COMMENTS AND SUGGESTIONS: PROPOSED REGULATIONS ON DISGUISED PAYMENTS FOR SERVICES

Introduction We are pleased to submit the following comments and suggestions concerning the notice of proposed rulemaking entitled "Disguised Payments for Services" (REG-115452-14, 80 F.R. 43652) (the “Proposed Regulations”). We appreciate the efforts of Treasury and the Service to provide guidance in this area, and would appreciate your consideration of these comments on the Proposed Regulations and the related statements in the Preamble to the Proposed Regulations (hereinafter, the “Preamble”) regarding the scope of Revenue Procedure 93-27, particularly as they relate to so-called management fee waiver arrangements that are frequently entered into between private equity funds and their sponsors. The Proposed Regulations and Preamble propose an expansive interpretation of Section 707(a) and a restrictive interpretation of Rev. Proc. 93-27, aimed squarely at partnership profits interests received by sponsors of private equity funds in lieu of management fees. We recognize the superficial appeal of the argument that private equity professionals are service providers and their income should, as a matter of tax policy, be taxed as ordinary income. A broad interpretation of Section 707(a) and narrow application of Rev. Proc. 93-27 would move partly toward that goal, and enactment of carried interest legislation as suggested by the current administration would complete the move. We believe, however, that the approach taken by the Proposed Regulations and their Preamble would improperly expand what the actual statutory language and legislative history suggest should be a narrow exception to the basic rules of partnership taxation and would improperly limit the scope of Rev. Proc. 93-27, in each case as a result of failing to give appropriate weight to the factual, legal and tax policy support for the current law flow-throw taxation of appropriately structured fee waiver profits interests. The Proposed Regulations and the proposed exceptions to Revenue Procedure 93-27 appear to be based on the notion that there is some separate and readily identifiable portion of the economic return of private equity professionals that is inherently received for services rendered in a nonpartner capacity. This notion is incorrect. While private equity funds typically are structured so that a portion of the returns received by private equity professionals do not depend on the returns of the fund, there is nothing wrong with the professionals negotiating to reduce the portion of their returns that do not depend on the returns of the fund and to increase the portion of their returns that do depend on the returns of the fund. And while some fund sponsors have chosen to adopt a structure in which their non-entrepreneurial returns are routed through an entity that is not a partner of the fund, this should not distract from the fact that the services provided by private equity professionals are central to the economic activity of private equity fund partnerships. Accordingly, where the returns received by private equity professionals in respect of the services and other valuable contributions they provide to private equity ventures are

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received by a partner and are dependent on the returns of the partnership, these returns are properly treated as received in a partner capacity. Moreover, the Proposed Regulations appear to make the following generalized assumptions about management fee waivers: (i) management fee waivers are not irrevocable; (ii) the general partners (“GPs”) of private equity funds have unfettered control over the timing of dispositions and the valuation of partnership assets; (iii) GPs have the ability to and will manipulate asset valuations and the timing of dispositions solely to enhance the tax results of a management fee waiver; (iv) management fee waiver clawbacks are unlikely to be observed or enforced; and (v) as a result of the foregoing factors, the risk inherent in profit allocations associated with management fee waivers is significantly reduced or eliminated. We acknowledge the need to prevent tax avoidance through fee waiver arrangements that actually display these characteristics. However, we respectfully submit that the foregoing assumptions are inapplicable to most private equity management fee waivers and GPs. In relation to the Proposed Regulations, one Service official has publicly stated: "We want to be pretty sure we aren't inadvertently capturing fairly standard economic arrangements." 1 We offer these comments in the hope that the guidance can be clarified to avoid inadvertently capturing management fee waiver arrangements which represent “fairly standard economic arrangements” that do not involve abusive behavior, and which conform to the principles set forth in the legislative history of Section 707(a)(2)(A). Summary of Recommendations •

The standard of risk required by the regulations should be the “appreciable risk” standard used by the legislative history.

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The five negative presumptions included in the Proposed Regulations should be eliminated or merely treated as factors in an analysis based on all the facts and circumstances, as contemplated by the legislative history.

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If presumptions are not eliminated, the regulations also should include the favorable presumptions suggested in the legislative history, including the presumption that an arrangement with “significant entrepreneurial risk” constitutes a distributive share.

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Given that the legislative history contemplates an analysis based on all the facts and circumstances, the addition of two negative presumptive factors not mentioned in the legislative history is unwarranted.

1

See A. Velarde, “Treasury, IRS Explain Rationale for Fee Waiver Regs” (Tax Notes Today, Tax Analysts, Sept. 30, 2015, Doc 2015-21856) (quoting Clifford Warren, Special Counsel, IRS Office of Associate Chief Counsel (Passthroughs and Special Industries, speaking at a District of Columbia Bar Tax Section event).

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•

Assumptions that private equity general partners manipulate valuations and dispositions should be eliminated, given the numerous constraints on, and motivations contrary to, such purported manipulation.

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Typical cashless contribution arrangements should be recognized as inherently involving sufficient entrepreneurial risk, particularly in light of the two layers of economic risk involved in such arrangements.

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Example 3 should be replaced with an example that includes more realistic facts and that recognizes the real world constraints on a general partner’s ability to manipulate valuations and dispositions.

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Restricting the pool of profits available to support distributions under a management fee waiver profits interest to long-term capital gain and qualified dividend income should be acknowledged as increasing entrepreneurial risk and the corresponding special allocation of such items should be respected so long as it is has real economic effect consistent with the partners’ interest in the partnership.

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A measurement period for available profits determined by reference to any one or more taxable years of the partnership should be respected as having sufficient entrepreneurial risk so long as real world constraints on manipulation are present.

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If the foregoing measurement period is determined to be insufficient, a measurement period determined by reference to any two or more taxable years of the partnership should be respected as having sufficient entrepreneurial risk so long as real world constraints on manipulation are present.

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The 6th factor listed in the regulations should be eliminated as it is unsupported by the legislative history, does not address any identifiable abuse, and is arbitrarily designed to target management fee waivers by a particular group of taxpayers.

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The proposed exception to Rev. Proc. 93-27 should be abandoned because:

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it does not address any potential abuse that is not already addressed by the existing exceptions listed in Rev. Proc. 93-27;

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it is inconsistent with fundamental principles of partnership allocations, distributions and capital account maintenance; and

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it will revive disputes and litigation concerning the valuation of profits interests, consuming Service resources that could be better utilized elsewhere.

If the proposed exception to Rev. Proc. 93-27 is implemented, Rev. Proc. 93-27 should remain applicable to irrevocable arrangements entered into at inception of the partnership.

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•

No identifiable abuse is addressed by excluding from Rev. Proc. 93-27 arrangements involving the provision of services by one party and the receipt of an associated allocation by another party. Accordingly, this interpretation of Rev. Proc. 93-27 should be reconsidered.

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If such bifurcated management fee waiver arrangements generally are no longer covered by Rev. Proc. 93-27, bifurcated management fee waiver arrangements irrevocably entered into at inception of the partnership should remain eligible for the safe harbor.

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Management fee waiver arrangements should be binding and irrevocable except in limited circumstances that are outside the control of the private equity professionals. The failure to provide notice of a management fee waiver within a certain period of time should not, by itself, constitute cause for treatment of the arrangement as a disguised fee. However, regular and continued failure to provide such notice should be a factor in evaluating such arrangements. Notice to a subset of limited partnership (such as a limited partner advisory committee) should be sufficient. For a hardwired cashless contribution arrangement, inclusion of the aggregate management fee waiver amount in the partnership agreement should serve as sufficient notice.

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If Treasury and the Service intend to apply the principles of the Section 707(a)(2)(A) legislative history to preexisting arrangements, the justification and authority for such application should be provided. Absent compelling authority and justification for such application, the principles set forth in the regulations should not be applied to preexisting arrangements.

1.

Observations about the private equity industry

As a preliminary matter, we think it is important to focus on a number of key features of the economic arrangements of private equity funds and the private equity professionals who are direct or indirect partners in such funds, and the basic tax rules that apply to these economic arrangements. Thereafter, we describe various “real world” constraints on the ability and motivations of private equity professionals to manipulate valuations and dispositions for purposes of a management fee waiver arrangement. a.

Nature of economic returns of private equity professionals

First, it is a fact that successful private equity professionals earn substantial economic income. Indeed, successful private equity professionals typically earn much higher economic income than successful lawyers and accountants. This is because, unlike lawyers and accountants, private equity professionals participate in an economic activity -- private equity investing -- that involves substantial entrepreneurial risk, they share in that entrepreneurial risk and they share in the positive returns when the entrepreneurial venture is successful. Second, private equity firms and their professionals provide a range of economic contributions to a private equity investment venture. A portion of their economic contributions is in the form of cash contributions to the venture. A portion of their economic contributions is in the form of services provided for the benefit of the venture -- e.g., investigating potential acquisition targets, 4 KE 38545297.7

negotiating with sellers, financing sources and management, providing portfolio companies with operational, financing and strategic advice and structuring and negotiating the disposition of portfolio companies. A portion of their economic contributions is in the form of goodwill and similar assets provided for the benefit of the venture -- e.g., trade name or brand, investment track record, relationships with acquisition and financing sources, business know-how, and shared service or purchasing synergies across portfolio companies. The economic returns received by successful private equity professionals are commensurate with the economic contributions they provide to their private equity investment ventures. These economic returns are negotiated with sophisticated investors. These sophisticated investors would doubtless prefer that private equity professionals earn a smaller share of a venture’s economic returns, but are willing to agree to the amount received by the private equity professionals because they expect that the private equity investment venture sponsored by the professionals, net of the portion of the returns going to the private equity professionals, will produce greater economic returns for the investor than are expected from other investment options. Third, private equity professionals participate in an economic activity that largely produces longterm capital gains and other income taxed at a favorable rate. The investment funds that private equity professionals create are engaging in the economic activity that the capital gain preference is intended to encourage -- investing capital and receiving a return based on entrepreneurial risk. The capital gain preference takes the form of a reduced rate on the income produced by the investment (as opposed to a credit for the amount of dollars invested). Hence, the preference favors “smart” investment, rather than “dumb” investment. Where capital gain is produced when a partnership invests capital intelligently, it is entirely consistent with the policies underlying this preference for 100% of the partnership’s gain to qualify for the preference, as opposed to a lesser percentage that subtracts out the portion of the gain attributable to any services that helped make the investment a good one rather than a bad one. Moreover it is entirely consistent with the partnership tax rules for a partner who provides services, in addition to cash and intangible assets, to an investment partnership to share in the partnership’s capital gain preference. It is a basic feature of the partnership tax rules that a partner who shares in the income of a partnership is taxed on this income based on the nature of the activities performed by the partnership, rather than on the nature of the activities of the particular partner. A German dentist making a passive investment in, or a UK manager providing services entirely outside the U.S. to, a partnership engaged in a business in the U.S. are both treated as engaged in a U.S. trade or business as a result of sharing in the returns of the partnership’s U.S. business activities despite their own lack of any personal activities in the U.S. Where the flow-through nature of partnership taxation produces a favorable tax result, rather than a negative tax result, this should not be viewed as a tax abuse that needs to be curbed. The economic returns typically received by private equity firms and their professionals can be divided into three categories with different economic characteristics. One category is a right to share in the cumulative profits (but not cumulative losses) of the private equity investment venture. This is commonly referred to as the carried interest or incentive allocation (the “Carried Interest”). With respect to the Carried Interest, the interests of the private equity firm and passive investors in the venture are aligned on the upside but not the downside. A second category is a right to share in the profits and corresponding obligation to share in the losses of the venture. This typically comes in the form of a commitment to contribute capital to the venture, 5 KE 38545297.7

