For U.S. history aficionados, November 15 is an auspicious day: It was on this day in 1777 that the Continental Congress approved the Articles of Confederation. These articles framed the basic form of government for what was to become the United States. Well, tax folks working with private funds are likely to remember November 15 for another reason as well. On this day in 2023, the Tax Court released its long-awaited decision in YA Global Investments, LP v. Commissioner.[1] In the same way that the original Articles of Confederation served as a basis for future U.S. governmental organization, the YA Global decision is likely to frame how U.S. private funds with non-U.S. investors structure their operations to avoid bringing those non-U.S. investors into the U.S. tax net.

The facts of YA Global are unique. The decision is likely to have the most precedential value to fund groups in which managers originate loans and equity raises and then transfer the funded positions to private funds and to private equity funds that directly fund their portfolio companies. From a high level, the case stands for the proposition that a private fund can be treated as engaged in a U.S. trade or business that generates income and gains taxable to non-U.S. investors when the private fund, or its affiliates, structures, negotiates and funds capital raises for U.S. portfolio companies.

I. A Brief Overview of the Stakes

If a fund treated as a partnership for U.S. federal income tax purposes, whether formed in the United States or elsewhere, is engaged in the conduct of a U.S. trade or business, then any income and gains earned by such partnership that are effectively connected to the conduct of such trade or business (effectively connected income, or ECI) are taxable to the investors in such fund as though they had earned the income directly. [2] Once the ECI is allocated to non-U.S. investors, it is generally taxable in the same manner as income and gains earned by a U.S. investor—that is, the net income and gains are taxable at a 21% rate to corporations and at graduated rates topping off at 37% for individuals.[3] If the non-U.S. investor is eligible for the benefits of an income tax treaty to which the United States is a party, the nexus standard is increased from conducting a trade or business to maintaining a permanent establishment in the United States. In all cases, the partnership generating the ECI is obligated to withhold on the amounts of ECI allocated to the non-U.S. partners and file returns reporting such withholding.[4]

With respect to investment funds, the U.S. Tax Code provides important exceptions from net US federal income taxation for trading in securities and commodities.[5] Under these “trading for your own account” safe harbors, notwithstanding that securities and commodity trading within the United States are treated as trades or businesses, the income and gains from such activities do not subject non-U.S. investors in funds engaging in such trading to net U.S. federal income tax. The exception does not apply to dealers. Credit funds, insurance companies, and various non-U.S. vehicles acquiring and holding debt securities often find themselves evaluating whether their activities constitute loan origination (which could be subject to net U.S. federal income tax) or trading in securities (which would be eligible for the safe harbor).

If the activities of a fund with non-U.S. partners are limited to investment activities, no matter how continuous or extended the work required may be, the fund’s activities will not constitute the carrying on of a trade or business.[6] The issue as to whether financial activities, like other endeavors undertaken for profit, amount to a trade or business is a question of fact.[7]

Accordingly, if a fund is engaged in trading in securities or commodities or investment activities, its non-U.S. partners will not be subject to net U.S. federal income tax (assuming that the non-U.S. investors are not themselves dealers). On the other hand, if the fund is dealing in securities or commodities or is engaged in lending activities, its activities will subject its non-U.S. partners to net U.S. federal income tax. This tax is enforced by requiring the fund to withhold on the ECI allocable to the non-U.S. partner.[8]

II. The Facts of YA Global

For the years at issue, YA Global was a Cayman Islands partnership and was taxable as a partnership for U.S. federal income tax purposes. YA Global had an offshore feeder fund named “YA Offshore” and several other direct non-U.S. limited partners. The offshore feeder fund was treated as a corporation for U.S. federal income tax purposes.

YA Global filed IRS Forms 1065 for each of the years at issue. The Form 1065 is the partnership income tax return. YA Global, however, did not file IRS Forms 8804 for any of the years at issue. The Forms 8804 report the amount of federal income tax withheld by the partnership in respect of ECI. Given that YA Global did not believe that it was generating ECI, its failure to file the Forms 8804 seems entirely understandable.

YA Global was a party to a management agreement with Yorkville Advisors (“Yorkville”), a U.S. company that served as the general partner of YA Global and also agreed to act as an agent with authority to buy, sell and otherwise transact in securities for YA Global’s account. Yorkville provided similar services for two other investment entities (but the court treated these other engagements as de minimis). Yorkville conducted extensive activities through its U.S. office on behalf of YA Global. YA Global had no employees of its own. Yorkville was compensated under a standard 2+20 structure, that is, it received a management fee of 2% of gross assets and received a 20% carried interest in YA Global’s net gains and income.

