| ||Partnerships as an Alternative to Secured Loans|
Robert H. Scarborough*
*Partner, Freshfields Bruckhaus Deringer LLP, New York, New York; Harvard College, A.B., 1977; University of Virginia, J.D., 1983. An earlier version of this article was presented to the Tax Forum in New York City on April 12, 2004. The author would like to thank Michael Schler, Dana Trier, and Bill Paul for helpful comments on earlier drafts.
This Article considers financing structures that resemble nonrecourse debt but are intended to be treated for tax purposes as partnerships. If respected, they have quite different tax consequences from economically similar loans and can serve a number of useful purposes. For example, a partnership of that sort can be used to create debt-like synthetic securities that produce tax-favored income including short-term floating-rate tax-exempt securities funded by a portfolio of long-term fixed-rate tax-exempt bonds. Similarly, such an arrangement can be used to generate highly rated auction-rate securities with yield that qualifies for dividends-received deductions and is funded by a portfolio of riskier fixed-rate preferred stock.
These financing structures also can serve to avoid rules that penalize leveraged investments, including the denial of interest deductions to leveraged investors in tax-exempt bonds, the denial of dividends-received deductions to corporations with debt-financed positions in portfolio stock, the unrelated business income tax (UBIT) on debt-financed income of tax-exempt investors, and the allocation of interest expense against foreign-source income. Finally, the financing structures considered in this Article can be used to shift tax ownership, but not economic exposure and control, in a way that accelerates built-in losses, avoids subpart F income, or effectively retires debt at a discount without creating debt cancellation income.
Whatever the intended tax effect, the general terms of the structures considered here are similar. A partnership, trust, or limited liability company intended to be a partnership for tax purposes (here, “Partnership”) holds stock, bonds, receivables, or other financial assets. One class of equity interest (the “Preferred Interest”) is entitled to a preferred yield and a priority claim for return of its capital contribution. The other (the “Residual Interest”) is entitled to most of the remainder, but cannot redeem the Preferred Interest or liquidate Partnership without consent. If the Residual Interest holder wants to shift or avoid tax ownership, it generally would be entitled to no more than half of Partnership’s profits and capital.
The Preferred Interest is intended to be equity for tax purposes. Thus, legal authorities recasting securities that are debt in form to deny interest deductions would not apply. Similarly, common law and statutory constructive sale rules would not frustrate the intended treatment. The Residual Interest holder does not want to shift economic ownership while keeping tax ownership, but rather to do the reverse.
These structures generally do not arbitrage inconsistent tax and accounting rules: the Residual Interest holder does not want its balance sheet to show the Preferred Interest as debt, and it will not report the structure as a tax financing. While accounting rules may require the Residual Interest holder to consolidate Partnership, that generally is not desired.
After describing different uses of two-class partnerships, this article examines the threshold issue for each: Will the structure be respected as a partnership or will the Preferred Interest instead be viewed as the Residual Interest holder’s debt?
This article then comments more briefly on a number of other issues to be considered once the threshold question is resolved. Some of these arise regardless of the structure’s use. For example, does the Preferred Interest holder face timing and character mismatches or withholding taxes that disadvantage it compared with a lender? Another issue is whether regulatory partnership anti-abuse rules apply to frustrate the intended results. A third is how common law economic substance and business purpose doctrines apply.
Other issues arise where the structure channels tax-favored income. Among these questions are whether the Preferred Interest’s yield is guaranteed payment and, if so, tax-favored income passes through. Another is whether special allocations will be respected. Finally, if the reason for employing the structure is to shift tax ownership, what percentage of Partnership’s profits and capital does the Residual Interest represent?
The goal of this article is to analyze current law treatment of partnership structures resembling secured financings and not to consider reforms. Policy considerations are still relevant, however, because they color judgments in applying current law. If a structure uses unintended interactions between rules to produce unreasonable results, lawyers should be less willing to advise favorably and the government more inclined to challenge. Thus, Part IV comments briefly on the general question of policy concerns presented by two-class partnerships resembling secured debt.