which may earn profits or incur losses depending on the success of the venture (the “Commitment Interest”). With respect to the Commitment Interest, the interests of the private equity firm and passive investors in the venture are aligned on both the upside and the downside. A third category is a right to receive payments that do not depend on the success of the venture. This typically comes in the form of a management fee (the “Fee Interest”). With respect to the Fee Interest, the interests of the private equity firm and passive investors in the venture are not aligned. While there may be a notion of a 20/1/2 “norm” for private equity funds -- 20% Carried Interest, 1% of aggregate capital commitments Commitment Interest and 2% of investor commitments Fee Interest -- there is in fact wide variation in the terms of private equity funds and hence in the nature of the economic returns received by private equity firms. The Carried Interest percentage may range from 0% (if there is a preferred return hurdle that is not satisfied) to 30% or higher. The Carried Interest may be net of all expenses or only some expenses. It may be based on returns over the life of the fund or over a shorter period (e.g., if the fund has “vintages” or, like most hedge funds, a “high water mark” with carry earned in an earlier period not reversed by later period losses). The timing of carry distributions may vary (e.g., between a realized investment “American waterfall” or a return-all-capital “European waterfall”). The capital commitment percentage of the private equity professionals may range from 0% to 10% or more. Increasingly, passive investors have sought higher levels of capital commitments by private equity professionals in order to increase the alignment of interests between the professionals and the passive investors. The level of management fee, the allocation of which expenses are borne by the private equity fund and which expenses are borne by the sponsor and the degree to which compensation received by the sponsoring private equity firm from portfolio companies or similar sources should be offset against the management fee varies significantly among different private equity funds. All three categories of economic returns for private equity firms are the subject of robust negotiation with the passive investors. The negotiation regarding the three categories of economic returns for private equity funds and their principals occurs as part of an overall economic package, not as separate and independent negotiations as to the Carried Interest, Commitment Interest and Fee Interest. In this negotiation, the principal desire of the passive investors is to increase the overall share of economic returns from the private equity venture captured by them and the principal desire of the private equity professionals is to increase the overall share of economic returns of the private equity venture captured by them. Because all of the categories of economic returns to the private equity professionals are borne by the same group of passive investors and are ultimately shared by the same group of private equity professionals, there is no principled basis on which to distinguish the portion of the overall economic returns to the private equity professionals that “should” be received as a payment not based on the returns of the venture (i.e., the Fee Interest) from the portion of the overall economic returns that are based on the returns of the venture (i.e., the Carried Interest and the Commitment Interest). There are inevitably trade-offs among the categories. Sometimes the tradeoff is explicit -- a number of funds offer investors the choice between paying either (a) a lower management fee and a higher Carried Interest or (b) a higher management fee and lower Carried Interest. At other times the trade-off is more subtle -professionals who are able to contribute greater intangible assets such as a strong brand and track record are able to raise larger funds and generate larger management fees than professionals who may be equally smart and hard-working but bring fewer intangible assets to the table. 6 KE 38545297.7

Moreover, there is no requirement under the partnership tax rules that a partner who provides services to a partnership receive any portion of that partner’s economic return from the partnership as compensation. Indeed the Service’s position is that a partner cannot be an employee of the partnership. As noted in the Preamble, there are only three categories within which returns from a partnership may be placed: a distributive share of partnership income under Code §704, a guaranteed payment for services or capital under Section 707(c) and a payment to a person not acting in a partner capacity under Section 707(a). These categories are based on the nature of the economic returns received by the partner and not on the nature of the economic benefit provided to the partnership in exchange for such economic return. It is permissible, and indeed common, for a partner who provides services to the partnership to receive all of his or her returns from the partnership in the form of a distributive share of profits. Historically, as noted above, private equity professionals have received three types of economic return from their private equity ventures. The first two -- the Carried Interest and Commitment Interest -- produce returns that are treated as distributive shares of partnership income. The third -- the Fee Interest -- produces returns treated as guaranteed payments if received by a partner in a partner capacity or as a Section 707(a) payment if received by a non-partner or viewed as received by a partner acting in a non-partner capacity. It is quite common for all of these economic returns to flow to one entity, typically the GP of the private equity fund, with the private equity professionals holding partnership interests in the GP. This is a natural structure because, as noted above, all of these economic returns are received for a single interrelated set of economic contributions (cash, intangible assets and services) provided by one group of persons, the private equity professionals. It is also common, however, to have the economic returns to the private equity professionals flow through more than one vehicle. In particular, because the Fee Interest has different economic and tax characteristics than the Carried Interest and Commitment Interest, private equity professionals often route management fee income through a management company that is not a partner of the fund. Such separation is usually driven by state or local tax considerations or estate planning considerations. For example, for private equity funds with substantial New York City operations, it is desirable to have management fee income paid to a management company that is engaged in business in New York City and is subject to the New York City unincorporated business tax, while investment income from the Carried Interest and Commitment Interest flows to a separate general partner entity that is not engaged in business in New York City. For other funds, the Carried Interest and Commitment Interest are often viewed as economic streams that are more suitable candidates for estate planning transfers than management fee streams. Separation of the management fee stream into a separate entity may avoid issues that could otherwise arise if a private equity professional makes an estate planning transfer of some, but not all, of his classes of interest in a GP entity. The fact that the management fee stream is often held through a separate non-partner entity should not be taken to mean that the management fee stream is fundamentally separate from the other economic returns received by private equity firms or is received for services that are inherently of a non-partner character. As discussed above, the Fee Interest is part of a package of economic returns to private equity professionals who provide a package of economic benefits to the private equity fund. Where all of the economic returns to the private equity fund flow through the GP, there is no requirement that any portion of the returns be in the form of a Fee 7 KE 38545297.7

Interest. Where a Fee Interest is held by a separate management company, Code § 482 principles may require that the management fee be an arm’s length price, but in light of the disparate ways one can assess the economic contributions provided by the private equity professionals through the GP and the economic benefits provided through the management company, there is a wide range of variability in determining the portion of economic returns that are reasonably allocable to the management company as opposed to the GP. While the principal desire of the passive investors is to increase the overall share of economic returns from the private equity venture captured by them and to reduce the overall share of economic returns captured by the private equity professionals, a significant secondary desire of the passive investors is increase the alignment of interests between the passive investors and the private equity professionals by reducing the portion of the professionals’ economic returns that do not depend on the success of the venture and to increase the portion of the professionals’ economic returns that share in both profits and losses of the venture. This desire to increase the alignment of interest between the passive investors and the private equity professionals has led to pressure on private equity professionals to increase their level of capital commitment to private equity funds. In particular, while a GP Commitment Interest of 0.2% is typically viewed as adequate to confirm the GP’s status as a partner for tax purposes, the market in recent years has generally pushed GPs seeking to raise private equity funds to show more “skin in the game” by assuming downside risk that is greater by a factor of 10 or more, i.e., to undertake a Commitment Interest of 2% or greater. As the business pressure to increase the Commitment Interest of private equity professionals rose, these professionals and their tax advisors recognized that while the professionals were receiving positive cash flows from the Fee Interest, they were incurring negative cash flows with respect to their Commitment Interest. This circular flow of funds -- from the private equity fund to the professionals (through the GP or management company) under the Fee Interest and from the professionals to the private equity fund (directly or through the GP) pursuant to the Commitment Interest -- produced the negative tax consequence of immediate taxation of the Fee Interest at ordinary rates without the corresponding cash (which was needed to fund the Commitment Interest). The so-called cashless contribution fee waiver arrangement has proven popular in the private equity industry for the simple reason that it achieves a business goal (facilitating a substantial capital commitment by the professionals which gives the professionals a greater stake in the individual gains and losses of the private equity fund) in a way that is tax efficient because it removes the tax inefficiencies that would otherwise be created by a circular flow of funds. The Proposed Regulations appear to be based on an assumption that the Commitment Interest is and must be separate from the Fee Interest and that a circular cash flow should be deemed to exist where one does not, in fact, exist. This is not the case. The effect of most fee waiver arrangements is to reduce the Fee Interest -- that is to reduce the amount that the private equity professionals have a right to receive independent of the economic returns of the venture -- and to increase the Commitment Interest -- that is, the amount of the returns to private equity professionals that reflects the positive returns and negative returns to the venture. This change in the economic arrangement achieves the business goal of increasing the alignment of interest of the private equity professionals with the passive fund investors and increases the exposure of the