YA Global provided direct capital to portfolio companies by purchasing convertible bonds and entering into “standby equity distribution agreements” (SEDAs). Under the SEDAs, YA Global had the right, for a period of time, to buy stock in the portfolio companies at a discount to the trading price of such stock. The portfolio companies paid substantial fees to YA Global and Yorkville under the SEDAs. The convertible bonds provided for conversion prices that were in-the-money to YA Global, and issuances were sometimes accompanied by the payment of substantial fees. YA Global typically exercised its conversion rights only when it desired to sell the underlying stock.

In the convertible bond activities, Yorkville directly negotiated with borrowers concerning key terms of hundreds of loans, and conducted extensive due diligence on a borrower, on behalf of YA Global before agreeing to cause YA Global to make a loan. The loans consisted of promissory notes, convertible debt instruments with discounted conversion prices (determined at the time of conversion) and warrants to purchase additional shares of the borrower’s stock. YA Global and Yorkville received various fees from the borrowers and, after converting a convertible debt instrument into stock at a discount, would often seek to earn a spread by quickly disposing of the stock.

In the SEDA activities, YA Global signed distribution agreements with unrelated issuers allowing the issuer to sell its stock periodically to YA Global for a specified purchase price. YA Global purchased the issuer’s stock at a discount, sold it to the public at its market price and earned a spread on each share sold plus fees from the issuer.

YA Global obtained access to deal flow through introductions from investment banks and referrals from securities attorneys and accounting firms; it also sponsored industry conferences. Its marketing materials stated that its “strong reputation leads many issuers to contact [YA Global] directly.” It further touted that the Yorkville principals were “authorities on structured finance.”

The IRS asserted and the court found that YA Global was not investing or trading. It was not investing because its activities went “beyond the management of investments.” It was not trading because YA Global did not seek to benefit from a change in value of the securities that it purchased (the hallmark of trading). Instead, YA Global and Yorkville received compensation from issuers in the form of discounted securities and fees.

The fact that the IRS was challenging YA Global’s treatment of its activities as protected by the Code § 864(b) trading safe harbor first came to light in 2015.[9] Shortly before the Tax Court petition was filed by the taxpayer, the IRS released a Chief Counsel Advice memorandum, CCA 201501013 (Jan. 2, 2015), widely believed (and then confirmed in the court’s opinion) [10] to relate to the dispute between YA Global and the IRS. Accordingly, many facts regarding YA Global’s activities were known to taxpayers significantly in advance of the release of the Tax Court opinion. The Tax Court opinion covers YA Global’s 2006 through 2009 activities.

A. The Agency Issue

The first issue addressed by the Tax Court was whether it was appropriate to attribute the activities of Yorkville to YA Global. YA Global asserted that Yorkville was not an agent of YA Global, but instead was a service provider. The court agreed that, if Yorkville was a service provider, its activities should not be imputed to YA Global. A lack of attribution of activities would have insulated YA Global from being considered to be engaged in the conduct of a U.S. trade or business.

The court framed the distinction between service providers and agents in the following manner. If YA Global could only direct what Yorkville did at the outset of the provision of instructions, Yorkville should be treated as a service provider. In contrast, if YA Global had the right to give interim instructions after the charge was given, Yorkville should be treated as an agent. The Tax Court found that YA Global had the right to give interim instructions and should be treated as an agent. This finding was curious because Yorkville served as the general partner of YA Global, and YA Global had no employees. It is not clear who the court thought was in a position to provide any instructions to Yorkville.

What will be astounding to many tax practitioners is that the Tax Court completely ignored both prior case law that set forth agency tests in the context of tax law questions[11] and the independent agent versus dependent agent dichotomy set forth in IRS regulations that relate to certain ECI rules and set forth in income tax treaties that relate to permanent establishment determinations. [12] Instead, the court applied the Restatement (Third) of the Law of Agency in determining agency for purposes of imputing activities under Code § 864, while still leaving open the possibility that certain activities could be attributed for tax purposes even in the absence of an agency relationship.[13] In this regard, the court focused on Yorkville’s assent to act on behalf of YA Global as an investment manager and YA Global possessing the power under the legal arrangement to control Yorkville’s actions, particularly through the right to give interim instructions to Yorkville during the relationship.

