Tax Traps to Avoid When Purchasing Debt from Your Portfolio Companies
If you’re like many private equity (PE) and venture capital (VC) firms, the financial stressors associated with the COVID-19 pandemic have put added strain to the companies in your portfolio. Portfolio companies may be particularly struggling with servicing their debts in this disrupted environment. Because federal incentives generally exclude debtors that are deemed to be too large or are not backed by federal mortgage loans, it may be worthwhile to alleviate financial tension from your portfolio companies through debt purchase
Purchasing debt from a portfolio company may trigger tax implications—including the cancellation of indebtedness income—but this and other tax consequences can be minimized and potentially avoided if the purchase is properly structured.
To evaluate whether a debt purchase will be beneficial to your firm and portfolio objectives, you’ll want to first ensure that it’s a legally viable transaction. Review fund documents with a lawyer to determine if the fund is legally able to purchase the portfolio company’s debt or if there are concentration limitations placed on the debt investment or the percentage of total commitments that can be invested.
Even if fund documents permit a debt purchase, the repurchase can also trigger a conflict of interest, particularly if the portfolio company manages multiple or affiliated funds with a shared sponsor. In some cases, you may need approval from each fund’s investors to resolve the conflict.
Further, confirm that the portfolio’s credit agreements don’t prohibit loan purchase by the borrower or its affiliates. Some credit agreements place a cap on the amount of loans that can be purchased or on the aggregate percent of debt held by the affiliate; contain limitations on voting rights; and outline specific requirements for the affiliate receiving the information.
Finally, your firm should consider the registration and disclosure requirements of the SEC or other governing bodies that may apply to the debt securities being purchased. A Venture Capital Operating Company (VCOC), for example, may want to consider if the debt purchase will fulfill the requirements of a good investment. If the debt investment isn’t directly in an operating company or the firm can’t maintain or obtain contractual management rights, the firm may not be in compliance with VCOC rules.
Avoiding Tax ‘Traps’
There are some adverse tax consequences of purchased debt that can be avoided or mitigated with some forethought. A key step of the analysis will be to determine whether the portfolio company and PE/VC fund are considered “related” for tax purposes. Generally, they will be considered related if the PE/VC fund directly or indirectly owns more than 50% of the value in stock of a corporate portfolio company or 50% of the capital or profits interests in a partnership portfolio company. However, there are complex attribution rules that can result in related party status even if the 50% ownership threshold is not met on its surface.
The purchase of debt from an unrelated party by an entity related to the debtor is treated as the purchase of the debt by the debtor for federal tax purposes. As a result, portfolio companies will be subject to cancellation of debt (COD) income if their debt is being acquired at a discount by a related PE/VC fund. This consequence also applies to indirect acquisitions of debt where an entity holding the debt instrument subsequently becomes related to the portfolio company, provided that the debt was acquired in anticipation of the holder and debtor becoming related parties. However, there is an exception to these acquisition of indebtedness rules where the debt is acquired by a dealer in the ordinary course of its business or where the stated maturity date of the debt is within one year of the acquisition date and the debt is retired by its stated maturity date.
If your PE/VC funds acquire the debt of related portfolio companies, you will want to determine if there is an original issue discount (OID) on the debt purchase. If debt is purchased at a discount, this difference between the stated redemption price at maturity and the issue price is reissued to the fund as accruable OID and will be included in taxable income. The portfolio company would include the OID in interest expense over the remaining term of the debt. However, here may be limitations on the portfolio company’s ability to actually deduct the OID or interest paid due to the business interest deduction rules first introduced by the tax reform law known as the Tax Cuts and Jobs Act (TCJA). The TCJA limited the business interest deductions under Section 163(j) to 30% of the taxpayer’s adjusted taxable income, though this deduction has been temporarily removed by the Coronavirus Aid, Response and Economic Security (CARES) Act.
It may be possible to structure the debt purchase through a corporate acquisition or other special purpose vehicle to avoid negative tax treatment. This allows for the purchase of debt to be taxed under market discount rules without COD income or OID, or may negate related party rules altogether. It’s worth considering, however, that corporate acquisition vehicles will be subject to entity-level income tax (or withholding tax if it is a non U.S. entity) on any income or gain resulting from the debt they acquire.
Planning to purchase your portfolio company’s debt should be taken on with care. What could be a well-meaning action could lead to unintended tax consequences. Careful tax structuring can help prevent unnecessary or added tax pitfalls that may be associated with a debt purchase and to minimize both COD and OID issues for the portfolio company.
For more information about the PE/VC tax issues involved in debt repurchases, please contact us.
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