Tax Court Ruling Offers Lessons for Funds With Foreign Investors

The US Tax Court’s Nov. 15 ruling in YA Global Investments v. Commissioner is the first significant decision to address the existence of a US trade or business in the context of an investment fund that originates debt instruments and other securities in the US.

Credit fund managers and their tax advisers have been watching the case closely, as it had potential to be a blockbuster case in the space. It’s unclear whether the decision is likely to spur much change in current market practices.

The decision could prompt some modest revision, for example, to guidelines that many investment funds follow to mitigate risk of being engaged in trade or business. The decision also could bear on use of management fee offsets in certain contexts.

And from a compliance perspective, the ruling may result in an uptick in scope and frequency of protective return filings and elections.

Question of Fees

YA Global was a foreign partnership managed by Yorkville Advisors, based in New Jersey. YA Global provided capital to small-cap and micro-cap US companies.

The transactions generated what the contracts termed fee income, requiring the issuing companies to pay “structuring fees” and/or “banker’s fees” to Yorkville and “commitment fees” to YA Global.

Fees received by Yorkville were used to offset its expenses, and Yorkville could either remit excess fees to YA Global or use them to offset management fees that YA Global owed Yorkville.

The Tax Court determined Yorkville acted as YA Global’s agent and, therefore, its activities could be attributed to YA Global. It also held that YA Global was engaged in a US trade or business, but it didn’t characterize the activity as that of either underwriting or loan origination.

Instead, the court’s 133-page analysis focused on various fees portfolio companies paid to YA Global and Yorkville, particularly whether the fees were returns on capital or payments for services.

Loan Origination Uncertainty

To find trade or business status, the court focused on the fees and whether YA Global earned them in exchange for provision of services. The court refrained from adopting any particular label for the service activities, such as underwriting or loan origination.

By not characterizing the business—e.g., as loan origination—the decision leaves open the question of whether and when private opportunistic loan origination is a trade or business, or whether it could ever be treated as trading in securities for purposes of the Section 864(b)(2) trading safe harbor.

The court’s finding that the fees in question were in for services raises questions about when income ought to be treated as service fee income versus income paid solely for the provision of capital.

In that regard, the fact Yorkville earned some of the fees proved to work against YA Global, forcing it to argue against its own form since Yorkville wasn’t itself providing capital.

Business Considerations

Some tax compliance takeaways can be gleaned from the case. Funds with foreign investors that are at risk of being treated as having US trade or business status should consider filing protective IRS Forms 8804—to start the statute of limitations for assessments for partnership-level withholding tax on effectively connected income.

Similarly, in addition to filing protective tax returns, foreign feeders and other foreign investors with material expenses at the partner level—that may be deductible against their allocable shares of effectively connected income—might consider delivering to the fund certifications of their non-partnership deductions pursuant to Treasury Reg. 1.1446-6(c).

And any fund concerned about risk of being treated as a “dealer” for purposes of Section 475 should consider affirmatively identifying its securities as investments for purposes of Section 475(b)(1)(A).

The IRS could go in different directions with this case. Few funds that originate debt and securities are likely to make radical changes to their activities or economic arrangements with their fund managers.

That said, the IRS has an ongoing audit campaign focused on private funds that engage in direct lending. Its success in YA Global could spur more audit activity of funds, especially considering the IRS’ audit campaign on large partnerships

The case is YA Global Investments v. Commissioner, T.C., No. 14546-15, 161, 11/15/23.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Dan Paulos is partner in Proskauer Rose’s tax department and a vice-chair of the American Bar Association Tax Section’s Investment Management Committee.

David Richardson is tax partner with Reitler Kailas & Rosenblatt and chair of the American Bar Association Tax Section’s Investment Management Committee.

Sam Riesenberg is principal in KPMG’s international tax practice of the Washington National Tax group and a vice-chair of the American Bar Association Tax Section’s Investment Management Committee.