Typically when you think of a Private Investment Partnership (a "Hedge Fund" or "Fund"), you think of a Fund that is engaged in buying equity and debt securities and derivative investments for the purpose of generating capital gains for their investors. However, an Asset Backed Lending Investment Partnership (or "ABL Fund") is an Investment Partnership with an investment strategy of originating and servicing asset backed loans. ABL is any kind of lending secured by an asset. If the borrower defaults on the loan, the lender has the right to foreclose on the asset, such as a mortgage. This is an example of an asset-backed loan. More commonly, however, the phrase is used to describe lending to a company using assets not normally collateralized in other loans. Typically, these loans are tied to inventory, accounts receivable, machinery and equipment, but they can also include exotic assets like software or technology, a trademark, or intellectual property.
Most ABL financing is done through banks, finance companies and factors. However, with traditional financing becoming increasingly difficult, Private Investment Partnerships have begun to engage in ABL financing. There are several issues for ABL Funds which engage in lending activities ("Loan Origination"). First and foremost, the Internal Revenue Service considers entities involved in loan origination, which creates ordinary income, to be engaged in a Trade or Business ("TOB"). ABL Funds are structured the same as any other investment partnership. Typical structures include (1) stand alone domestic entity, (2) side by side domestic entities, and (3) side by side domestic and offshore entities. A Master Feeder or Mini Master Structure would create significant tax issues, and therefore, it is rare to create an ABL Fund in these structures.
Tax and Accounting Issues related to a Domestic Fund
- Income Taxes
Since lending activities are considered a TOB, the income is subject to federal, state, and local income taxes. For Federal purposes, all parties are taxed at ordinary income rates and the Limited Partners’ ("LPs") must file U.S. tax returns. The ABL Fund has created nexus in the state(s) in which it has its TOB and may be subject to state income tax. In addition, the LPs may be required to file tax returns in these states and most likely will be subject to withholding of tax at the ABL Fund. For example, if a loan is originated in New Jersey, a New York LP will have to file a New Jersey tax return. If the ABL Fund is located in New York City, the ABL Fund will be subject to Unincorporated Business Tax ("UBT") and this will be a fund expense which reduces the rate of return.
- Original Issue Discount (OID)
A Fund may originate a loan with an OID. OID is the difference in the actual cash paid to originate the loan and the amount that the payee must repay when the loan matures. For example, if an ABL Fund makes a $1,000,000 5-year loan and funds the payee with $760,000, the OID would be $240,000. OID would accrete as interest income over the life of the loan by calculating the debt instrument’s "yield to maturity".
- Warrants and Put Warrants
A Fund may receive warrants when originating a loan. Warrants are "kickers" to security transactions and must be valued at fair market value for ABL Funds. Warrants can be valued using the Black Scholes, Discounted Black Scholes, or the Bi-nominal methods. For privately held companies the warrant’s value may be a calculation that is defined in the loan agreement. Such values are typically based off of company’s earnings before income taxes, depreciation and amortization ("EBITDA"). In some instances, the warrants may have "Put Rights". A put right gives the ABL Fund an option to either exercise the warrant or "Put" it back to the company at a pre-determined price. The price could be a fixed or variable amount and is typically defined in the loan agreement.
- Origination Fees and Points
ABL Funds may charge a company an "origination fee" or "points" to enter into a loan agreement. The accounting is the same whether or not these fees are refundable. The fees are recorded as income ratably over the life of the loan.
- Tax Issues related to The Offshore Fund
If an Offshore Fund originates loans in the United States, then it is engaged in a TOB in the United States and is subject to U.S. income taxes, as well as being subject to withholding taxes on the foreign entity’s behalf. In addition, the Offshore Fund may be subject to any state or local taxes where the loan was originated. However, if a loan or a participation in a loan is purchased, it could be considered a security, which would thereby change the nature of the loan to an investment in a security. Trading securities for your own account is NOT considered a TOB in the United States and, therefore, is NOT subject to U.S. Federal, State, and Local income taxes. Because of these rules, Fund groups with Onshore and Offshore Funds may utilize a "Season & Sell Concept" for Offshore Funds. The concept is that the Offshore Fund is purchasing a "seasoned" loan participation from the Onshore Fund, which would be considered a security.
- How the "Season and Sell Concept" works:
- Either the Onshore Fund or an Entity related to the Investment Manager would "Originate" the Loan.
- After a "Seasoning Period" (typically 30 to 180 days), the Originator of the Loan would sell a Participation in the Loan to the Offshore Fund
- The sale would be at the fair value of the loan at the date of the sale.
- The end result is the Offshore Fund purchased a security and did not originate a loan.
- Issues with the Season and Sell Concept
- Many attorneys who work with these Funds advise their clients to diversify and purchase no more than 85% of their loans from the Onshore Fund. It is believed that by diversifying their purchases the Offshore Fund would demonstrate that it’s purchasing a security and not originating a loan. Facts and circumstances may make this difficult to achieve. Often the offshore fund purchases 100% of its loans from the Onshore fund or related originating Entity.
- There is no case law for the Season and Sell Concept – therefore it has not been tested or argued in court.
- In September 22, 2009, the IRS Chief Legal Counsel issued a memo asserting that lending activities undertaken by foreign corporations that negotiated loans with U.S. borrowers through a separate U.S. Loan origination company were engaged in a U. S. TOB. In addition, the memorandum specifically rejected many of the arguments on which some Offshore funds have relied on for years.
- What happens if it is determined that an Offshore Fund is engaged in a U.S. trade or business:
- All income becomes subject to Federal, State and Local income tax. Depending on the state and local rates, the tax could exceed 40%.
- There is no statute of limitations. If the returns are not filed as noted, an outstanding liability exists for Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48") purposes, and could include substantial interest and penalties for non-filing. In addition, the ABL Fund is required to withhold taxes on the Offshore Fund. If the ABL Fund does not withhold, it, too, will be subject to significant penalties for non-withholding.
- The Fund could also be subject to a Branch Profits Tax if it is considered a corporation for U.S. purposes. The Fund may be required to pay an additional 30% on distributions made to its shareholders. If the Offshore Fund redeemed investors from the Offshore Fund, the Offshore Fund needs to pay income tax on the income earned by the redeeming investors while they were in the Fund. Recovering the redeemed capital from investors that left the Offshore Fund will be difficult, if not impossible. The remaining investors will have to bear the income tax expense of the previously redeemed investors.
The bottom line is Fund Managers who are managing ABL Funds that are engaged in lending activities need to be aware of the pitfalls and risks that go beyond the risks of just managing a portfolio of high risk loans. Fund managers should proceed with caution if they are considering asset based lending as an investment strategy and they should consult with their audit and tax professionals before they do so.