B. The Trade or Business of YA Global

YA Global asserted that it was not engaged in a lending business by positing that the convertible securities that it acquired directly from issuers were not true loans. It further asserted that the fees paid to it under the SEDAs were akin to option premiums and not true fees. The court analyzed whether YA Global was engaged in a lending and underwriting trade or business or investment and trading by engaging in a three-part analysis:

• Were the YA Global transactions continuous, regular, and engaged in for profit?
• Were the YA Global transactions limited to the management of its own investments?
• Did the YA Global transactions constitute trading in securities within the meaning of the Code § 864(b)(2) safe harbor?

The answer to the first question was a clear “yes.”

The court’s approach to the second question was unexpected. The IRS argued that YA Global was either or each of a lending business, underwriter business, dealer business, and/or servicing business. However, the court focused more on the fact that the activities were not investment management as opposed to what particular business label were given to the activities. It seems the court implicitly held that YA Global was a servicing business; however, the court noted that this conclusion does not depend on identifying specific services that the relevant agreements required.

While the court did not articulate a standard or the elements for making this determination and the facts of the case were unique, the court did focus on the following three items: (i) the taxpayer earning income in excess of “returns on invested capital,” (ii) issuers paying fees, and (iii) issuers realizing a benefit from a taxpayer (other than, perhaps, a mere receipt of capital on an existing offering where the taxpayer simply needs to show up on the issuer’s doorstep to hand over capital).

The court extensively discussed the fees the issuers paid in connection with YA Global’s activities. The court noted that fees were paid to Yorkville as well as YA Global and that generally fees paid to Yorkville were retained as compensation for its expenses or as offset to YA Global-owed management fees (with any excess sometimes remitted to YA Global). It concluded that the fees were indicative of the conclusion that negotiating, structuring and documenting the terms of the transactions provided value to the portfolio companies.[14] The court found the fact that portfolio companies paid fees directly to Yorkville was a strong indication that the generation of fee income was a key driver of the fundings. The court held that such value creation was the provision of services to the portfolio companies that was not protected by the trading safe harbor. It further held that these capital raising services were antithetical to the conclusion that YA Global was acting as an investor. YA Global’s activities of providing direct capital to companies were not merely investing but provided substantial value to the companies in which YA Global invested. In effect, the court viewed the activities as some sort of capital solutions business or purveyor of structured capital raise products.

The court largely limited its reliance on precedence to two Supreme Court cases regarding U.S. trade or business, without entering the fray of prior authorities that addressed the outer limits of a lending business in other contexts such as bad debt deductions and personal holding companies. Arguably, the Tax Court’s line of thinking (ostensibly influenced by the facts focused on in the parties’ briefs) that YA Global should be considered engaged in the conduct of a trade or business follows the similar logic of the promoter line of cases. The promoter line of cases addresses whether an individual can take a business bad debt deduction under Code § 166 for unrepaid loans advanced to business entities promoted by the taxpayer on the basis that the taxpayer’s promotional activities are trade or business activities, even though the taxpayer is not strictly in a lending business per se.

In Giblin v. Comm’r,[15] the taxpayer, an attorney, devoted at least 50% of his working time to the development of at least 11 separate business ventures over a 20-year period. In general, these business ventures were organized as corporations. The taxpayer made equity contributions to the ventures, directed their business operations, made loans to the companies, and managed their capital structures. The businesses were diverse—some were engaged in real estate development, others in gaming, and yet others in the ownership and operation of a restaurant. A loan to one of these companies defaulted, and the taxpayer claimed a business bad debt (an ordinary loss). The IRS countered that the loan was a non-business bad debt on the basis that the taxpayer was not engaged in the trade or business of lending money. This conclusion would only have allowed the taxpayer to claim a capital loss.

The court, reversing the Tax Court, held that the taxpayer’s activities constituted trade or business (not investment) activities even though he was not engaged in the trade or business of lending money:

Taxpayer did not seek to show that he was engaged in the business of making loans. Neither did he seek to have the Tax Court "pierce the corporate veil" and find that he was engaged in the restaurant business or in any of the other businesses which he had promoted and dealt with during the preceding twenty years. What he did seek to prove was that he was regularly engaged in the business of seeking out business opportunities, promoting, organizing and financing them, contributing to them substantially 50% of his time and energy and then disposing of them either at a profit or loss.

In Newman v. Commissioner,[16] the Tax Court set forth the requirements for promoter status:

1. compensation sought is other than the normal investor's return, and income received is the direct product of the taxpayer's services and not primarily from the deployment of capital;
2. the activity is conducted for a fee or commission or with the immediate purpose of selling the securities at a profit in the ordinary course of the taxpayer's business;[17] and
3. the taxpayer had a reputation in the community for promoting, organizing, financing and selling businesses.
   
