THE CHANGING VENTURE CAPITAL LANDSCAPE:

1
THE CHANGING VENTURE CAPITAL LANDSCAPE
Summary of Recent U.S. and European Legislative
ProposalsEvolving PRC Investment StructuresBest
Tax Compliance Practices for Funds with U.S.
Investors or Managers

• CVCFO November 2009 Meeting

Steven R. Franklin sfranklin_at_gunder.com

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• U.S. Advisers Act Legislation

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U.S. Advisers Act Legislation

• Private Fund Investment Advisers Registration Act
  of 2009 (House of Representatives)
• Removes exemption from registration historically
  relied upon by venture capital and private equity
  funds
• Authorizes SEC to collect additional information
  in the public interest/investor protection
• Exempts
• Venture Capital funds, a term to be defined
  later
• Unclear how this will ultimately be defined. It
  is intended to exclude buy-out funds, which may
  pose problems for late-stage venture capital
  funds
• Advisers managing SBICs
• Advisers with individual funds lt150m
• Includes Non-U.S. funds that have raised money
  from U.S. investors
• Passed House Financial Services Comm. 67-1

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U.S. Advisers Act Legislation (Cont.)

• Private Fund Investment Advisers Registration Act
  of 2009 (Senate)
• Remove Adviser Act exemption from funds with less
  than 15 clients
• Limited foreign private adviser exemption
• No U.S. place of business
• Fewer than 15 U.S. clients
• Less then 25 million assets under management
  attributable to U.S. Clients
• Exempts
• Venture Capital Funds, term to be defined by
  SEC exempt from registration
• Private Equity Funds, term to be defined by
  SEC exempt from registration, but subject to
  recordkeeping and access requirements
• Family Offices, term to be defined by SEC
  excepted from the definition altogether
• Advisers with individual funds lt150m
• Introduced by Sen. Chris Dodd
• Chairman of the Senate Committee on Banking,
  Housing and Urban Affairs.
• Likely supersedes previous legislation (including
  Sen. Reeds similar proposal)
• Part of gt1000 page legislation on financial
  systems reform
• Increases the minimum threshold from 25M to
  100M for SEC registration smaller funds must
  register with the states.
• Directs the SEC to adjust the accredited
  investor threshold under the 1933 Act every 5
  years.

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U.S. Advisers Act Legislation (Cont.)

• What does Adviser Act compliance entail?
• Electronic registration on Form ADV
• Part I Basic information, including
  jurisdiction of incorporation, place of business,
  structure of investment adviser, states in U.S.
  where they operate, criminal/civil legal
  proceeding history
• Part II Nature of services, fees charged,
  investment objectives, risks, strategies, methods
  of analysis of prospective investments, sources
  of information, affiliations in financial sector
  including related conflicts, education and other
  business background
• Performance Fees
• May only be charged if investor is a Qualified
  Client defined as (i) a Qualified Purchaser
  under the Investment Company Act, (ii) if
  750,000 is invested in fund, (iii) net worth in
  excess of 1.5 million or (iv) non-U.S. person
• Result Traditional 3(c)(1) funds (i.e, funds
  that want to raise money from smaller
  institutions and from individuals with less than
  5MM of investment assets) will be more difficult
  to form without an exemption
• SEC Examinations, compliance program, code of
  ethics, periodic filings to clients and the SEC,
  appointment of Chief Compliance Officer,
  custodial rules, prohibitations on certain forms
  of advertising, no assignment of services without
  consent, and recordkeeping

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• Additional U.S. Legislation

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Additional U.S. Legislation

• Other bills have been introduced to study the
  effects investment funds have had on the market
  and recommend further regulations.
• Financial Oversight Commission Act of 2009
• Financial Crisis Investigation Act of 2009
• Hedge Fund Adviser Registration Act of 2009
• Pension Security Act of 2009
• Hedge Fund Transparency Act

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Additional U.S. Legislation (Cont.)