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professionals to the entrepreneurial risks of the investment venture. It is perfectly appropriate for this change in the economic arrangement to affect the tax results of the arrangement. The proposed regulations also appear to be based on the assumption that the Fee Interest involves services that that are most appropriately viewed as rendered in a non-partner capacity. This is also not the case. The key statutory requirement of Section 707(a)(2)(A) is that the allocation and distribution “are properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the partnership.” Prior to the enactment of Section 707(a)(2)(A), case law had indicated that the nature of the services rendered by the partner -- that is, whether the services were part of the partnership’s basic operations or were more ministerial or collateral -- was the key factor in determining whether services were rendered in a non-partner capacity. Thus, in Pratt the court held that a partner who provided management services which were central to the partnership’s operations was acting in a partner capacity notwithstanding that the partner shared only in gross, rather than net income. The legislative history of Section 707 makes clear that Congress expected regulations to require a sharing in economic risk which was not present in Pratt. However the basic words of the statute -- focusing on the resemblance of the arrangement to one between the partnership and a person who is not a partner -- is most consistent with a view that services which are central to the operations of a partnership and are commonly performed by a partner should generally be treated as performed in a partner capacity. Consistent with this view is the fact that the two examples provided by the legislative history address services (architectural services and stock brokerage services) that are customarily provided on a completely separate and independent basis from any equity interest in the venture. As noted earlier, many private equity funds (particularly those based in New York) have chosen to route the Fee Interest received by private equity funds through a non-partner management company. For private equity funds located outside of New York this is not a uniform or standard practice. Private equity professionals who have not historically held the Fee Interest through a separate management company should not have any portion of their interest viewed as of a type normally received in a non-partner capacity merely because other sponsor groups have chosen that structure for their own reasons. Even for sponsor groups that do hold the Fee Interest through a separate entity, it ignores reality to suggest that the Fee Interest is somehow economically independent of, or could be received independent of, the other economic interests in the investment venture held, directly or indirectly, by the private equity professionals. Moreover, as discussed in greater detail below, typical fee waiver arrangements expose the private equity professionals to a level of entrepreneurial risk that is more than adequate under a fair reading of the legislative history. Under virtually all of the management fee waiver arrangements utilized by our clients in recent years, partnership distributions may be received and retained by the private equity professionals only to extent these distributions are supported by net profit of the partnership over the standard accounting period of a taxable year. Under the most prevalent cashless contribution version of the fee waiver arrangement, additional entrepreneurial risk comes from the fact that, in lieu of a fixed management fee, the professionals receive a contingent amount that depends entirely on the positive or negative returns of the investment venture. As discussed further below, the legislative history fully supports distributive share treatment for allocations of net income, particularly where they are contingent in amount

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and are not calculated in a manner similar to how fees for services typically rendered in a nonpartner capacity are calculated. b. Private equity sponsors generally have very limited ability to manipulate valuations and dispositions, and any motivation to do so is greatly outweighed by the desire to remain in business and protect reputation. The private equity industry is highly regulated. Since 2010, over 1,500 additional private equity fund managers have registered with the SEC as registered investment advisers. 2 The SEC’s Office of Compliance, Inspections and Examinations (OCIE) employs 900 examiners “who go out into the world and directly engage with registrants for the purpose of collecting information” for the SEC. 3 The OCIE employs a team with private equity specific industry expertise. The SEC has promulgated guidance governing virtually every aspect of fund management, including valuations, financial reporting to limited partners, fees and expenses, offering materials, and many others. A significant percentage of U.S. private equity fund managers are also subject to additional registration requirements and regulation under the European “alternative investment fund management directive” or “AIFMD.” Most fund managers are required to provide annual audited financial reports to their investors with respect to each fund vehicle. These audits are typically performed by Big 4 or other large accounting firms and are required to comply with GAAP standards, including quarterly determinations of the fair market value of each asset owned by each fund. These valuations typically are carefully scrutinized by and ultimately controlled by the auditing accounting firm. Empirical evidence indicates that value manipulation by private equity fund managers is very limited and, when undertaken, is ascertained by investors. The ultimate objective of every private equity fund manager is to maximize actual investor returns. A fund manager that prioritizes any other objective is unlikely to remain in business. Private equity fund results and peer comparisons are widely available through industry publications. Based on an analysis of an extensive fund performance dataset, Professors Brown, Gredil and Kaplan state: Our findings suggest that little manipulation of NAVs goes unnoticed by institutional investors. Some GPs of poorly performing funds appear to game returns in a last ditch effort to raise a follow-on fund. However, these attempts are unsuccessful in so far as those firms are ultimately unable to raise a new fund. In contrast, we find evidence of conservatism among the GPs of the best performing funds. This is consistent with a concern on the part of GPs about being wrongly

2

See Keynote Address at the Managed Fund Association: “Five Years On: Regulation of Private Fund Advisers After Dodd-Frank” (October 15, 2015 speech by SEC Chair, Mary Jo White to MFA Outlook 2015 Conference, New York, New York), available on www.sec.gov.

3

See “Spreading Sunshine in the Private Equity Industry” (May 6, 2014 speech by Andrew Bowden, Director of OCIE to Private Equity International (PEI), Private Fund Compliance Forum 2014 New York, NY), available on www.sec.gov.

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labeled a manipulator. This also suggests that the equilibrium behavior of GPs in reporting NAVs is influenced by the potential for gaming reported values. 4 In a May 6, 2014, speech concerning the private equity industry, Andrew Bowden, director of the OCIE, stated: “We believe that most people in the industry are trying to do the right thing, to help their clients, to grow their business, and to provide for their owners and employees.” 5 Private equity limited partnership agreements are heavily negotiated with sophisticated counterparties who utilize experienced counsel. The investors in private equity funds consist exclusively of highly sophisticated institutions and high net worth individuals. In negotiating limited partnership terms, these investors typically reference well-developed standards (such as the ILPA standards) and market norms. In addition, most of these investors are required -- either by law or by their own institutional policies -- to perform rigorous due diligence on, and continuous monitoring of, the performance of the funds in which they invest. Private equity investing involves significant risk, and private equity fund results typically are uneven from year-to-year. In addition to the aforementioned safeguards against manipulation of periodic asset valuations, there are also inherent limitations over a GP’s ability to “time” dispositions of fund assets. First and foremost among these is the reality that any disposition requires a willing buyer. Willing buyers of private equity portfolio investments consist of either other private equity funds or large companies making a strategic purchase. This universe of buyers is highly sophisticated, and as a result, both price and other terms are heavily negotiated. Acquisition agreements tend to range from 50 to 150 pages in length, and include many exhibits and require substantial disclosure concerning most key aspects of the business. Such buyers also employ rigorous due diligence utilizing teams of both legal and accounting advisers. In many cases, third-party lenders are also involved in financing such transactions. Finally, regulation such as HSR filings or industry-specific administrative approvals can significantly impact the acquisition process. All of these factors significantly limit a GP’s ability to control the timing of either acquisitions or dispositions. 2.

The Proposed Regulations diverge from the legislative history

The Proposed Regulations diverge from the legislative history of Section 707(a)(2)(A) in certain critical respects. a. Significant entrepreneurial risk is not contemplated by the legislative history as a base requirement for distributive share treatment. The Preamble to the Proposed Regulations states that “Congress identified as its first and most important factor whether the payment is subject to significant entrepreneurial risk” and that “[u]nder the Proposed Regulations, an arrangement that lacks significant entrepreneurial risk constitutes a disguised payment for services.” The legislative history does not support this key 4

Brown, Gredil and Kaplan, “Do Private Equity Funds Game Returns?” 2013 (SSRN Working Paper No. 2271690)

5

Id.

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element of the Proposed Regulations. Instead, the legislative history provides that “[t]he first, and generally the most important, factor is whether the payment is subject to an appreciable risk as to amount” and that an arrangement involving significant entrepreneurial risk “will generally be recognized as a distributive share.” 6 Thus, the legislative history refers to the presence of significant entrepreneurial risk as a presumptive factor favoring distributive share treatment, rather than as a base requirement for achieving such treatment. We suggest that the regulations be revised to replace the “significant entrepreneurial risk” requirement with the “appreciable risk” factor actually used in the legislative history. If significant entrepreneurial risk is included as a factor, the regulations should use that factor as presumptively favoring distributive share treatment, consistent with the legislative history. b.

The legislative history did not contemplate the use of negative presumptions.

The Proposed Regulations provide five factors that would be deemed to result in an automatic presumption that an arrangement lacks significant entrepreneurial risk. By contrast, the factors listed in the legislative history are described as factors which “should be considered in determining whether the partner is receiving the putative allocation and distribution in his capacity as a partner” or as factors which “may” result in recharacterization. Such language contemplates a balancing of all the relevant facts and circumstances. There is no suggestion in the legislative history of negative presumptions. The legislative history refers no less than six times to an analysis based on “all the facts and circumstances.” 7 We suggest that the regulations would more closely reflect the legislative intent behind Section 707(a)(2)(A) if all presumptions were merely treated as factors in a true “facts and circumstances” analysis. 8 c.

The legislative history did contemplate certain favorable presumptions.

If presumptions are to be included in the regulations, the presumptive factors should be revised to more closely reflect the legislative history. As noted above, significant entrepreneurial risk is arguably referenced by the legislative history as a presumptive factor in favor of distributive share treatment. Similarly, the legislative history suggests that allocations and distributions which are contingent in amount should be presumptively viewed as distributive shares: There may be instances in which allocation/distribution arrangements that are contingent in amount may nevertheless be recharacterized as fees. Generally, these situations should arise only when (1) the partner in question normally 6

Staff of J. Comm. Tax’n, 98th Cong., General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984: (Comm. Print 1984) (hereinafter, “DEFRA Bluebook”) at 227.

7

See Senate Comm. on Finance, Explanation of Provisions Approved by the Committee on March 21, 1984 (S. Prt. 98-169, Vol. 1, 226-230) (hereinafter “Senate Explanation”).

8

We note (and commend) the reference in the Preamble to an analysis based on the “totality of the circumstances.” Given the weight that regulatory presumptions are typically attributed by both tax practitioners and auditing agents, we respectfully suggest that the inclusion of several presumptive factors in the actual text of the Proposed Regulations will, in practice, effectively foreclose a true “totality of the circumstances” analysis.

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performs, has previously performed, or is capable of performing similar services for third parties; and (2) the partnership agreement provides for an allocation and distribution to such partner that effectively compensates him in a manner substantially similar to the manner in which the partner’s compensation from third parties normally would be computed. 9 The legislative history further states that “net income allocations generally appear to constitute distributive shares” unless they are “fixed as to amount and probability of payment” and are “coupled with a distribution or payment from the partnership.” 10 The language in the legislative history concerning the foregoing favorable factors more strongly suggests presumptive treatment than the language related to any negative factors. Accordingly, any list of presumptions included in the regulations should be revised to include the foregoing presumptions (including significant entrepreneurial risk) in favor of distributive share treatment. d. The addition of two presumptive factors not mentioned in the legislative history is unwarranted. Two of the negative presumptive factors listed by the Proposed Regulations include elements that are not mentioned in the legislative history. These are: •

a failure to timely notify the partnership and its partners of the waiver and its terms; and

•

an allocation “designed to assure that sufficient net profits are highly likely to be available to make the allocation to the service provider (e.g., if the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods and this allocation does not depend on the long-term future success of the enterprise).”