   

In addition to these specific requirements, courts have looked to some of the same criteria applied to determine the presence of a lending business, including the amount of time spent on promotion activities and the number of business ventures promoted.[18]

The recitation of the facts of the activities of YA Global generally follow these requirements. First, YA Global and Yorkville earned substantial fee income in connection with the financings, and the built-in discounts also provided income in the nature of fees. Second, the financings were frequently undertaken for immediate sales and generation of fees. Third, YA Global’s business was known in the industry for promoting and financing businesses and selling equity in companies.

C. The Mark-to-Market Issue

The IRS asserted that YA Global should be treated as a dealer in securities under Code § 475. Dealers in securities generally are required to use mark-to-market accounting to determine their income for federal income tax purposes.[19] All income and loss marks are ordinary in character, and the use of such accounting method would have deprived the non-corporate investors in YA Global from the favorable tax rate applicable to the substantial long-term capital gains recognized by YA Global. While a taxpayer subject to the dealer mark-to-market rule can designate certain securities as held for investment (and thereby exempt such securities from mark-to-market accounting), the court held that YA Global did not make appropriate investment designations. It was clear that YA Global did not sell securities to customers. Accordingly, the dispute was whether YA Global purchased securities from customers and whether this was sufficient to cause YA Global to be treated as a dealer for purposes of the mark-to-market rules.

The court held that the portfolio companies that sold securities to YA Global should be treated as its customers for purposes of the mark-to-market accounting rules. The linchpin of that analysis was not the nature or interpretation of the portfolio companies as “customers”; rather, YA Global held itself out as being willing to provide capital to portfolio companies as illustrated by Yorkville’s reputation, industry sponsorships, press, and referral network. Further, the court read the mark-to-market rules as not requiring sales to customers in order for a taxpayer to be treated as a dealer. Therefore, the court sustained the IRS’s position that YA Global was a dealer and was required to use mark-to-market accounting for all of its positions.

D. Liability for Withholding Tax

The court concluded that all of YA Global’s net income and gains, including its net mark-to-market gains, were ECI, and YA Global and Yorkville should be held liable for failure to withhold appropriate federal income tax from the amounts allocable to its non-U.S. investors.[20] The court’s analysis on this seemingly obvious conclusion given the court’s holdings described above is probably more interesting to tax practitioners than our readers. From our perspective, it’s interesting that the court spent time discussing whether Yorkville should be treated as an independent or dependent agent in generating the income—an issue that the court ignored in determining whether Yorkville’s activities should be imputed to YA Global generally.

YA Offshore, a limited partner in YA Global, directly incurred expenses with respect to its investment in YA Global. YA Global asserted that its withholding tax liability should be decreased by taking these deductions into account. A Treasury regulation allows a non-U.S. person to claim advantage of such deductions by providing notice to the withholding agent.[21] Because YA Offshore did not follow these procedures, however, the court refused to allow YA Global to reduce its withholding obligation by taking these deductions into account.

Next, YA Global argued that the statute of limitations prohibited the assessment of withholding tax against it. It argued that the tolling of the statute of limitations should be measured by the dates on which it filed its Forms 1065. It argued that any Forms 8804 that it would have filed would have simply shown all zeros (no withholding tax due) because YA Global believed that it was not engaged in the conduct of a trade or business in the United States; thus, any Forms 8804 would have been meaningless to the IRS. The court disagreed and held that the statute of limitations should be determined with reference to the dates on which it filed the Forms 8804 and since such forms were not filed, YA Global had no statute of limitations defense. In dicta, the court stated that it “might” have computed the statute of limitations from the date of the filing of Forms 8804 even if such returns were “zero” returns as long as such returns described its activities and explained the grounds for the belief that it was not engaged in a U.S. trade or business.

To make matters even worse, the court sustained a 25% penalty on YA Global for its failure to file Forms 8804. YA Global had defended against the penalty on the ground that its failure to file was due to reasonable cause. Specifically, it had received advice (though no formal opinion) from a prominent accounting firm that it was not involved in activities that would have generated ECI, and a likewise prominent law firm prepared offering material on the same basis (though fell short of delivering YA Global a clear view on the question). The court rejected this defense because YA Global had sued the accounting firm for providing negligent advice in 2015 when the case went to court and YA Global could not offer evidence that it was unaware prior to 2007 of whatever lack of information available to or negligence performed by the accounting firm for which YA Global was relying on in its malpractice suit.