• NY State Power of Attorney Statute
• Effective Sep. 1, 2009 all powers of attorney
  (POA) signed in NY by natural persons must
  comply with a new set of rules
• Require disclosures, certain fonts, notarization
• Any new POA revokes all previously executed POAs
• Major implications for funds
• Changes fiduciary relationship (GP owes duty to
  LP)
• Careful drafting of new POAs so as not to affect
  old POAs
• Passing through New York problems
• Be careful about amending vs. amending and
  restating agreements so as not to extinguish
  existing POA

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• EU Legislation

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EU Legislation

• The Directive on Alternative Investment Fund
  Managers was proposed on April 29, 2009 by the
  European Commission.
• Attempts to regulate investment funds that are
  not already covered by current EU regulations,
  UCITS (Undertakings for Collective Investment in
  Transferrable Securities).
• Subjects fund manager with 500 million in
  assets under management with no right of
  redemption for 5 years (or 100 million in assets
  if leveraged) to various regulatory restrictions.
• Aimed at both EU and Non-EU domiciled funds.
• Requires disclosure requirements similar to
  Adviser Act of 2009.

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EU Legislation (Cont.)

• EU based fund managers would be subject to local
  regimes (i.e. U.K. Financial Services Authority)
• LPA must be provided to regulator
• Conduct of business principles, strict conflicts
  of interest rules, risk management, GP capital
  account requirement (125,000 0.02 of assets gt
  250,000), independent valuator for portfolio
  valuation, custodial requirements, annual report
  to investors and regulator, among other items

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EU Legislation (Cont.)

• Marketing to EU based investors
• EU based manager
• Must be authorized (see above)
• Can only market to professional investors
  (institutions, and only limited high net worth
  individuals), except as provided by local law
• Before marketing must provide regulator with all
  fund related documents
• Non-EU domiciled funds ? Same rules as above and
  must be based in OECD compliant tax jurisdiction
• Non-EU fund mangers ? Must elect to be subject to
  the financial regulatory rules of at least one EU
  country

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EU Legislation (Cont.)

• Recent developments regarding these proposed EU
  regulations
• Charles River study of compliance costs (as a
  of assets under management)
• VC one-time .338, ongoing annual.248
• PE one-time .421, annual .138
• European Central Bank warned in October that
  private equity would flee Europe if adopted
• UK has mounted stiff opposition, though France,
  Spain and Germany are supportive
• Requires approval of EU Parliament and EU
  governments

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• U.S. Carried Interest Tax Legislation

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U.S. Carried Interest Tax Legislation

• History of Proposals
• In 2007 Representative Sander Levin introduced
  bill to address carried interests, treating
  carried interests as services income
• Later in 2007, House of Representatives passed
  the Temporary Tax Relief Act of 2007, which
  included provision on carried interests
• Similar provision passed House in Alternative
  Minimum Tax Relief Act of 2008
• On April 3, 2009, Representative Levin introduced
  bill revising technical aspects of House
  legislation
• On May 11, 2009, Administration budget described
  provision to tax carried interests

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U.S. Carried Interest Tax Legislation (Cont.)

• Recent Developments
• House Ways and Means Committee has announced it
  intends to move forward in the coming months to
  pass carried interest tax legislation
• Sen. Schumer, a past critic, is now in favor of
  such proposals
• Any proposal will require 60 votes in the Senate
• Top marginal tax rate is scheduled to increase to
  39.6 in 2011 self employment tax would add
  another 3

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U.S. Carried Interest Tax Legislation (Cont.)

• Who is Covered?
• Levin Bill covers only holders of investment
  services partnership interest
• Obama Administration budget proposal would expand
  scope so that all industries are covered by
  carried interest legislation
• Obama Administration proposal would apply
  ordinary income treatment to a services
  partnership interest
• Accordingly, covers a common/preferred capital
  structure of an operating company (including a
  non-U.S. company that is treated as flow-through
  entity)
• Earlier versions of the bill would have taxed
  even non-U.S. investment managers (not resident
  in the U.S.) if the Fund had any personnel inside
  the U.S. Current version appears to only affect
  managers who are U.S. citizens or residents or
  otherwise generally subject to U.S. tax
  (including Green Card holders) or who are
  performing services in the U.S.

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U.S. Carried Interest Tax Legislation (Cont.)

• Potential Impact
• What is the potential impact of the Levin bill
  for a party who holds a carried interest?
• Net income and net loss with respect to an
  investment services partnership interest is
  treated as ordinary.
• However, net losses are allowed only to the
  extent that aggregate net income for prior years
  exceeds aggregate net losses for such years.
• Net income is also treated as self-employment
  income, subject to self-employment tax

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U.S. Carried Interest Tax Legislation (Cont.)