In particular, the second of these presumptions appears to have been added in order to to “catch” cashless contribution fee waiver arrangements, in recognition the fact that such arrangements -because they create entitlements to allocations and distributions that are neither predominantly fixed in amount nor reasonably determinable under all of the facts and circumstances -- would pass the entrepreneurial risk standard suggested by the legislative history. While the legislative history does contemplate that the regulations may include other factors, the attachment of an automatic presumption to factors not listed in the legislative history seems unwarranted, particularly given the absence of any negative presumptive factors in the legislative history. We also note the inclusion of a new (non-presumptive) factor not included in the legislative history: whether the arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one person or by persons that 9

Senate Explanation at 229.

10

DEFRA Bluebook at 228.

13 KE 38545297.7

are related, and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly. This factor also contradicts the legislative history in certain respects, as discussed in more detail in Part 4, below. 3. Typical management fee waiver arrangements While management fee waiver arrangements can take many forms, the two most common approaches utilized in the private equity fund context can be categorized as follows: (i) a capped allocation approach in which the special profit allocation cannot exceed the amount of fees waived, and (ii) a “cashless” or “deemed” contribution approach in which the special profit allocation is created by treating the amount of fees waived as a notional investment in the partnership by the service partner that has the potential to earn the same return and suffer the same losses as cash investments in the partnership by passive investors (referred to herein as the “Cashless Contribution Model”). Both approaches can be designed with varying degrees of economic risk and service partner control, depending on the ancillary features included in (or excluded from) the relevant partnership agreement. In particular, the entrepreneurial risk inherent in a typical cashless contribution arrangement fulfills both the spirit and the letter of the Section 707(a)(2)(A) legislative history and is virtually indistinguishable from the economic participation of service providers under innumerable other partnership profits interests. We also believe strongly that capped allocation arrangements can be imbued with sufficient entrepreneurial risk to warrant recognition as partnership interests, just as any number of similar allocations in other contexts are so recognized (such as “preferred return” allocations that are contingent on the existence of partnership profit). However, we recognize that a lack of unlimited “upside” participation in a capped arrangement may require that ancillary factors be reviewed more carefully under an analysis of “all the facts and circumstances” (as contemplated by the legislative history). a.

Typical cashless contribution features.

A typical management fee waiver arrangement employing the Cashless Contribution Model can be described as follows:

11

•

The management fee payable to the GP is reduced by either a fixed amount specified at inception of the partnership or periodically over the fund’s life based on GP elections. 11

•

The GP’s obligation to make cash capital contributions to the partnership is reduced by a like amount, but the GP is treated for purposes of allocations and distributions, subject to

In funds that use the “New York” model of generally routing management fees through a separate management company, the management fee may be reduced at inception of the fund, leaving the management company entitled to receive a reduces, although still reasonable, level of management fee payments. Alternatively, the management company may hold a Commitment Interest in the fund and the partner management company, rather than the GP may participate in the cashless contribution arrangement.

14 KE 38545297.7

the Fund’s generation of sufficient Available Profits as discussed below as if such amount had been contributed in cash by the GP. •

This cashless capital contribution treatment results in allocations of profit to the GP which include both the amount of the cashless contribution, as well as a positive or negative return on the cashless contribution amount. Because most private equity partnerships use a distribution-driven allocation approach, the portion of the profit allocation equal to the cashless contribution amount is “forced” (based on the principles of Treas. Reg. 1.704-1(b)(2)(iv)) to occur in priority to other profit allocations. The remainder of that allocation (i.e., the positive or negative return on the cashless contribution amount) generally occurs at the same times as profit allocations to investors with respect to their capital investment and is based entirely on the performance of the investment to which the cashless contribution relates. A negative return on an investment reduces the net allocation to the GP with respect to the cashless contributions amount.

•

The pool of profits available for the portion of the allocation equal to the cashless contribution amount (referred to herein as “Available Profits”) is restricted to long-term capital gain and qualified dividend income generated after the date of the associated waiver election, excluding appreciation inherent in the partnership’s assets as of the time of such waiver election. However, such Available Profits may only be allocated to the GP in a taxable year in which the partnership has overall net profit. There are no restrictions on the pool of profits available for the remainder of the allocation (i.e., the amount in excess of the cashless contribution amount). Distributions in respect of cashless contributions may be restricted unless and until a corresponding amount of Available Profits has been generated. Alternatively, the GP may be entitled to receive distributions in respect of cashless contributions under the general distribution waterfall, in which case, if, upon liquidation of the partnership, the aggregate Available Profits are less than the aggregate distributions received in respect of the GP’s cashless contributions, the GP is required to return the excess distributions to the other partners. The Available Profits needed to support such distributions typically can come from any one or more taxable years. For ease of reference, an Available Profits allocation arrangement based on the terms and requirements described in this paragraph is referred to hereinafter as an “Any Year Available Profits Requirement.”

•

For purposes of determining the sharing of distributions, the cashless contribution amount for a particular investment is treated in the same way as actual cash invested in the same investment. The GP’s distributions attributable to the cashless contribution are not fixed in either amount or timing. The total amount distributed in respect of any particular cashless contribution depends on the performance of the investment to which the cashless contribution relates. A proportionate share of the cashless contribution amount is distributed to the GP at the same time or times as investors receive “return of capital” distributions for that investment. The amount of any such distribution to be received by the GP is based on the ratio of the cashless contribution amount to the aggregate amount deemed to be invested in that investment (i.e., if, in a particular distribution, investors receive a return of 50% of their capital contributions for an investment, the GP will receive 50% of its cashless contribution amount for that same investment). If the investment to which a cashless contribution relates generates a profit, the return on that 15

KE 38545297.7

cashless contribution amount is distributed to the GP at the same time or times as investors receive profit distributions attributable to that investment (again based on the ratio of the cashless contribution amount to the aggregate amount deemed to be invested in that investment). If the investment to which a cashless contribution amount relates results in a loss, the amount distributed to the GP is reduced. •

As noted above, if distributions in respect of cashless contributions are permitted in advance of the generation of Available Profits, upon liquidation of the fund, the GP is required to pay to the limited partners management fee waiver distributions that were not supported by sufficient Available Profits (this requirement is typically referred to as a “clawback” or “giveback” requirement).

b. Many cashless contribution arrangements satisfy the requirements for distributive share treatment as set forth in the legislative history. A typical cashless contribution arrangement, as described above, clearly satisfies the requirements for distributive share treatment set forth in the legislative history: •

Such arrangements involve both “appreciable risk” and “significant entrepreneurial risk.” The service partner’s receipt of the waived fee amount is dependent on both (a) the partnership generating proceeds from investments to which the cashless contribution is applied to return the capital deemed to be invested in the relevant investment (not infrequently, the amount of such proceeds is zero), and (b) the generation by the partnership (also after the cashless contribution) of sufficient net profits in measurement periods of no less than 1 year. Any returns “on” the cashless contribution amount are entirely contingent on the performance of the specific investment to which the cashless contribution relates.

•

There is no cap on the allocation or distribution in such an arrangement and the allocations and distributions are neither fixed in amount nor reasonably determinable. The profit allocation subject to the cashless contribution arrangement participates in the success or failure of a particular investment in the same manner as passive investors. If the investment to which a cashless contribution relates generates a 10x return for investors, the service partner will participate proportionately in that same 10x return. If passive investors realize no return on a particular investment, the service partner will similarly realize no return on its notional investment. And if there is a loss on an investment, the GP’s overall return on its cashless contributions is reduced.

•

The interest in partnership profits attributable to a typical cashless contribution arrangement endures for the same period as the interest of passive investors in the same pool of partnership profits. The profit participation in returns on both the cashless contribution and actual cash contributions for a particular investment last until that investment is sold.

•

Distributions of the cashless contribution amount and any return on that amount are made at the same times as fund investors receive distributions attributable to that investment. In other words, the allocations and distributions received under the Cashless Contribution 16

KE 38545297.7

Model are not in any way designed (or expected) to be close in time to the GP’s performance of services for the partnership. •

As discussed above, the GP is a partner of the partnership independently of the management fee waiver profits interest. Accordingly, the GP does not become a partner solely to obtain tax benefits.

•

As discussed above, the GP typically has significant interests in both fund capital and profits in addition to the management fee waiver profits interest. Thus, the GP’s interest in general and continuing partnership profits is substantial and is not limited to a particular time period.

We also note that private equity fund managers normally do not perform services for third parties in a non-partner capacity, and we think it is clear that cashless contribution arrangements do not remotely resemble the manner in which compensation normally would be computed in a thirdparty arrangement. 12 c. Cashless contribution arrangements have independent business purposes. As discussed in detail in Part 1, cashless contribution arrangements developed in large part as a response to increasing business pressure to increase the Commitment Interest of private equity professionals and as a way to avoid tax inefficiencies that would otherwise be created by a circular flow of funds. In addition, the cashless contribution approach is now widely accepted industry practice by both investors and fund managers. This is particularly important given the difficulty of introducing alternative arrangements into highly complex and heavily-negotiated partnership agreements. d. Suggested clarifications of the Proposed Regulations in relation to cashless contribution arrangements. If, despite their inconsistency with the legislative history, the regulations retain “significant entrepreneurial risk” as a base requirement for distributive share treatment, and the five negative presumptions set forth in the Proposed Regulations, we suggest that various aspects of the regulations be revised to clarify that cashless contribution arrangements as described above generally will be afforded distributive share treatment. i. circumstances.

Replacement of Example 3 with an example based on realistic

We understand that determinations concerning the ability of any particular GP to control valuations and the timing of dispositions ultimately must be based on the facts and circumstances applicable to such GP. However, for the reasons described above, the assumptions set forth in Example 3 of the Proposed Regulations ignore reality. It is inappropriate and unrealistic to assume that such control typically exists, or that GPs typically would utilize their position to prioritize the GP’s own tax results under a management fee waiver arrangement over compliance with fiduciary and regulatory obligations or over maximizing investor returns. We urge the Service to caution agents against such assumptions and to replace Example 3 in the Proposed 12

Senate Explanation at 229.

