Final Noncompensatory Partnership Options Regulations Could Affect The Tax Treatment Of Penny Warrants And Other Arrangements

Investments in partnerships (and other pass-through entities such as limited liability companies treated as a partnership) often involve the acquisition of warrants, options or other rights to acquire securities. This is often because the investor either (i) does not want to be an actual partner in the partnership for tax purposes or (ii) wants the potential for an equity upside in connection with a debt financing transaction without currently being considered to be a partner for tax purposes. Whether the investment security achieves those goals depends on whether the security is respected as a separate instrument or is treated as exercised for tax purposes.

In 2013 the U.S. Treasury Department finalized regulations addressing when noncompensatory options (also called investment warrants1) will be treated as equity for federal tax purposes. Under the regulations, nominally priced investment warrants will be treated as equity for federal tax purposes if both (i) the investment warrant provides for rights that are similar to an owner of the underlying security and (ii) there is a strong likelihood that the failure to treat the investment warrant holder as the owner would result in a substantial reduction in the present value of the aggregate tax liabilities of the investment warrant holder and the owners. Penny warrants raise a significant risk that the warrants will be treated as equity. Equity treatment may cause: foreign investors to be liable for filing U.S. tax returns and paying U.S. taxes; tax-exempt investors to have "unrelated business taxable income" (UBTI); and taxable U.S. persons to have taxable income without the right to receive a tax distribution.

Federal Tax Consequences of Nominally Priced Investment Warrants in Partnerships that Are Treated as Equity

If the investment warrant is treated as an equity interest, the holder will be treated as a partner in the issuing partnership for all federal tax purposes.2 A holder that is treated as a partner in the issuing partnership will be allocated income, gain, loss, deduction or credit of the investment warrant issuer to the extent of its "interest in the partnership" (taking into account all facts and circumstances).3 While the rules determining a holder's "interest in a partnership" are quite complex, certain situations would clearly lead to the allocation of income, gain, loss, deduction or credit to the holder. For example, if the investment warrant is classified as equity under the tests described below and the terms of an investment warrant grant the holder a right not to only share in the future upside of the partnership but also to share in partnership capital in an amount that exceeds the exercise price of the warrant, the holder should be considered to have an "interest in the partnership." In this case, income, gain, loss, deductions and credits of the partnership would be allocated to the holder in accordance with its interest in the partnership. Therefore, depending on the holder's interest in the partnership, it is possible that a holder will be allocated taxable income even though the holder may not be entitled to any distributions (including tax distributions) under the issuer's operating agreement. The unexpected receipt of income without the right to receive a corresponding distribution is a possible consequence that should be considered when structuring investments.

Pepper Perspective

If it is determined that the investment warrant will be treated as an equity interest, the investment warrant agreement and the partnership agreement should state that the investment warrant holder will be treated as a partner for purposes of tax allocations and tax distributions.

Further, the possibility of a holder of an investment warrant being treated as a partner in the issuing partnership raises additional concerns for special types of holders. For example:

U.S. tax-exempt investors should consider whether the investment warrant would cause them to receive UBTI. Regulated Investment Companies should consider whether the investment warrant would cause them to have income or assets that do not qualify under Section 851(b). Foreign investors should consider whether the investment warrant causes them to be "engaged in a trade or business in the United States" or to have a "permanent establishment" in the United States, which could require such foreign investors to file U.S. tax returns and pay U.S. tax. The investment...

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