• In-Kind Distributions Will Become Difficult
  Impossible for Funds with U.S. Managers
• Property distributions no longer qualify for
  favorable deferral available under existing law
• If the partnership distributes appreciated
  property with respect to an investment services
  partnership interest
• Gain will be triggered to the partnership as if
  it sold the property for its fair market value
  and that gain will be allocated to the
  distributee as ordinary income
• The property is treated as cash with respect to
  the distributee partner, so that gain will be
  triggered to the extent that the value of the
  distributed property exceeds the partners basis
  in the partnership interest (determined after
  adjustment for gain allocated)
• Distributee partner takes fair market value basis
  in distributed property

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U.S. Carried Interest Tax Legislation (Cont.)

• Treatment of Capital Interests
• The Levin bill exempts from its coverage the
  portion of a service providers partnership
  interest that is acquired for invested capital.
• This requires that the partnership interest be
  acquired on account of invested capital and that
  allocations of distributive share to the service
  partner satisfy certain requirements, primarily
  that the allocations are no more favorable than
  those made to other third-party investors.
• A partner providing services will not be treated
  as having a qualified capital interest to the
  extent that contributed capital is attributable
  to a loan or other advance made or guaranteed,
  directly or indirectly, by any partner or the
  partnership (or a related person).
• Similarly, the Common cashless contribution
  technique would convert all returns on cashless
  contributions into ordinary income rather than
  capital gain.

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U.S. Carried Interest Tax Legislation (Cont.)

• Anti-Avoidance Rules
• Section 6662 would be amended to provide a 40
  penalty where a person had an underpayment as a
  result of being treated as violating anti-abuse
  regs.
• The penalty imposes strict liability, as it
  could not be avoided by showing reasonable cause.

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U.S. Carried Interest Tax Legislation (Cont.)

• Effective Date
• Effective date under Levin bill would apply to
  income with respect to carried interests in
  taxable years after the date of enactment
• No grandfather for existing carried interests

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U.S. Carried Interest Tax Legislation (Cont.)

• Obama Budget
• Other than applying to a broader class of service
  providers, the Obama Administration proposal
  appears to follow the general structure of the
  Levin Bill
• Ordinary income and self-employment tax
• Exception for invested capital
• No mention of 40 penalty
• Administration proposal would be effective for
  taxable years beginning after December 31, 2010

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U.S. Carried Interest Tax Legislation (Cont.)
Cashless Contributions
Assumes 1) a 25 federal and state capital gains
rate and 50 ordinary income rate (including
state and self-employment tax) 2) a 4-year
deferral period and 3) a cost of capital of 6,
compounded annually.
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U.S. Carried Interest Tax Legislation (Cont.)

• Planning Options
• Front-load income to the General Partner prior to
  the effective date of Carried Interest bill.
• Change in Law provisions of the Fund limited
  partnership agreement theoretically can provide
  future flexibility, although difficult to
  negotiate in todays fund-raising environment.
• There is no effective date specified for Carried
  Interest bill and it is still early in the
  legislative process.
• Taking steps to plan for Carried Interest bill
  now may be premature.

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• Other U.S.Tax Legislation

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Other U.S. Tax Legislation

• Elimination of Disregarded Entities
• The Obama budget plan proposed that after
  December 31, 2010, certain Non-U.S. disregarded
  entities be classified as corporations for U.S.
  tax purposes.
• Exceptions
• An eligible entity with a single owner organized
  in the same jurisdiction can elect to be
  classified as a disregarded entity and
• An eligible entity owned by a single U.S. person
  can elect to be classified as a disregarded
  entity if it is not used for U.S. tax avoidance.
• U.S. tax avoidance is so far an undefined
  concept.
• Current disregarded entities not meeting an
  exception will likely be converted when and if
  the law takes effect.
• This could impact most of the common investment
  structures used by international funds to make
  PRC investments

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Other U.S. Tax Legislation (Cont.)

• Eliminate Look-Thru on Withholding for
  Non-Qualified Intermediary
• The Obama budget plan proposed that the rules
  regarding withholding on Non-U.S. partnerships
  and other pass-thru entities be tightened up.
• Under the proposed rules, a Non-U.S. pass-thru
  entity (such as a Cayman limited partnership)
  would no longer be entitled to provide the
  withholding agent with the relevant tax
  information of its beneficial owners.
• Instead, unless the Non-U.S. pass-thru entity
  registered with the IRS as a qualified
  intermediary, the pass-thru entity could be
  treated as an unknown foreign person, thereby
  requiring the withholding agent to withhold tax
  at the maximum 30 rate.

