Before any private equity fund lawyers panic, the government isn’t necessarily going to change what it thinks trade or business means. Craig Gerson, attorney-adviser in the Treasury Office of Tax Legislative council said, "I think there's a recognition that the court's decision in the First Circuit may give us an opportunity to reassess what trade or business means. We are approaching it with caution. We understand that the law here has worked fairly well as it has stood for a long period of time.” Gerson added that no one was in a rush to issue guidance and that any change would be “policy-driven” (whatever that means) and would come after the results of the case’s remand.
Any new Treasury position is likely to be unfavorable to private equity taxpayers. The permissive interpretation of trade or business status has allowed funds to achieve favorable tax treatment for their income and kept foreign investors from having what is called effectively connected income, which would subject them to U.S. tax. Treasury has always been lenient on foreign investors in terms of tax and information reporting as a means of encouraging investment in the United States (notice how often the United States is referred to as a tax haven by foreign countries and the uproar over the possible reporting of Florida bank accounts to foreign tax administrators). If the government were to reassess its view on trade or business, private equity funds could be subject to ordinary income rates or UBIT rules, and foreign investors could have to pay U.S. tax. Any or all of those would be devastating to an industry already struggling to meet expectations.
Gerson’s statement that “the law here has worked fairly well” shows where Treasury’s bias lies and should give some comfort to fund managers, investors, and advisers. The fact is that the law is only really working well for private equity funds. It’s not exactly clear how it benefits regular taxpayers, the fisc, or the economy at large. The government is forfeiting revenue it could be collecting from private equity funds, both in the form of taxing foreign investors and preferential rates given to fund income (particularly regarding carried interest compensation). Is this permissive tax policy encouraging more productive investment? The workers at Scott Brass probably aren’t so sympathetic after Sun Capital’s funds tried to avoid paying pension liabilities.
Sun Capital is a unique case, with particularly bad facts for the funds. The funds’ attempts to avoid $4.5 million in pension liabilities after being intimately involved in the failed restructure of Scott Brass were not viewed sympathetically. And the First Circuit went out of its way to stress how limited its holding was (although it did reference both the tax law definition of trade or business and a paper by Steven Rosenthal on why private equity funds are in a trade or business for tax purposes). The court could easily have reached a different conclusion on ERISA liability with even slightly different facts.
But bad facts make bad case law, as the old saying goes. In this case, bad for private equity funds, might be good for the tax system in general. There is no valid tax policy reason why funds that engage in the business of buying and developing companies or those that take an active management role in restructuring should be considered mere investors by the tax law. Treasury might not want to reassess its position, but if funds keep up unsympathetic conduct perhaps outside parties like the Teamsters in Sun Capital might force it to. And that would probably be good for everyone.
For those interested in a lively discussion of what Sun Capital might mean for the law, Tax Analysts will host a panel discussion of the case on Friday, September 27, at the National Press Club in Washington. There will be a live videostream of this event that you can access on Friday afternoon.