a tax attorney in the New York office of Swidler Berlin Shereff Friedman. His practice extends into the area of private investment funds, such has hedge funds and venture capital funds.