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Other Tax Legislation (Cont.)

• Foreign Tax Compliance Act
• Introduced to both House and Senate in late
  October
• Will require U.S. LPs in Non-U.S. Venture Funds
  to disclose such investments
• This will, in turn, increase LP information
  requests
• Similarly, direct and indirect holders of PFICs
  will be required to report details of such
  holdings
• May possibly require sponsors of Non-U.S. Funds
  to files certain reports detailing U.S. investor
  participation in the Fund

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• PRC Permanent Establishment (PE) Developments

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PRC PE Developments
Traditional Offshore Structure
Cayman SPV
WFOE
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PRC PE Developments (Cont.)
More Recent Offshore Structure
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PRC PE Developments (Cont.)

• Circular 124 and Recent PRC cases (Xingjiang and
  Chongging) have cast doubt on the effectiveness
  of structures utilizing special purpose vehicles
  (SPV) in tax treaty jurisdictions where the tax
  treaty entity has no substance (i.e., no office,
  place of business, employees or activities) in
  its country of organization

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PRC PE Developments (Cont.)
Evolving Offshore Structure
Typical Locations Hong Kong Mauritius Barbados Sw
itzerland Luxembourg Singapore Ireland
Treaty Platform (Including Employees and Offices)
Treaty SPV 1
Treaty SPV 2
Treaty SPV 3
Cayman 1
Cayman 2
Cayman 3
Treaty SPV A
Treaty SPV B
Treaty SPV C
Offshore
PRC
WFOE
WFOE
WFOE
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PRC PE Developments (Cont.)

• Query how recent U.S. international tax
  proposals, including the Obama administrations
  elimination of check the box rules will impact
  the choice of optimal structure
• Circular 601, released last week, also calls into
  question the use of intermediate SPVs

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• Best Tax Compliance Practices
• for Funds with U.S. Investors

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Best Tax Compliance Practices for Funds with U.S.
Investors

• UBTI
• Most funds that have raised money from U.S. tax
  exempt investors will have an obligation to
  avoid, or at least minimize, the generation of
  unrelated business taxable income (commonly
  referred to as UBTI).

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Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Type of Investors Subject to UBTI
• U.S. private pension funds
• U.S. Charitable organizations
• U.S. Charitable Remainder Trusts
• U.S. Universities (including state universities)
• U.S. State and local pension plans if qualified
  under 401, but possible exception under 115 (most
  state and local plans take the position they are
  exempt under 115 and thus not subject to UBTI tax)

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Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Tax Treatment if There Is UBTI
• File 990T U.S. Tax Return
• Pay tax at graduated corporate or trust rates as
  if a taxable entity

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Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Non-UBTI Income Categories (Good Income)
• Assuming No Debt Financing (See UDFI discussion
  below)
• Capital gains
• Interest
• Dividends
• Subpart F inclusions (except insurance)
• PFIC distributions
• Royalties
• Some rental income from real estate
• Other income from routine investments (See Rev.
  Rul. 78-88)

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Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• UBTI Income Categories (Bad Income)
• Income from business activity (e.g., sales of
  goods/services) conducted anywhere
• Includes business conducted through lower-tier
  tax partnerships (e.g., portfolio companies not
  treated as corporations for U.S. tax purposes)
• Gains from dealer property (relevant to real
  estate funds)

42
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Fees as Potential UBTI
• Portfolio companies may pay fees to the Fund or
  its management company, e.g.
• directors fees
• advisory fees
• transaction-related fees
• Issue
• Is this UBIT for the Fund?
• What if the benefit to the Fund is indirect?

43
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Tax Treatment of Various Fees
• Directors Fees services/UBTI
• Advisory Fees services/UBTI
• Break-Up Fees arguably lost profits/Non-UBTI
• Completed Transaction Fees probably reduce
  basis/Non-UBTI
• Loan Commitment Fees, Equity Commitment Fees
• loan commitment fee is not UBTI per IRC 512(b)(1)

44
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Debt-Financed UBTI (UDFI)
• Income from debt-financed property is UBTI, in
  ratio that average acquisition indebtedness
  bears to average adjusted basis
• Debt-financed property financed with
  acquisition indebtedness (a broadly defined
  term)
• Acquisition indebtedness may in some cases
  include debt incurred before the asset was
  acquired
• Indebtedness may include non-traditional
  sources of financing such as deferral of accrued
  management fees
• May also include deferred payments for stock
  (i.e., 100 shares of stock acquired for a 50
  immediate payment and a 50 payment due six
  months later).
• Property is debt-financed property if there is
  acquisition indebtedness at any time during the
  taxable year in which the income is earned or,
  with respect to sales, the preceding 12 months
• Applies to borrowing by the exempt entity or by
  an investment partnership such as a venture
  capital fund

