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									Panel: Update on tax issues impacting private
          equity real estate funds
    Moderator: Harry Shannon, Tax Principal, Global
        Real Estate Group, Ernst & Young LLP

                    Panel Members:
      Erica Herberg, Principal, The Carlyle Group

          David S. Miller, Partner, Cadwalader,
                Wickersham & Taft LLP
                                     Case Study
                      Managers                      Investors



                                     Real Estate
                                                             U.S. Investors           Offshore
                                 Private Equity Fund
                                                                                      hedge
                                                                                      funds and
                                                                                      CLOs
  •      Assume that the
                                              Mezz
         mezzanine loan will soon           Borrower                 Mezz Lenders
         default and is probably              LLC        Mezzanine
                                                           Loan
         worth about $.50/$1.00
                                                                                       REMIC
  •      The PE fund would like to           Property
                                              Owner                  Senior Lenders
         restructure the loan in a             LLC        Mortgage

         tax-efficient manner
USActive 17418885.1                         Property
Tax Considerations
  Tax Issues for the PE Fund and Its Investors
  • Cancellation of Indebtedness (COD) Income if the Debt Is
     Cancelled
  • Gain Upon Foreclosure (Difference between Face Amount of
     Debt and Basis in Property) if the Property is Foreclosed

  Tax Issues for Offshore Hedge Fund and CLO Investors
  • Trade or Business Issues if Debt Is Restructured
  • FIRPTA, Trade or Business, and Withholding Issues if
     Foreclosure

  Tax Issues for the REMIC
  • Ensuring that its mortgages remain “qualified mortgages”
Avoiding COD Income
  Modify the Debt in a Manner that Does Not Give Rise to a
  Taxable Exchange for Tax Purposes
  •   Temporary Forbearance
       – Two years following the issuer’s initial failure to perform
       – Any additional period during which the parties conduct good
          faith negotiations or during which the Issuer is in a title 11 or
          similar case
  •   Defer Payments; Extend Maturity
       – Scheduled payments may be deferred for a period that begins on
          the original due date and extends for a period equal to the lesser
          of five years or 50% of the original term of the debt instrument
  •   Change the Yield
       – The yield of the modified instrument may be changed so long as
          it varies by no more than the greater of:
             • ¼ of one percent (i.e., 25 basis points) or
             • 5% of the annual yield (0.05 x annual yield)
Avoiding COD Income (cont’d)
  •   Change the Collateral
       – Recourse loan: Collateral may be released, substituted,
         added, or altered, or a guarantee or other credit
         enhancement added, so long as the change does not
         change payment expectations

       – Nonrecourse loan: Cannot release, substitute, add or
         otherwise alter a “substantial amount” of the collateral
         for, or provide a guarantee or add credit enhancement, for
         a nonrecourse loan. However, collateral may be
         substituted if the collateral is fungible or otherwise of a
         type where there particular units pledged are unimportant
Avoiding COD Income (cont’d)
 Rely on the “Privately-Traded” Debt Rules
 • If the debt is not publicly traded, modify the terms of debt (i.e.,
    extend maturity, provide for PIK interest, reduce interest rate to AFR),
    but do not change the principal amount
 • To avoid being publicly traded, debt must not
      – be listed on a national securities exchange,
      – be listed on an “interdealer quotation system,”
      – be listed on certain foreign exchanges or boards of exchange, or
      – appear on a “system of general circulation” that provides a
        reasonable basis to determine fair market value by
        disseminating recent price quotations of one or more identified
        brokers, dealers or traders or actual prices of recent sales
        transactions
 • Debt-for-tax issues
      – If the modified loan does not constitute debt-for-tax purposes,
        then COD income will arise
    Avoiding COD Income (cont’d)
        Have an “Unrelated Party” Acquire the Debt at a Discount

                     Managers                         Investors


                                    Real Estate
                                Private Equity Fund
                                                           U.S. Investors           Offshore
                                                                                    hedge
•   If the PE Fund were to buy              REIT                                    funds and
    the mezzanine loan for                                                          CLOs
    $.50/$1.00, the REIT would              Mezz
                                          Borrower                 Mezz Lenders
    realize COD income under                LLC
                                                       Mezzanine
                                                         Loan
    the “related party” rules of
    section 108(e)(4)                                                                REMIC
                                           Property
                                            Owner                  Senior Lenders
                                             LLC        Mortgage


                                           Property
    Avoiding COD Income (cont’d)
          Have an “Unrelated Party” Acquire the Debt at a Discount