17 KE 38545297.7

Regulations with an example involving a real world set of circumstances in which a GP is subject to typical fiduciary duties and regulatory requirements and desires to remain in business. (For ease of reference, we refer hereinafter to a typical set of duties, requirements and business motivations as “Real World Constraints.”) Such an example should conclude that such a GP could not and would not control either partnership asset valuations or the timing of asset dispositions in a way that could realistically impact the GP’s results under a properly designed (and typical) management fee waiver arrangement. ii. Clarification regarding appropriate net profit measurement periods for purposes of determining GP’s right to receive or retain distributions. (a) An Any Year Available Profits Requirement should be recognized as sufficient where Real World Constraints are present. As noted above, many management fee waiver arrangements under the Cashless Contribution Model include an Any Year Available Profits Requirement, which allows the allocation of Available Profits from any one or more taxable years (ending after the date of the relevant waiver election) to serve as support for distributions received under the management fee waiver arrangement. Although private equity professionals always hope and expect that their fund will generate a net profit in one or more calendar-year periods, this is by no means guaranteed. Private equity partnerships generate significant expenses in every calendar-year period, and they generate investment losses in many calendar-year periods. There has been no shortage of private equity funds that have failed to return all invested capital (i.e., that produced an overall net loss) for any number of reasons, including: (i) an investment thesis that was ill-timed relative to macro-economic forces, (ii) an investment thesis that was ill-advised based on factors specific to a particular region or industry, (iii) a lack of needed experience or knowledge by the relevant private equity professionals; or (iv) the lack of sufficient capital to sustain the companies in which the fund invested. Given the myriad variables that may cause a particular fund to succeed brilliantly or fail miserably, and the number of funds that have failed to return invested capital, it simply ignores reality to assume that every fund will generate a net profit in at least one calendar year. Because of this, where Real World Constraints are present, an Any Year Available Profits Requirement (i.e., a measurement of Available Profits determined by reference to any one or more taxable years) clearly gives rise to appreciable risk (as contemplated by the legislative history) and should be recognized as having sufficient entrepreneurial risk in final regulations. 13 (b)

Alternative Available Profits measurement periods.

If the Treasury and Service ultimately conclude that an Any Year Available Profits Requirement results in insufficient entrepreneurial risk, we respectfully suggest that an arrangement requiring net profit over any two or more successive calendar years (ending after the date of the applicable waiver election) should be viewed as resulting in sufficient risk, so long as Real World 13

We note that in arrangements where waiver elections may be made during the fund’s life (rather than solely at inception), the risk inherent in an Any Year Available Profits Requirement increases for waiver elections in later years because the number of years from which Available Profits may be taken is reduced to those occurring during the remaining life of the fund and because any appreciation inherent in the fund’s investments as of the date of such waiver elections must be excluded.

18 KE 38545297.7

Constraints are present. A two-calendar year requirement imposes the additional risk that losses in one of the years will exceed the profit, if any, generated in the other year. Accordingly, such a requirement clearly involves significant entrepreneurial risk. iii. overlapping risk.

Cashless contribution arrangements involve multiple layers of

As described above, under the Cashless Contribution Model, the service provider typically receives with respect to any given cashless contribution amount the right to participate in the proceeds of a particular investment (a “CC Investment”) or group of investments. Although the service provider’s right to retain any particular distribution is generally subject to the presence of sufficient Available Profits in one or more applicable measurement periods (i.e., the Any Year Available Profit Requirement), the distributions of profit actually received by the service provider in respect of a particular cashless contribution amount (i.e., the return “on” that cashless contribution amount) are typically attributable to a single partnership investment (i.e., the CC Investment to which such cashless contribution amount relates). If the CC Investment generates proceeds in excess of the aggregate amount of partnership capital invested in that CC Investment, the service provider will receive a portion of those proceeds. If the CC Investment does not generate proceeds in excess of the amount invested in the CC Investment, the service provider may still receive distributions representing the related cashless contribution amount, 14 but will never receive any more (with respect to that cashless contribution amount) than the cashless contribution amount. In effect, the profits interest in respect of any given cashless contribution amount is subject to two overlapping layers of risk: (i) the risk that the related CC Investment may or may not generate actual distributable proceeds (as well as the fact that the return “on” any given cashless contribution amount can be generated solely by the related CC Investment), and (ii) the Any Year Available Profits Requirement, which involves the risk that the partnership may or may not generate net profit in any one or more applicable measurement periods sufficient to permit the service provider to retain distributable proceeds from the related CC Investment. The Proposed Regulations appear to contemplate an analysis based solely on the second of these risks. Given the prevalence of the Cashless Contribution Model, final regulations should address the first layer of risk inherent in such arrangements. In addition, it should be noted that, by tying the service provider’s participation in distributions to a single investment, the first layer of risk by itself constitutes sufficient entrepreneurial risk (so long as Real World Constraints are present). Indeed, the risk inherent in a single investment in a privately-held company is in most cases greater than the risk that a multi-investment partnership will or will not generate a cumulative net profit over its entire lifespan. Moreover, while we believe that an Any Year Available Profits Requirement generally constitutes a level of risk consistent with the spirit of the legislative history, it is beyond question that adding 14

As is the case for passive investors, this will happen only if other investments made by the partnership generate sufficient proceeds in excess of the capital invested in those other investments to restore any loss on the investment to which the cashless contribution relates.

19 KE 38545297.7

the additional “first layer” of risk inherent in the Cashless Contribution Model results in significant entrepreneurial risk. Accordingly, given the prevalence of the Cashless Contribution Model, final regulations should expressly recognize arrangements involving overlapping layers of risk and provide an example acknowledging that such arrangements typically involve sufficient entrepreneurial risk (so long as Real World Constraints are present). iv. Restricting the pool of Available Profits to long-term capital gain and qualified dividend income generally should be respected so long as such restriction has real economic consequences and the allocation of such items is contingent on the presence of sufficient net income in the applicable measurement period. As described above, in a cashless contribution arrangement, the pool of Available Profits is frequently restricted to long-term capital gain and qualified dividend income. There is no question that this restriction has tax benefits for the private equity professionals. However, this restriction also has real economic consequences and indeed increases the entrepreneurial risk of the arrangement. The management fee waiver profits interest entitles the GP to receive and retain only that amount of distributions equal to the long-term capital gain and qualified dividend income allocated as Available Profits. Moreover, restricting the pool of Available Profits to these items results in a smaller pool of Available Profits relative to the total potential pool of partnership income. Accordingly, entrepreneurial risk is increased relative to the risk inherent in an unrestricted pool. Given the real economic consequences and the increased entrepreneurial risk resulting from this restriction, as well as its prevalence in management fee waiver arrangements, the final regulations should address such restrictions and recognize their consistency with the partners’ interests in the partnership. v. Strict compliance with the substantial economic effect requirements of Treas. Reg. 1.704-1(b)(2) should not be required for distributive share treatment of a management fee waiver profits interest. Given the prevalence of distribution-driven partnership agreements among private equity funds, we respectfully suggest that final regulations acknowledge this fact and include an example involving such a partnership agreement where distributive share treatment is acknowledged. The use of distribution-driven partnership agreements should be encouraged, as they increase the likelihood that allocations will be consistent with the economic consequences realized by the partners. In any case, distribution-driven agreements are almost universally required in private equity fund partnerships by the passive investors, who are unwilling to subject their economic results to the vagaries of partnership capital accounting rules. In private equity partnerships, the economic deal between the passive investors and the sponsor is the "dog" and the section 704(b) capital account maintenance rules are the "tail." It is entirely appropriate that the fail follow the dog, rather than the reverse. Accordingly, private equity fund GPs rarely have the option of complying with the substantial economic effect requirement that the partnership liquidate in accordance with capital account balances. A contractual requirement imposed by passive investors is not a legitimate basis for denying distributive share treatment, particularly where that contractual requirement merely increases the likelihood that the partnership’s profit allocations reflect the partners’ economic results. 20 KE 38545297.7

4.

New 6th Factor One non-presumptive factor included in the Proposed Regulations reads as follows: The arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by a single person or by persons that are related under Sections 707(b) or 267(b), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.

This factor is not included in the legislative history and contradicts the legislative history in certain respects. As noted above, the legislative history indicates that appreciable risk is the most important factor, and that allocations which are contingent in amount should be recharacterized only in limited circumstances. In addition, the partnership tax law imposes no requirement that all allocations made to a partner must have the same level of entrepreneurial risk and there are innumerable instances in which partnership agreements create multiple allocations to a single partner (or group of partners) that have varying levels of entrepreneurial risk. As discussed in detail in Part 1, the professionals who manage private equity investment ventures have a package of economic interests in the venture that are ultimately inseparable, and are the subject of trade-offs resulting from negotiation. The allocations attributable to their commitment interest and carried interest have levels of entrepreneurial risk that vary significantly, even in the absence of a management fee waiver profits interest. As discussed in Part 1, it ignores reality to analyze these various interests as if they existed in isolation. They do not. And private equity professionals should not be constrained from agreeing to different methods of allocating their package of economic interests between the various categories of partnership returns into which they might fall. There is no identifiable abuse in doing so. Accordingly, we respectfully suggest that this factor be omitted from the regulations. 5.

Proposed exception to Rev. Proc. 93-27

a. Rev. Proc. 93-27 should remain applicable to profits interests that satisfy the requirements of the regulations. The Preamble describes the intention of Treasury and the Service to issue a revenue procedure excluding from Rev. Proc. 93-27 a profits interest issued in conjunction with a partner forgoing payment of an amount that is substantially fixed (including a substantially fixed amount determined by formula, such as a fee based on a percentage of partner capital commitments). The rationale for such an exception is not stated. Rev. Proc. 93-27 was published primarily to end disputes between the Service and taxpayers concerning the valuation of partnership profits interests, given disparate decisions by the courts concerning whether and how such interests can be valued upon issuance. Rev. Proc. 93-27 does not apply if (1) the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high21 KE 38545297.7