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Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• UDFI Solutions
• Borrowing is usually restricted, e.g.,
• To short-term borrowing pending receipt of
  capital calls, or where borrowing is essential
  (e.g., to fund commitments where there are
  defaulting partners)
• If viewed as acquisition indebtedness,
  (perhaps) the debt will be history by the time
  there is significant income or gains (i..e, paid
  off more than 12 months prior)
• Borrowing incidental to the management of an
  investment portfolio and not increasing its size
  does not create UDFI (Rev. Rul. 78-88)
• Application not clear to Venture Funds
• Occasional borrowing incident to investment, but
  also serving exempt function, and not increasing
  the overall portfolio size, does not create UDFI
  (PLRs 8721104 8721107)
• Application not clear to Venture Funds

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Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Management Fee Offsets and UBTI Risk
• Offset is a reduction in the periodic management
  fee otherwise payable by the Fund to its manager
  on account of fees payable by portfolio companies
  or other parties to the manager
• Offset typically range from 50 to 100, and
  unused offsets carry forward to reduce the
  management fee in future periods
• Sometimes fee amounts not offset against
  management fee prior to the end of the Funds
  term will be payable to the investors upon the
  liquidation of the Fund

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Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Guarantees Of Portfolio Company Debt and UDFI
• UDFI could be created as a result of funds
  guarantee of portfolio company debt if the fund,
  rather than the portfolio company, is the true
  borrower (Plantation Patterns). Should turn on
  portfolio companys ability to service the debt
  based on its own assets/anticipated revenues.
• GP may be contractually obligated not to allow
  fund to provide a guarantee unless GP first
  determines that there is not a material risk of
  UBTI

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Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Fees (such as cash or warrants) For Guaranteeing
  Portfolio Company Debt as Potential UBTI
• Guarantee Fee should not be UBTI if the guarantee
  activity was isolated and not regularly carried
  on.
• This could be helpful, but as fund size
  increases, perhaps multiple guarantees will be
  given and multiple fees will be charged.
• Unclear whether recurring guarantee fees will be
  treated as services income and thus UBTI

49
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Critical Portfolio Company Information
• Rights and Covenants

50
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Summary of Portfolio Company Information Rights
  and Covenants
• In general, in connection with each investment in
  a Non-U.S. portfolio company, a Fund with U.S.
  taxable and tax-exempt investors should
• Corporate Status confirm that the Non-U.S.
  portfolio company will be classified as a
  corporation for U.S. income tax purposes, and not
  as a partnership or other pass-through entity.
  For those entities that are eligible to elect to
  be treated as a pass-through entity, obtain a
  representation that the entity will not elect to
  be treated as a partnership for U.S. income tax
  purposes

51
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Summary of Portfolio Company Information Rights
  and Covenants (Cont)
• CFC obtain protective provisions addressing CFC
  issues
• PFIC Negotiate to obtain the information
  necessary for the Funds investors to make a QEF
  election or protective statement for U.S. income
  tax purposes, and obtain protective provisions
  facilitating this election and
• Misc obtain other miscellaneous information
  reporting provisions.

52
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Representations and Warranties Regarding
  Classification as a Corporation for U.S. Tax
  Purposes

53
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Classification of Portfolio Company as a
  Corporation
• Generally, investment in an entity treated as a
  corporation for U.S. income tax purposes will not
  result in either UBTI or effectively connected
  trade or business income.
• Investment in a business organized as a
  partnership or other pass-through entity,
  however, will give rise to UBTI and trade or
  business income, both of which are prohibited
  under most Fund agreements.

54
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Classification of Portfolio Company as a
  Corporation (Cont.)
• A Non-U.S. portfolio company will be classified
  as a corporation or a partnership under the
  entity classification regulations (the
  Regulations). The Regulations provide that
  certain Non-U.S. entities will always be treated
  as corporations for U.S. income tax purposes.
• If the corporate form of a prospective Non-U.S.
  portfolio company is not mandatory under the
  Regulations, then the Non-U.S. portfolio company
  should represent that it will either elect to be
  treated as a corporation for U.S. income tax
  purposes or refrain from making an election to be
  treated as a partnership if it would otherwise be
  taxed as a corporation.