                            Managers                                     Investors


                                            Real Estate
                                        Private Equity Fund

•   Two corporations are not            Irish section
    treated as “related parties” so     110 com pany           REIT
    long as five or fewer individuals
                                                   Interest
    do not own 50% or more of the
    value of each                                               Mezz
                                                              Borrower
                                        Mezzanine
•   An Irish section 110 company          Loan                  LLC
    or Luxembourg securitization
    company that qualifies for U.S.
                                                                                                       REMIC
    treaty benefits is needed to                              Property
    avoid 30% U.S. withholding tax                             Owner                  Senior Lenders
    on interest. (The REIT and the                              LLC        Mortgage
    Irish/Lux company are related
    for portfolio interest purposes.)                         Property
 Avoiding COD Income (cont’d)
        Have an Unrelated Party Acquire the Debt at a Discount and
        Enter Into a Total Return Swap with the Owner of the Borrower

                          Managers                         Investors


   Investment
                                         Real Estate
      Bank           Total Return
                                     Private Equity Fund
                        Swap




                                                 REIT

                                                 Mezz
                                               Borrower
      Mezzanine                                  LLC
        Loan
                                                                                         REMIC
                                                Property
                                                 Owner                  Senior Lenders
• Risk that PE fund is treated as the “tax        LLC        Mortgage
owner” of the mezzanine loan (which would
cause the REIT to realized COD income).         Property
Section 108(i)

 •    For debt cancelled in 2009 or 2010:
       – COD income is deferred until 2014 and
       – Then included ratably in each year from 2014 to 2018


Section 108(a)

  •   If a taxpayer is insolvent or bankrupt, COD is not
      recognized, but tax attributes (NOLs, basis) are reduced on
      a dollar-for-dollar basis. (But if a partnership is the
      borrower, section 108(a) is applied at the partner level (i.e.,
      the partners have to be insolvent or bankrupt).)
COD Versus Realization for
Nonrecourse Debt
 •   A foreclosure on nonrecourse debt is treated as a sale of the
     property for the face amount of the debt.

 •   Assume that the debtor has $100 basis in property that is
     subject to $90 of debt and the property is now worth $50
      – If $40 of debt is cancelled, the taxpayer realizes $40 of
        COD income
      – If the creditor forecloses on the property, the taxpayer
        has a $10 capital loss and no COD, even though the
        foreclosure is the economic equivalent of the cancellation
        of $40 of debt and a sale of the property for $50 (i.e., $40
        COD and $50 capital loss)
Tax Issues For Offshore Hedge Funds and
CLOs
 Workout Activity
 • The IRS takes the position that origination activities cause an
   offshore fund or CLO that has a U.S. manager to be engaged in
   a “trade or business” in the United States and subject to U.S.
   corporate income tax.
            IRS Office of Chief Counsel Memorandum (September 22, 2009)

 •   A workout that gives rise to a taxable event under section 1001
     is treated as a redemption of the original loan and an
     origination of the modified loan.

 •   Working out a nonperforming loan will generally increase its
     value; the increase in value is entirely attributable to services
     performed in the United States (as opposed to changes in the
     credit of the borrower or changes in market conditions).
Tax Issues For Offshore Hedge Funds and
CLOs (cont’d)

 •   Risk for offshore hedge fund or CLO

      – Least risk if the fund purchased a performing loan that
        was not expected to default, the debtor subsequently
        defaulted, and the U.S. manager is negotiating or
        agreeing to a workout to preserve its investment

      – Most risk if the fund purchases the loan when it is
        distressed in order to work it out and sell it at a profit.
Tax Issues For Offshore Funds and CLOs
Owning Real Estate
 •   Income from the real estate subject to a 30% withholding tax
     or 35% net income tax
 •   Gain on the sale of the real estate (measured from its value
     on the date of foreclosure) subject to 35% net income tax
 •   Many offshore funds are prohibited from directly owning real
     estate
 •   If an offshore fund owns an interest in U.S. real estate, the
     real estate will often be held in a U.S. “blocker” corporation
     (and the fund may, in turn, hold this U.S. corporation through
     a foreign “blocker” corporation)
Tax Issues For Offshore Funds and CLOs
Owning Real Estate (cont’d)

                   Foreign Fund


            Cayman “blocker” corporation


                   U.S. “blocker”
                    corporation

                      Interest in
                   U.S. real property
Tax Issues For REMICs That Hold
Distressed Real Estate Loans

 •   If a REMIC agrees to a “significant modification” of a
     mortgage loan when the loan is not in default or default is not
     “reasonably foreseeable,” the mortgage may fail to be a
     qualified mortgage, which could jeopardize the REMIC’s
     status as a REMIC. A REMIC’s governing documents may
     have other (non-tax) limitations on modifications.
      – Revenue Procedure 2009-45 (September 15, 2009)
        expands the definition of “reasonably foreseeable”
        default and provides that a mortgage may be modified
        without losing its status as a qualified mortgage if there is
        a “significant risk of default” upon maturity or before
        based on a “diligent contemporaneous determination
        (including credible written representations from the
        borrower).” The risk of default may be a year (or possibly
        later) in the future.

								
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