quality net lease; (2) within two years of receipt, the partner disposes of the profits interest; or (3) the profits interest is a limited partnership interest in a “publicly traded partnership” within the meaning of section 7704(b). These existing exceptions describe circumstances in which the value of a profits interest can be more easily ascertained. We assume that the proposed new exception is based on a similar premise -- i.e., that the willingness of a partner to accept an interest in partnership profits and forego a fixed amount of fees necessarily means the value of that profits interest is not sufficiently uncertain to justify application of Rev. Proc. 93-27. Given that Rev. Proc. 93-27 applies only to partnership profits interests and that an interest in profits will be considered a partnership interest only if it is not recharacterized as a disguised payment for services under the new regulations, the logical inference is that only interests which satisfy the entrepreneurial risk standard of the regulations will be affected by the proposed new exception. We respectfully suggest that the apparent scope of the proposed exception to Rev. Proc. 93-27 is overbroad. A blanket exception like the one suggested in the Preamble would capture many “fairly standard economic arrangements,” including the arrangements that the Proposed Regulations recognize as non-abusive. Moreover, it is unclear what abuse the proposed exception would prevent that is not already addressed by the requirements of the Proposed Regulations and the existing exceptions to Rev. Proc. 93-27. In order to qualify as a distributive share under the Proposed Regulations, a profits interest must have sufficient entrepreneurial risk, which, based on the legislative history, the Preamble and the requirements of the Proposed Regulations, should mean that a substantial degree of uncertainty exists concerning the valuation of that profits interest. This level of uncertainty appears to be entirely consistent with the uncertainty inherent in the profits interests Rev. Proc. 93-27 was intended to cover. If there is concern that a particular profits interest may satisfy the requirements of the Proposed Regulations even though it (i) confers a right to participate in “a substantially certain and predictable stream of income from partnership assets,” (ii) is disposed of shortly after receipt, or (iii) is an interest in a publicly traded partnership, those concerns are already addressed by the existing exceptions to Rev. Proc. 93-27. If the proposed exception is intended to address a situation involving an allocation that is capped (or some other narrow situation in which the value of a profits interest is deemed to be readily ascertainable) but which nonetheless somehow satisfies the requirements of the Proposed Regulations, the proposed exception could be crafted narrowly to address such situations. A blanket exception like the one suggested by the Preamble would appear to be premised on an assumption that every profits interest issued in conjunction with a partner forgoing payment of an amount that is substantially fixed must necessarily have a value equal to the foregone amount (as illustrated by the assumption in Example 5 of the Proposed Regulations). There are multiple reasons to reject this as a blanket assumption. First, as discussed above, in addition to their economic and tax benefits, GPs typically have significant independent motivations for agreeing to management fee waiver arrangements. The Cashless Contribution Model facilitates satisfaction of investor requirements that the private 22 KE 38545297.7

equity professionals commit ever larger amounts of their personal capital to the venture. Management fee waiver arrangements also more closely align the private equity professionals’ economic interests with that of passive investors because management fee waiver arrangements subject more of the professionals’ interest to the risk and reward of the venture, and typically defer more of the GP’s economic interest until the venture generates distributable proceeds. Second, as discussed in detail in Part 1, the “package” of economic interests in a private equity venture held by private equity professionals is ultimately a blend of various interrelated interests all of which are ultimately “borne” by the same group of passive investors. The negotiation regarding the three categories of economic returns for private equity funds and their principals occurs as part of an overall economic package, not as separate and independent negotiations as to the Carried Interest, Commitment Interest and Fee Interest. There are inevitably trade-offs among the categories -- some explicit and others more subtle. Accordingly, it ignores reality to suggest that a particular value “should” be ascribed to any one portion of the ultimately inseparable package of economic interests held by the private equity professionals. Third, even if one were to ignore the inseparability of the various economic interests held by the private equity professionals, with respect to many management fee waiver arrangements (such as, for example, those under the Cashless Contribution Model), it would be inappropriate to assume that the waived fee amount constitutes compelling evidence of the value of the management fee waiver profits interest. For most federal tax purposes, the most compelling evidence of value is the price point at which both (i) a willing seller would sell and (ii) a willing buyer would buy. No such sellers or buyers are present in the context of management fee waiver arrangements. While a periodic election by a GP of a private equity fund to give up a right to a fixed management fee and to receive, in lieu thereof, a profits interest in the fund may provide a data point regarding the subjective view of the private equity principals as to the value of the profits interest, private equity professionals are, by nature, optimistic risk takers and the amount of fixed management fee that the principals agree to give up is likely to bear no close correlation to what a third party would be willing to pay for the profits interest. Accordingly, determining the value of the management fee waiver profits interest is necessarily a speculative exercise. Valuation methodologies exist which allow one to ascribe a value to any partnership profits interest, no matter how speculative. That was the case long before Rev. Proc. 93-27 was published. So it is clear that Rev. Proc. 93-27 was not intended to be limited to profits interests which are impossible to value or for which there is a complete absence of variables that potentially could be considered as part of a valuation analysis. Instead, Rev. Proc. 93-27 relates to interests for which a value is not “readily ascertainable” -- i.e., interests that involve a meaningful degree of uncertainty in valuation. Profits interests which satisfy the requirements of the Proposed Regulations will necessarily involve a meaningful degree of valuation uncertainty. Accordingly, we urge Treasury and the Service to reconsider the need for the proposed new exception. If the new exception is perceived to be necessary, we suggest that its scope be limited so that it applies only in very limited circumstances with respect to arrangements which satisfy the requirements of the Proposed Regulations. b. It is fundamentally inconsistent with the principles of partnership allocations and capital account maintenance to impose tax upon the issuance of a partnership profits interest that satisfies the requirements of the Proposed Regulations. 23 KE 38545297.7

Fundamental to subchapter K are the concepts that partnership income is taxed once and that partnership income or loss is allocated among the partners in accordance with their economic interests in such income or loss. To ensure that partnership income is taxed only once, subchapter K and the regulations thereunder generally seek to achieve the result that a partner’s “outside” basis in his partnership interest matches his “inside” basis in his share of the partnership’s assets. To ensure that partnership income or loss is allocated among the partners in accordance with their economic interests in such income or loss, the regulations under § 704(b) generally seek to have each partner’s capital account equal the amount that such partner would receive in a hypothetical liquidation of the partnership. Illustrating the concern about the impact of taxation of compensatory grants of profits interests on partnership tax accounting, the Diamond and St. John cases both quote a passage from the Willis treatise on partnership taxation: “the service partner is taxable on his distributive share of partnership income as it is realized by the partnership. If he were taxed on the present value of the right to receive his share of future partnership income, either he would be taxed twice, or the value of his right to participate in partnership income must be amortized over some period of time.” Another leading treatise on partnership taxation states the following: Intuitively, it seems that a person should be taxed on receipt of an interest in existing partnership capital in connection with the performance of services, subject to the timing rules of § 83. Intuition also leads to the expectation that a transfer of a mere right to share in future partnership appreciation and income should not be taxed upon receipt. This intuition is informed by experience: admission to professional partnerships has never been treated as a taxable event. Finally, it is informed by practical considerations: (1) valuing a mere expectancy is difficult and (2) more fundamentally, the transferee's share of future partnership income and appreciation will be included in his distributive share of partnership income when realized by the partnership. Certainly, service providers should not be taxed twice on the same partnership income. 15

The quoted passages highlight the issue that the mechanics of capital account maintenance and the allocation of items of income and deduction among partners appear to break down when a compensatory profits interest is taxed upon issuance. This point is made clear when, as discussed further below, an attempt is made to reconcile the partners’ respective capital accounts and liquidation entitlements following a taxable issuance of a compensatory profits interest. If Treasury and the Service do intend to impose tax on profits interests issued in common commercial arrangements like management fee waivers, we respectfully suggest that taxpayers (and auditing agents) will require a substantial amount of immediate guidance beyond that provided in the Proposed Regulations in order to report the tax consequences of such arrangements. Even under the existing paradigm, the courts and Treasury have struggled to provide a coherent set of rules. As McKee, Nelson & Whitmire note: [T]he tax consequences of the issuance and receipt of a partnership interest in connection with the performance of services are among the most unsettled in the partnership area. The issues have never been dealt with legislatively, are dealt with only opaquely by 15

McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners (4th ed. 2007 & Supp. 2015-4) at ¶5.01.

24 KE 38545297.7

existing Regulations, and have been thoroughly confused by a welter of inconsistent and poorly analyzed court decisions. Further, the era of relative administrative certainty initiated by the issuance of Revenue Procedure 93-27 closed with the issuance of Proposed Regulations on May 24, 2005 (the 2005 Proposed Regulations). 16

In the wake of the proposed exceptions to Rev. Proc. 93-27, in addition to the fundamental question concerning the valuation of partnership profits interests, taxpayers (and auditing agents) will need answers to the following questions, among others: •

Is the partnership entitled to a deduction upon issuance of a profits interest?

•

If so, how is that deduction allocated among the partners?

•

Does the service provider receive a capital account and tax basis equal to the taxed income amount?

•

How does the service provider recover such tax basis?

The 2005 proposed regulations would potentially provide answers to some of these questions. However, those regulations have now been in limbo for over 10 years. We respectfully suggest that adopting exceptions to Rev. Proc. 93-27 like those proposed in the Preamble before providing guidance to taxpayers about the foregoing questions (among numerous others) puts the cart before the horse. To illustrate the uncertainty (and difficulty) created by the proposed exceptions to Rev. Proc. 9327, consider the following facts, which are not at all uncommon in the private equity context: In Year 1, GP waives $1 million of management fees that otherwise would be payable in Year 1 by Partnership and receives an interest in Partnership profits under the Cashless Contribution Model that satisfies the requirements of the Proposed Regulations. In Year 1, Partnership makes certain investments and incurs certain expenses but generates no items of gross income. If GP is to be taxed in Year 1 upon receipt of its profits interest, the first question of course is the amount of income GP is deemed to recognize. As to this valuation issue, the proposed exceptions are virtually certain to revive the uncertainty and concomitant valuation disputes and litigation that Rev. Proc. 93-27 put to rest 22 years ago. Given the budget and resource constraints under which the Service operates, and the general lack of success enjoyed by the Service in the courts prior to Rev. Proc. 93-27, this is a surprising choice and is totally inconsistent with most of the other rulemaking decisions made by Treasury in recent years. The next question arising in this example is whether GP receives a capital account and/or tax basis in Partnership equal to the income deemed to be recognized on issuance of the profits interest. If so, does this involve a shift of capital (book and/or tax) from other partners? If a shift of capital is involved, how is that consistent with the notion that GP’s interest is not, in fact, a capital interest but is merely an interest in future profits? If Partnership liquidated on the date of 16

Id, referring to proposed regulations concerning the receipt of partnership interests in connection with the performance of services (REG-105346-03, May 24, 2005).