55
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Sample Entity Classification Representation
• The Company shall take such actions, including
  making an election to be treated as a corporation
  or refraining from making an election to be
  treated as a partnership, as may be required to
  ensure that at all times the company is
  classified as corporation for United States
  federal income tax purposes

56
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Representatons and Warranties from Portfolio
  Companies Regarding Controlled Foreign
  Corporation (CFC) Status and Subpart F Income

57
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Controlled Foreign Corporation
• If a Non-U.S. corporation is a Controlled Foreign
  Corporation (CFC) for an uninterrupted period
  of 30 days during any taxable year, then certain
  income of the CFC, whether or not distributed,
  will be currently taxed to certain U.S.
  shareholders (U.S. Shareholders, as defined
  below) who are shareholders of the CFC on the
  last day of the CFCs taxable year.
• In addition, disposition of CFC shares in a
  merger may result in tax in what would otherwise
  be a nontaxable transaction for U.S. income tax
  purposes.

58
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Determination of U.S. Shareholder Status
• Three requirements must be met before the Fund or
  its investors could be subjected to tax on
  undistributed income from a CFC.
• First, the Fund or its investors must be U.S.
  Shareholders (generally U.S. persons that own,
  directly or indirectly 10 or more of the voting
  power of the stock of the Non-U.S. portfolio
  company). Note that the General Partner of a
  Fund is arguably deemed to own ALL of the Voting
  Power of the stock owned by the Fund.
• Second, the Non-U.S. portfolio company must be a
  CFC (generally a Non-U.S. corporation in which
  U.S. Shareholders own or control, directly or
  indirectly, 50 of the voting power or value of
  the stock). Note that a Fund formed under the
  laws of the United States (e.g. Delaware) will
  itself be a U.S. Shareholder if it owns more than
  10 of the Portfolio Company.
• Finally, either the CFC must earn certain types
  of income or the CFC must be acquired in a
  transaction that would otherwise be nontaxable
  under U.S. income tax law.

59
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Sample CFC Representations to be Obtained from
  Non-U.S. Portfolio Companies
• Minimum Representation
• Immediately after the Effective Time, the Company
  will will not be a Controlled Foreign
  Corporation (CFC) as defined in the U.S.
  Internal Revenue Code of 1986, as amended (or any
  successor thereto). The Company shall make due
  inquiry with its tax advisors on at least an
  annual basis regarding the Companys status as a
  Controlled Foreign Corporation (CFC) as
  defined in the United States Internal Revenue
  Code of 1986, as amended (or any successor
  thereto) (the Code) and regarding whether any
  portion of the Companys income is subpart F
  income (as defined in Section 952 of the Code)
  (Subpart F Income). Each Investor shall
  reasonably cooperate with the Company to provide
  information about such Investor and such
  Investors Partners in order to enable the
  Companys tax advisors to determine the status
  of such Investor and/or any of such Investors
  Partners as a United States Shareholder within
  the meaning of Section 951(b) of the Code. No
  later than two (2) months following the end of
  each Company taxable year, the Company shall
  provide the following information to the
  Investors (i) the Companys capitalization
  table as of the end of the last day of such
  taxable year and (ii) a report regarding the
  Companys status as a CFC. In addition, the
  Company shall provide the Investors with access
  to such other Company information as may be
  necessary for the Investors to determine the
  Companys status as a CFC and to determine
  whether Investor or any of Investors Partners is
  required to report its pro rata portion of the
  Companys Subpart F Income on its United States
  federal income tax return (and if so, what such
  portion is), or to allow such Investor or such
  Investors Partners to otherwise comply with
  applicable United States federal income tax laws.
  For purposes of the foregoing as well as the
  representations contained in Sections ___ Note
  insert section references for all CFC/PFIC
  representations, (i) the term Investors
  Partners shall mean each of the Investors
  partners and any direct or indirect equity owners
  of such partners and (ii) the Company shall
  mean the Company and any of its subsidiaries.