III. A Few Takeaways

If a private fund is advancing cash to U.S. portfolio companies in exchange for debt instruments, whether or not convertible, it should take a long, hard look at whether it is engaged in a lending business. Furthermore, YA Global raises the specter that advancing cash for equity securities on a regular and continuous basis could cause a fund to be considered a promoter and engaged in a U.S. trade or business. The court held that regularly structuring, negotiating, and executing on such transactions were trade or business activities and not investment activities. This conclusion is likely much harder to escape when the portfolio companies are paying material fees to the funds provider and other service providers (such as the general partner). Lastly, all funds with non-U.S. partners should be filing IRS Forms 8804 even if they are not engaged in the conduct of a U.S.. trade or business, as a protective measure.

 

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Mark Leeds is a tax partner with the New York office of Mayer Brown. Mr. Leeds can be reached at mleeds@mayerbrown.com or (212) 506-2499.  

 

The author wishes to thank Mr. Steve Garden for his contribution to this article.

The view expressed herein are solely those of the author and should not be attributed to Mayer Brown.

Mistakes and omissions are the sole responsibility of the author.

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[4] Code § 1446.

[5] Code § 864(b)(2).

[6] See Higgins v. Comm’r, 312 U.S. 212, 218 (1941); Neill v. Comm’r, 46 B.T.A. 197, 198 (1942). In Higgins, supra, a taxpayer was disallowed deductions for salaries and other expenses incurred in hiring others to assist him in offices rented for the purpose of overseeing his extensive investments because his activities—including keeping records and collecting interest and dividends from his securities—were insufficient to establish a trade or business. In Neill , supra, a nonresident alien whose only US source income was rents paid on a net lease (i.e. , the lessee was obligated under the lease to pay taxes and insurance and to maintain the property) was held not to be engaged in a US trade or business. The court here stated “[a]lthough the investment exception is widely recognized, its rationale is unclear. And the absence of a clear rationale for the investment exception makes it difficult to define its parameters,” and “the line separating business activities from the management of investments is not always clear.”

[7] See F.S.A. 199911003 (Nov. 18, 1998); U.S. v. Henderson, 375 F.2d 36 (5^th Cir. 1952), cert. den. 346 U.S. 816 (1953).

[8] Code § 1446.

[9] Jackson, et. Al., Hedge Fund Petitions Tax Court Over $310 Million in Assessed Business Income, Daily Tax Report, 114 DTR K-3.

[10] [Footnote 22 in Opinion]

[11] E.g., National Carbide Corp. v. Comm’r, 336 U.S. 422 (1949); Commissioner v. Bollinger, 485 U.S. 340 (1988); Sundance Ranches, Inc. v. Comm’r, T.C. Memo 1988-535.

[12] See Treas. Reg. § 1.864-7(d)(1)(i). In InverWorld Inc. v. Comm’r, 71 T.C.M. 3231 (1996), the Tax Court took a view that Treas. Reg. § 1.864-7’s agency principles furnish “a proper framework for interpreting” Code sections relating to trade or business determinations that Treas. Reg. § 1.864-7 was not otherwise expressly provided to apply. The court here did address this dichotomy later in its opinion in relationship to determining the source of income and who was liable for withholding. See also Tasei Fire & Marine Co. Ltd. v. Comm’r, 104 T.C. No. 27 (1995).

[13] The IRS has been eroding the independent versus dependent agent rule for some time. See AM 2009-10 (Sep. 22, 2009).

[14] One troubling aspect of this approach was, perhaps in dicta, the court’s dismissal of certain commitment fees as being a return of invested capital because the fees were payable before the issuer sought any advances. Modern investing in the current marketplace evaluates opportunity cost as a basic economic input. Therefore, it is arguably very investment-like for an investor to earn non-use and similar commitment-type fees that compensate for the investor’s need to maintain available capital and limit its deployment to other investments. Given the court’s analysis, it seems questionable as to how to evaluate such a fee under a trade or business determination for a fund, and a further confusion in applying such a determination is that the weight given by the court to the fact that many fees effectively compensated Yorkville within its analytical framework is not entirely clear.  

[15] 227 F.2d 692 (5^th Cir. 1955)

[16] 56 T.C.M. 1232 (1989)

[17] In Newman, a holding period of 18 months or less was considered indicative of promotor status.

[18] See Giblin v. Commissioner, 227 F.2d 692 (5th Cir. 1955), Farrington v. United States, 111 B.R. 342 (Bankr. N.D. Okla. 1989), and Ingram v. Commissioner, 20 T.C.M. 1447 (1961).

[19] Code § 475(a).

[20] See Code § 1446(a).

[21] See Treas. Reg. § 1.1446-5(c).