Venture capital and other securities investment funds organized as domestic partnerships ("Domestic Funds") often have foreign persons as limited partners. In addition, domestic fund managers often establish investment partnerships outside the United States ("Offshore Funds"). In recent months, there has been substantial controversy surrounding: (i) the potential application of a 35 percent excise tax (the "Excise Tax") under Section 1491 of the Internal Revenue Code (the "Code") in respect of Domestic Fund distributions to certain foreign limited partners; and (ii) reporting obligations (the "Reporting Obligations") under Section 1494 of the Code in respect of capital contributions by domestic persons to Offshore Funds as well as Domestic Fund distributions subject to the Excise Tax.
On February 24, 1997, the Internal Revenue Service released Notice 97-18, which addresses these issues as well as certain others arising under Sections 1491 and 1494 of the Code. This memorandum briefly describes the background to Notice 97-18, its impact on Domestic and Offshore Funds, and the steps that such funds should take to deal with remaining uncertainties.
Summary of Principal Issues
1. Notice 97-18 suspends application of the Excise Tax with regard to distributions by Domestic Funds to foreign limited partners, but the Excise Tax may be retroactively reinstated.
2. The notice also modifies the Reporting Obligations, which previously mandated a separate report on the date of each applicable contribution or distribution. Under Notice 97-18, reporting is required only once for each taxable year.
Background
Excise Tax. Under Section 1491 of the Code, the Excise Tax generally is imposed on each transfer of property by a United States person to a foreign partnership, trust or estate. The Excise Tax may also apply in connection with transfers to foreign corporations, but only those transfers that qualify as paid-in surplus or contributions to capital. [1] Distributions by Offshore Funds generally are not subject to the Excise Tax.
If applicable, the Excise Tax is payable by the transferor at a rate equal to 35 percent of the transferred property's built-in gain (specifically, the excess of the property's fair market value over the sum of (i) the property's tax basis and (ii) any taxable gain recognized by the transferor in connection with the transfer).
Determining the applicability of the Excise Tax can be difficult. For example, the classification of a foreign entity as a partnership, trust or estate must be made using United States Federal income tax rules which, under certain circumstances, may require considerable analysis of the entity's organizational documents. Similarly, a foreign limited partner who is an individual could die during the term of a Domestic Fund, with the result that subsequent distributions by the Fund might be made to his or her estate.
Historically, most tax advisors working with investment partnerships believed that the Excise Tax would not apply to distributions by Domestic Funds to foreign limited partners. This view was challenged when the Internal Revenue Service issued Letter Ruling 9640022 (July 8, 1996), which, although not directly on point, suggests a willingness on the part of the Internal Revenue Service to assert Excise Tax liability in respect of such distributions. [2]
Following the issuance of Letter Ruling 9640022, several organizations (including this Firm and the National Venture Capital Association) submitted formal and informal comments to the effect that the Excise Tax should not apply in respect of distributions by Domestic Funds to foreign limited partners.
Reporting Obligations. Section 1494 of the Code was amended by the Small Business Job Protection Act of 1996 (the "Act") to impose a penalty (the "Section 1494 Penalty") for each failure to file an information return in connection with a transfer that (i) is described in Section 1491 of the Code and (ii) occurs after August 20, 1996. The penalty is equal to 35 percent of the gross value of the cash and other property transferred, even if Excise Tax does not apply because the transferred assets have no built-in gain.
Under previously existing regulations, the information return to which the Section 1494 Penalty relates must be filed on the date of each separate transfer described in Section 1491 of the Code. The resulting potential for large, inappropriate penalties under Section 1494 was recognized shortly after passage of the Act. In response, the Internal Revenue Service issued Notice 96-60 which suspended application of the Section 1494 Penalty pending the issuance of subsequent guidance. Notice 97-18 provides the guidance referred to in Notice 96-60.
Effect of Notice 97-18
Excise Tax. In Notice 97-18, the Internal Revenue Service states that it is studying the appropriate scope of the Excise Tax with regard to certain types of transfers, including distributions by domestic partnerships. Until this study is completed and subsequent guidance issued, the Excise Tax will not apply in respect of distributions by Domestic Funds to foreign limited partners. If, however, the Internal Revenue Service ultimately concludes that such distributions are properly within the scope of the Excise Tax, the tax may become due (retroactively, but without penalties) 60 days after the issuance of such guidance.
Based upon informal discussions with personnel at the Treasury Department and Internal Revenue Service, as well as our analysis of the underlying purposes of Section 1491, we consider it unlikely that the Internal Revenue Service will conclude that distributions by Domestic Funds to foreign limited partners are properly within the scope of the Excise Tax. Nevertheless, it remains possible that the Internal Revenue Service will reach a different conclusion and seek to collect the Excise Tax on a retroactive basis.
In light of this possibility, Domestic Fund managers should obtain information from limited partners to determine whether such limited partners are partnerships, trusts or estates in respect of whom the Excise Tax could apply. Based upon such information, a Domestic Fund manager may wish to consider taking steps to minimize the possible adverse impact of the Excise Tax. Such steps might include: (i) amending fund agreements to provide that the economic burden of any Excise Taxes will be allocated to the foreign limited partners in respect of whom such taxes arise; (ii) organizing separate Offshore Funds for foreign limited partners; or (iii) requesting that foreign limited partners transfer their fund interests to persons (such as individuals or corporations) in respect of whom the Excise Tax ordinarily does not apply.
Reporting Obligations. Notice 97-18 provides that, until such time as the Internal Revenue Service concludes that distributions by Domestic Funds to foreign limited partners are properly within the scope of the Excise Tax, such distributions will be exempt from the Reporting Obligations under Section 1494 of the Code.
In addition, Notice 97-18 states that information returns with respect to other transfers described in Section 1491 of the Code will no longer be due on the date of each such transfer. Instead, a domestic transferor may file a Form 926 with the transferor's annual tax return. Moreover, no reporting is required with respect to (i) a cash contribution or (ii) a transfer in which all built-in gain is recognized by the transferor, but only if in each case the transferor holds (after the transfer) less than 10 percent of both the capital and profits interests in the transferee. These changes will substantially reduce the reporting burden on domestic persons, such as fund managers, making capital contributions to Offshore Funds.
Effective Date. Notice 97-18 generally applies to transfers occurring after August 20, 1996, and therefore covers all transfers potentially subject to the Section 1494 Penalty. Moreover, although the language of Notice 97-18 is not perfectly clear, the suspension of the Excise Tax in respect of Domestic Fund distributions to foreign limited partners appears to apply retroactively to all prior transfers, without regard to when they occurred.
For additional information regarding the foregoing, please e-mail Don Bradley, Ron Roth,Ivan Humphreys or Jonathan Axelrad or call any of them at (650) 493-9300.
For additional developments in this area, see Comments on Proposed Tax Legislation Affecting Venture Capital Funds.
ENDNOTES
1. Under Section 1492 of the Code, application of the Excise Tax in respect of transfers to foreign corporations generally is superseded by Section 367 of the Code, which may require the recognition of income and gain for Federal income tax purposes, but does not impose a separate excise tax.
2. Letter Ruling 9640022 ultimately concluded that no Excise Tax was due because the partnerships in question made a technical election to have the principles of Section 367 of the Code apply to the distributions. While the language of the ruling is unclear, it appears that this conclusion was based upon the fact that only foreign partners received non-cash distributions from the partnerships (the domestic partners received only cash). Based upon our experience, very few distributions by venture capital and other securities investment funds are similarly bifurcated.