60
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Sample CFC Representation to be Obtained from
  Non-U.S. Portfolio Companies (Cont.)
• In addition to the foregoing representation, in
  the event that the Company is a CFC and any of
  the Investors Partners are United States
  Shareholders with respect to such CFC, then if
  possible one or more of the following additional
  representations should be obtained
• 1 The Company and the shareholders of the
  Company shall not, without the written consent of
  Investor, issue or transfer stock in the Company
  to any investor if following such issuance or
  transfer the Company, in the determination of
  counsel or accountants for Investor, would be a
  CFC.
• 2 In the event that the Company is determined
  by the Companys tax advisors or by counsel or
  accountants for the Investor to be a CFC, the
  Company agrees to use commercially reasonable
  efforts to avoid generating Subpart F Income.
• 3 In the event that the Company is determined
  by the Companys tax advisors or by counsel or
  accountants for the Investors to be a CFC, the
  Company agrees to use commercially reasonable
  efforts to annually make dividend distributions
  to the Investors, to the extent permitted by law,
  in an amount equal to 50 of any income of the
  Company that would have been deemed distributed
  to the Investor pursuant to Section 951(a) of the
  Code had the Investor been a United States
  person as such term is defined in Section
  7701(a)(30) of the Code.
• 4 (If the company is or ever was a CFC) The
  Company will not be required to determine its
  Subpart F Income for any taxable period (or
  portion thereof) ending after the Closing Date by
  taking into account the recharacterization
  provisions of Section 952(c)(2) of the Code.

61
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Portfolio Company Representations and Warranties
  Regarding Passive Foreign Investment Company
  (PFIC) Status

62
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Passive Foreign Investment Companies
• In general, the Passive Foreign Investment
  Company or PFIC rules are broader in scope
  than the CFC rules discussed above since they are
  not dependent upon control by U.S. shareholders.
• Any Non-U.S. portfolio company may be a PFIC
  regardless of the size or number of U.S.
  shareholders if (i) 75 or more of its gross
  income is passive income or (ii) if 50 or more
  of the companys assets generate passive income.1
  
• 1 This determination is made based on the
  adjusted bases (as determined for the purposes of
  computing earnings and profits) of the companys
  assets if (a) the company is not a public company
  and (b) either the company is a CFC or it elects
  to have this method of determination apply.
  Otherwise, the determination is made on the basis
  of the value of the companys assets.

63
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Passive Foreign Investment Companies (Cont.)
• Subject to certain exceptions, if a Non-U.S.
  portfolio company meets either the passive income
  test or the passive asset test during the
  shareholders holding period for such companys
  stock, the PFIC rules will apply in all
  subsequent years, including those during which
  the company ceases to earn significant passive
  income and/or ceases to own a majority of passive
  assets.

64
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Passive Foreign Investment Companies (Cont.)
• If (i) a Non-U.S. corporation is a PFIC and (ii)
  the Fund (or, in the case of a Non-U.S. fund, its
  U.S. LPs) has not elected to be taxed under the
  Qualified Electing Fund rules described below,
  then the Fund and its investors would be taxed
  currently on all actual dividend distributions
  from the PFIC, such dividends being ineligible
  for the preferential rate applicable to
  qualified dividends.
• In addition, to the extent that any
  distributions, including gains from the
  disposition of PFIC stock, constitute excess
  distributions, such distributions will be deemed
  distributed ratably throughout the Funds
  ownership of the PFIC, with an annual interest
  charge applied to amounts deemed allocable to
  past taxable years.
• The annual interest charge and taxation of excess
  distributions is intended to eliminate any
  benefit to a shareholder of retaining assets in a
  PFIC rather than distributing all available
  assets on an annual basis.

65
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Passive Foreign Investment Companies (Cont.)
• To avoid being subjected to tax upon a return of
  capital, the special interest charge, and loss of
  ability to engage in tax-free transactions, the
  Fund (if it is formed in the U.S.) or its U.S.
  investors (if the fund is formed outside the
  U.S.), may make a Qualifying Electing Fund
  (QEF) election to pay tax on its proportionate
  share of a PFICs earnings and profits annually,
  as if such earnings and profits had been
  distributed to shareholders.
• This election may not be particularly costly,
  since many Non-U.S. portfolio companies will not
  generate any earnings and profits
  (notwithstanding earning passive interest income
  on the proceeds of financings) during the early
  years of their operations, as earnings and
  profits are determined in the aggregate, and
  passive interest income will likely be offset by
  losses related to business operations.