25 KE 38545297.7

issuance (or at the end of the issuance year), the other partners would still receive all of the value inherent in their existing capital accounts and GP would receive nothing. If GP receives no capital account or basis, is that consistent with GP’s Year 1 recognition of income? Will GP then be double taxed on the recognized amount when income is allocated in future years? If GP receives basis equal to the income recognized, is GP entitled to recover that basis incrementally to avoid double taxation as income is allocated in future years? Or will GP be entitled to basis recovery only upon liquidation of its Partnership interest, causing GP to initially suffer and live with double taxation for Partnership’s entire lifespan and perhaps longer (or permanently), depending on whether GP can ever use the capital loss? Is a deduction generated by Partnership upon issuance of GP’s profits interest? Does this increase Partnership’s allocable loss in Year 1? If so, who is allocated the deduction? The collective interest of the other partners in existing Partnership capital is not impaired in Year 1 (or in any future year, for that matter). Should GP be allocated the deduction as a means to effectively zero-out a GP capital account deemed to arise as a result of the Year 1 income recognition thereby shifting back to the other partners the capital initially shifted over to GP? Presumably (and appropriately), this would eliminate GP’s risk of double taxation, but is this the Year 1 tax result that Treasury and the Service intend? We believe the foregoing questions illustrate the fundamental inconsistency of the proposed exceptions to Rev. Proc. 93-27 with basic partnership allocation and capital account maintenance rules, and -- if Treasury and the Service do intend to proceed with such exceptions -- the importance of first providing taxpayers with guidance for tax reporting under the new paradigm. Ultimately, we believe a far more rational approach to the above fact pattern is to apply existing principles of Subchapter K and tax GP as profits are allocated to GP in the future. If Treasury and the Service intend to move forward with the proposed exceptions to Rev. Proc. 93-27, Treasury should explain how those exceptions are consistent with the principles of partnership tax accounting that serve as the underpinning to Subchapter K. Absent a coherent reconciliation with such principles, the proposed exceptions appear to arbitrarily single out one common commercial arrangement (primarily used by one group of taxpayers) for irrational tax treatment that is inconsistent with the treatment of many other common commercial arrangements with similar or identical economic characteristics. 17 We fail to see how this furthers the goal of sound tax policy. c. If the exception to Rev. Proc. 93-27 is generally applicable to arrangements that satisfy the requirements of the regulations, it should be inapplicable to irrevocable arrangements entered into at inception of the partnership. Many management fee waiver arrangements are entered into as part of the original terms of understanding between partners. While it may be possible in at least some of such cases to ascertain a foregone fee amount, arrangements entered into at the partnership’s inception would seem to entail the lowest risk for potential abuse and the highest degree of entrepreneurial risk and valuation uncertainty. 17

Recall that the questions raised by the Rev. Proc. exceptions arise only in the context of an interest in partnership profits that is respected as a partnership interest pursuant to the Proposed Regulations.

26 KE 38545297.7

More importantly, as discussed at length in Part 1, there is no principled basis on which to distinguish the portion of the overall economic interest of the private equity professionals that “should” be received as a payment not based on the returns of the private equity venture and no requirement under the partnership tax rules that a partner who provides services to a partnership receive any portion of that partner’s economic return from the partnership as compensation. Accordingly, private equity professionals should not be penalized for agreeing at the inception of a partnership to any particular allocation of their economic interest among the possible categories of partnership returns. In addition, it is difficult to draw a principled line between “up-front” arrangements where a foregone fee amount may be ascertainable from those where a foregone payment may be less clear. The Proposed Regulations and Rev. Proc. 93-27 relate solely to interests in partnership profits received for services. As noted above, methodologies exist for ascribing value to virtually any stream of potential profits no matter how speculative. So as a purely theoretical matter, one could say that virtually any interest in partnership profits issued to a service partner represents a substitute for some fixed amount. As a practical matter, Rev. Proc. 93-27 was promulgated to end disputes over whether and how such amounts could be determined. We believe that management fee waiver arrangements entered into as part of the original terms of understanding between partners generally represent the type of interests to which Rev. Proc. 93-27 was intended to apply. Moreover, we believe most such arrangements fall into the category of “fairly standard economic arrangements” that Treasury and the Service purportedly do not intend to “capture.” Accordingly, if Treasury and the Service do intend to move forward with the proposed exception, we urge Treasury and the Service to craft the exception so that “up front” or “hardwired” arrangements remain eligible for coverage under Rev. Proc. 93-27 (except, of course, where they fall into one of the existing exceptions). d. Arrangements involving the provision of services by one party and the receipt of an associated allocation by another party are not inherently abusive and should not automatically be excluded from coverage under Rev. Proc. 93-27. The Preamble states that Treasury and the IRS believe Rev. Proc. 93-27 does not apply to a situation where one party (e.g., a management company) waives a management fee and a related party (e.g., the GP) “receives an interest in future partnership profits the value of which approximates the amount of the waived fee.” The Preamble cites two reasons for this conclusion: first, that the recipient (here the GP) is not receiving the interest in partnership profits “for the provision of services to or for the benefit of the partnership in a partner capacity or in anticipation of being a partner” and, second, that the “service provider [here the management company] would have effectively disposed of the partnership interest (through a constructive transfer to the related party [here the GP]) within two years of receipt.” We find this interpretation of Rev. Proc. 93-27 unpersuasive, at least where this occurs in private equity fund context. These arrangements are typically entered into in connection with the formation of a fund. Whether the sponsors of a private equity fund set up a management company in addition to a GP and the division of responsibilities and of fee income and future profits between the management company and the GP, is, in our experience, based on business 27 KE 38545297.7

considerations (e.g., control of the entities and allocation of income among principals) and state and local tax planning, not federal income tax planning. We see little reason (or grounds) for Treasury and the IRS to second guess the allocation of income and profits between the general partner and a management company in an attempt to argue that the GP is not receiving the interest in future profits for services as a partner or that there is a constructive transfer transfer of a profits interest from the management company to the GP. In our experience, the management company (the entity typically receiving a reduced management fee) and the GP (the entity typically receiving an interest in future partnership profits) are generally both (i) entities treated as partnerships for federal income tax purposes, (ii) largely owned and controlled by the same persons, and (iii) providing services to the fund partnership through the services of their owners and principals. Thus, the recipient of the interest in future profits (i.e., the GP) is in fact providing services to the fund partnership in a partner capacity as required by Rev. Proc. 93-27. As noted above, it seems relatively clear that the existing exclusions from Rev. Proc. 93-27, including the non-applicability of Rev. Proc. 93-27 where a service partner disposes of a profits interest within two years of its receipt, are designed to address situations where the value of a profits interest is readily ascertainable. However, even if it were appropriate to view a profits interest as first issued to the management company and then transferred by the management company to a related GP (and for the reasons noted above we think this is far from clear), the transfer of a profits interest between related parties for no cash or other consideration simply provides no indication of the value of the profits interest at all. Thus, the suggested interpretation of Rev. Proc. 93-27 will create in this context all the valuation issues and disputes that the revenue procedure was designed to avoid. In addition, as noted above, it creates many complex issues regarding basis, capital accounts and their connection to partners’ distribution rights, whether the partnership is entitled to a deduction and how any deduction should be allocated among the partners. In short, we see little tax policy reason to change the interpretation of the revenue procedure. The real question here is whether there is a disguised fee for services and that should be addressed by the final regulations, not by changing the interpretation of the revenue procedure or adding new exclusions to it. Finally, if notwithstanding this discussion, Treasury and the IRS believe it appropriate to exclude this situation from benefits of the revenue procedure, we think they should not do so by announcing a new interpretation of the revenue procedure; rather, they should do so only by adding an explicit exception and applying it prospectively (with guidance on how to address the associated issues). e. If bifurcated management fee waiver arrangements generally are no longer covered by Rev. Proc. 93-27, management fee waiver arrangements irrevocably entered into at inception of the partnership should remain eligible for the safe harbor. For the same reasons described in Section 5.c. above, if bifurcated management fee waiver arrangements generally are no longer covered by Rev. Proc. 93-27, management fee waiver arrangements irrevocably entered into at inception of the partnership should remain eligible for the safe harbor. In addition, the (apparent) concern about dispositions of profits interests is not 28 KE 38545297.7

present with management fee waiver arrangements irrevocably entered into at inception of the partnership. In a hardwired arrangement, the entity which receives management fees is simply never entitled to the amount by which the management fee is reduced and the profits interest is held from inception by a single holder. Finally, even if a transfer of the profits interest is perceived to occur in such situations, such a transfer provides no meaningful evidence of the profits interest’s value, as discussed in Section 5.a., above. Given the interdependent nature of the three economic interests of private equity professionals in a typical private equity fund (as discussed in Part 1 above), it ignores reality to suggest that the Fee Interest is somehow economically independent of, or could be received independent of, the other economic interests in the investment venture held, directly or indirectly, by the private equity professionals. Accordingly, there is no way to impute independent value to one of those three interests simply by virtue of the fact that the private equity professionals choose (for reasons unrelated to federal income tax) to hold one or more of those interests through a separate vehicle. f. If the proposed exception to Rev. Proc. 93-27 is deemed to apply to a management fee waiver profits interest, the uncertainty inherent in the value of such a profits interest should be acknowledged. As described in more detail in Sections 5.a. and 5.b. above, we believe it is illogical to exclude from Rev. Proc. 93-27 a profits interest that has the level of entrepreneurial risk contemplated by the legislative history (not to mention the higher level of risk apparently contemplated by the Proposed Regulations). Moreover, if the proposed exception is applied to such profits interests, this will undoubtedly give rise to the same disputes and litigation Rev. Proc. 93-27 was intended to avoid. Finally, as discussed in detail above, it ignores reality to suggest that the value of such a profits interest is generally equal to the amount of fees waived. Accordingly, if the proposed exception is applied to such profits interests, the regulations or the revenue procedure should not presume that the value of such profits interests will typically be equal to the amount of fees waived. 6.

Notification and related requirements.

The Preamble requests comments concerning notification and other requirements that “sufficiently bind” the service provider and “that are administrable by the partnership and its partners.” We agree that it is important that management fee waiver arrangements be binding on private equity professionals and that providing notice of the arrangement in some fashion to other partners furthers that objective. We note that the Cashless Contribution Model typically involves notice to all partners because the investors are generally asked to contribute capital at different times and for different purposes than they otherwise would. That is, instead of contributing capital for the payment of waived management fees, investors are asked to contribute those amounts at different times in respect of investments made by the partnership. Typically, this is clearly described in capital call notices delivered to all partners. Moreover, even if it were not described in capital call notices, it must be reflected in quarterly financial statements required to be delivered to investors. In addition, for cashless contribution arrangements that are hardwired at inception of the partnership, the aggregate amount of management fees to be waived and capital contributions to be reduced is often specified in the partnership agreement itself. 29 KE 38545297.7

In other management fee waiver variations, notice is typically delivered either prior to the beginning of a tax year or, in some cases, prior to the due date of the management fee being waived. Most private equity funds have a “limited partner advisory committee” or similar body (often referred to as the “LPAC”) composed of a subset of the fund’s limited partners (typically those with the largest commitment and in some cases those who may have strategic importance to the fund’s investment strategy). We believe that providing notice of a management fee waiver arrangement to the LPAC is generally administrable by the partnership and its partners, and would further the objective of ensuring that management fee waiver arrangements are binding on private equity professionals. While we do not believe that providing such notice within a designated period of time should be an absolute requirement for distributive share treatment of a management fee waiver profits interest, we think that the regular and continuous failure of a GP to satisfy a reasonable notice requirement should be a factor that is considered in evaluating whether a given management fee waiver profits interest is truly binding. We believe that notice -- either electronic or on paper -- within 30 days after a GP’s commitment to a management fee waiver arrangement is a reasonably administrable approach. We also believe that, for a hardwired cashless contribution arrangement, inclusion of the aggregate management fee waiver amount in the partnership agreement should serve as sufficient notice (regardless of when the partnership agreement is executed by any particular partner). With respect to cashless contribution arrangements, we do not believe that “hardwiring” the aggregate waiver amount over the partnership’s life should be required at inception of a fund. However, if such hard-wired management fee waiver arrangements are ultimately determined to be the only management fee waiver arrangements in which the profits interest remains eligible for Rev. Proc. 93-27, we expect that other management fee waiver variations will become less prevalent. With respect to cashless contribution arrangements that do involve an up-front GP commitment to an aggregate reduction in management fees and capital contribution obligations over the partnership’s life, we do not believe it is necessary to require commitment to a particular schedule for applying such reductions. We note that commitment to a precise schedule of reductions is difficult for some GPs due to (a) investor requirements that cashless contributions never exceed fee reductions and (b) the difficulty in predicting operating cash flow requirements several years in advance. These constraints are driven by business considerations rather than tax motivations. Accordingly, the lack of a precise schedule for management fee waiver reductions should not be viewed as undermining the overall validity or binding nature of the arrangement. 7.

Effective date and application to arrangements entered into prior to finalization

We agree with the proposal in the Preamble that final regulations should apply only to an arrangement entered into or modified on or after the date of publication of the final regulations. Congress acknowledged with the revision of Code § 7805(b)(5) in 1996 that it is appropriate to 30 KE 38545297.7

limit the circumstances under which tax regulations can apply retroactively. 18 In general, retroactive regulations may be appropriate where (i) they are narrowly drafted solely to curb abusive tax-motivated transactions with no business purpose, 19 (ii) they merely implement a mechanical rule expressed in the statute (or otherwise rely solely on sources available to taxpayers prior to the publication of such regulations), or (iii) they are issued close in time to the enactment of the statute. 20 Given that none of these factors are present here, we agree that prospective application is appropriate here. a. The Proposed Regulations do not reflect Congressional intent and accordingly their principles should not be applied to preexisting arrangements As discussed at length in Part 2 above, we do not agree with the statement in the Preamble that the Proposed Regulations “reflect Congressional intent as to which arrangements are appropriately treated as disguised payments for services.” In addition to disagreeing with the substance of this statement, 21 we believe it muddies the waters as to whether taxpayers can rely on the Proposed Regulations’ stated effective date in analyzing preexisting business arrangements, and appears to have the same effect as retroactivity, despite the prospective effective date. We note that Section 707(a)(2)(A) was enacted over 30 years ago, and was primarily motivated by what Congress saw as an inappropriate use of Subchapter K to avoid expense capitalization rules. Management fee waivers have been in use for approximately 15 years, and have gradually been adopted in some form by a wide portion of the alternative asset fund management sector. Throughout this period, no guidance (proposed or otherwise) has been issued under Section 707(a)(2)(A). This long period of inactivity, the range and volume of business practices that have developed in relation to management fee waivers, and the inconsistency with the legislative history of certain key elements contained in the Proposed Regulations, weigh heavily against the stated position that the Proposed Regulations reflect current law and therefore can effectively be applied to preexisting arrangements. b.

Section 707(a)(2)(A) should not be construed as self-executing

We also disagree with the position of Treasury and the Service (as stated in the Preamble) that, with respect to an arrangement entered into or modified before the final regulations are published, the “determination of whether an arrangement is a disguised payment for services under section 707(a)(2)(A) is made on the basis of the statute and the guidance provided regarding that provision in the legislative history of section 707(a)(2)(A).” We do not believe

18

While the revised Code § 7805(b)(5) does not apply by its terms to the issuance of regulations under Section 707(a)(2)(A) (new Code § 7805(b)(5) only applies to statutes enacted after its enactment in 1996), we believe it reflects Congressional views (and general fairness and the ability of taxpayers to rely on tax laws in force in conducting their business affairs) as to what circumstances generally justify retroactive tax regulations.

19

See Code §7805(b)(3).

20

See Code §7805(b)(2).

21

See the detailed discussion under Part 2 above for an analysis of how the Proposed Regulations diverge, in several ways materially, from the anticipated rules sketched out in the legislative history.

31 KE 38545297.7

that Section 707(a)(2)(A), which expressly contemplates the issuance of regulations, 22 should be viewed as self-executing. To the extent Treasury and the Service intend to rely on Section 707(a)(2)(A) to challenge existing fee waiver arrangements, we believe Treasury and the Service should explain their authority for such reliance. While some courts have in the past been willing to interpret certain tax statutes containing similar language as self-executing in the absence of formal regulations, more recent case law, including most importantly the Supreme Court’s decision in Mayo Foundation v. United States, 562 U.S. 44 (2011), casts serious doubt on the continued validity of such interpretations. In Mayo, the Supreme Court clarified that generally applicable principles of administrative law also apply to the administration of tax law. Outside of the federal tax context, courts have generally been unwilling to give effect to statutory provisions affirmatively requiring the issuance of regulations until and unless such regulations are actually issued. 23 Moreover, under those tax-specific authorities that have in the past (i.e., pre-Mayo) considered tax statutes to be self-executing even in the absence of implementing regulations, Section 707(a)(2)(A) is not a good candidate for self-execution, given that (1) the regulations do not benefit taxpayers, but instead apply new concepts adversely to taxpayers, (ii) the regulations were intended to change existing law, replacing the approach in Pratt (discussed above in Part 1) with an entrepreneurial risk test, and (iii) the legislative history proposed application of a complex multi-factor test with the expectation that it would be implemented through regulations. 24 Accordingly, we urge Treasury and the Service to reconsider the position that Section 707(a)(2)(A) and its legislative history can be relied upon to challenge existing management fee waiver arrangements. ***

22

The introductory clause of Section 707(a) is “[u]nder regulations prescribed by the Secretary”; this clause is followed by the concepts set forth in Section 707(a)(2)(A), under which certain services performed by a partner will be treated as performed in a non-partner capacity. The Senate Finance Committee report states that “[t]he bill authorizes the Treasury Department to prescribe such regulations as may be necessary or appropriate to carry out the purposes of the provision.” Senate Comm. on Finance, 98th Cong., 2d Sess., Deficit Reduction Act of 1984, S. Prt. No. 169, at 226 (Comm. Print 1984).

23

See, e.g., California Bankers Association v. Shultz, 416 U.S. 21 (1974) (rejecting constitutional challenge to a statute requiring the issuance of regulations as not yet ripe on the basis that regulations giving effect to the statute had not yet been issued). See also A. Grewal, Mixing Management Fee Waivers with Mayo, 16 Fla. Tax Rev. 1 (2014) (hereinafter, “Grewal”) (analyzing case law and concluding that Section 707(a)(2)(A) “should not apply in the absence of implementing regulations”).

24

See, e.g., Grewal at 18-27, 39 (discussing factors applied by those cases that have approved of “phantom” tax regulations and concluding that under those cases, “it is doubtful, or at best unclear, whether section 707(a)(2)(A) would be treated as self-executing”).

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Appendix: Comment Letter Outline 1. 2.

3.

4. 5.

Observations about the private equity industry The Proposed Regulations diverge from the legislative history a. Significant entrepreneurial risk is not contemplated by the legislative history as a base requirement for distributive share treatment b. The legislative history did not contemplate the use of negative presumptions c. The legislative history did contemplate certain favorable presumptions d. The addition of two presumptive factors not mentioned in the legislative history is unwarranted Typical management fee waiver arrangements a. Typical cashless contribution features b. Many cashless contribution arrangements satisfy the requirements for distributive share treatment as set forth in the legislative history c. Most cashless contribution arrangements have independent business purposes. d. Suggested clarifications of the Proposed Regulations in relation to cashless contribution arrangements i. Replacement of Example 3 with an example based on realistic circumstances ii. Clarification regarding appropriate net profit measurement periods for purposes of determining GP’s right to receive or retain distributions iii. Cashless contribution arrangements involve multiple layers of overlapping risk iv. Restricting the pool of Available Profits to long-term capital gain and qualified dividend income generally should be respected so long as such restriction has real economic consequences and the allocation of such items is contingent on the presence of sufficient net income in the applicable measurement period v. Strict compliance with the substantial economic effect requirements of Treas. Reg. 1.704-1(b)(2) should not be required for distributive share treatment of a management fee waiver profits interest New 6th Factor Proposed exception to Rev. Proc. 93-27 a. Rev. Proc. 93-27 should remain applicable to profits interests that satisfy the requirements of the regulations b. It is fundamentally inconsistent with partnership tax accounting principles to impose tax upon the issuance of a partnership profits interest that satisfies the requirements of the Proposed Regulations. c. If the exception to Rev. Proc. 93-27 is generally applicable to arrangements that satisfy the requirements of the regulations, it should be inapplicable to irrevocable arrangements entered into at inception of the partnership d. Arrangements involving the provision of services by one party and the receipt of an associated allocation by another party are not inherently abusive and should not automatically be excluded from coverage under Rev. Proc. 93-27 e. If bifurcated management fee waiver arrangements generally are no longer covered by Rev. Proc. 93-27, management fee waiver arrangements irrevocably 33

KE 38545297.7

6. 7.

entered into at inception of the partnership should remain eligible for the safe harbor f. If the proposed exception to Rev. Proc. 93-27 is deemed to apply to a management fee waiver profits interest, the uncertainty inherent in the value of such a profits interest should be acknowledged Notification and related requirements Effective date and application to arrangements entered into prior to finalization a. The Proposed Regulations do not reflect Congressional intent and accordingly their principles should not be applied to preexisting arrangements b. Section 707(a)(2)(A) should not be construed as self-executing

34 KE 38545297.7