66
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Passive Foreign Investment Companies (Cont.)
• In a year in which the PFIC ceases to receive 75
  passive income and ceases to have at least 50
  passive assets, those U.S. shareholders that
  have previously made the QEF election avoid both
  the deemed distribution of companys current
  income to the shareholder and the application of
  the special interest charge to any gains realized
  on the disposition of the PFICs stock, while
  those shareholders that failed to make a timely
  QEF election would continue to be taxed as
  discussed above.
• If the Investor has a reasonable belief that a
  Non-U.S. portfolio company does not exceed the
  PFIC passive activity limits before the Fund has
  made a valid QEF election for its interest in the
  company, the Fund may make a protective
  statement to preserve its right to make a
  retroactive QEF election if the company is ever
  determined to be a PFIC.
• The cost of making the protective statement is
  the elimination of the statute of limitations for
  the IRS to raise PFIC issues on tax returns filed
  after the protective statement is made.

67
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Sample PFIC Representation to be Obtained from
  Non-U.S. Portfolio Companies
• Minimum PFIC Representation.
• The Company has never been, and, to the
  best of its knowledge after consultation with its
  tax advisors, will not be with respect to its
  taxable year during which the Effective Date
  occurs, a passive foreign investment company
  within the meaning of Section 1297 of the
  Internal Revenue Code of 1986, as amended (or any
  successor thereto). The Company shall use its
  commercially reasonable best efforts to avoid
  being a passive foreign investment company
  within the meaning of Section 1297 of the
  Internal Revenue Code of 1986, as amended (or any
  successor thereto). In connection with a
  Qualified Electing Fund election made by any of
  Investors Partners pursuant to Section 1295 of
  the Internal Revenue Code of 1986 or a
  Protective Statement filed by any of Investors
  Partners pursuant to Treasury Regulation Section
  1.1295-3, as amended (or any successor thereto),
  the Company shall provide annual financial
  information to Investor in the form provided in
  the attached PFIC Exhibit (or in such other form
  as may be required to reflect changes in
  applicable law) as soon as reasonably practicable
  following the end of each taxable year of the
  Company (but in no event later than 90 days
  following the end of each such taxable year), and
  shall provide Investor with access to such other
  Company information as may be required for
  purposes of filing U.S. federal income tax
  returns of Investors Partners in connection with
  any such Qualified Electing Fund election or
  Protective Statement.

68
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Sample PFIC Representation to be Obtained from
  Non-U.S. Portfolio Companies (Cont.)
• Additional PFIC Representation. Depending upon
  the circumstances, it may be possible to
  negotiate this additional representation as well
• In the event that an Investors Partner who has
  made a Qualified Electing Fund election must
  include in its gross income for a particular
  taxable year its pro rata share of the Companys
  earnings and profits pursuant to Section 1293 of
  the United States Internal Code of 1986, as
  amended (or any successor thereto), the Company
  agrees to make a dividend distribution to the
  Investor (no later than 90 days following the end
  of the Companys taxable year or, if later, 90
  days after the Company is informed by Investor
  that such Investors Partner has been required to
  recognize such an income inclusion) in an amount
  equal to 50 of the amount that would be included
  by Investor if Investor were a United States
  person as such term is defined in Section
  7701(a)(30) of the Code and had Investor made a
  valid and timely Qualified Electing Fund
  election which was applicable to such taxable
  year.

69
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Representations and Warranties from Portfolio
  Companies with Respect to Miscellaneous U.S.
  Reporting Requirements

70
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Miscellaneous Information Reporting Requirements
• Certain information reporting requirements apply
  to owners of control positions in Non-U.S.
  corporations and persons making transfers of
  property to Non-U.S. business entities that would
  be tax-free transfers if undertaken between U.S.
  parties. Failure to comply with these
  requirements may result in the imposition of
  monetary penalties by the IRS.
• The IRS requires a U.S. person who owns a control
  position (more than 50 of voting power or more
  than 50 of total value) in a Non-U.S.
  corporation, along with U.S. residents or
  citizens who are officers or directors of a
  Non-U.S. corporation in which a U.S. person has
  acquired at least 10 of such corporations stock
  (vote or value), to file an informational return.
  For the purposes of determining stock ownership,
  certain constructive ownership rules apply.

71
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Miscellaneous Information Reporting Requirements
  (Cont.)
• Generally, the Fund will be considered to own not
  only the stock it holds directly, but also any
  stock owned by its U.S. partners as well as a
  proportionate share of the holdings of most
  entities in which the Fund has interests. If the
  Fund is determined to hold a control position in
  a Non-U.S. corporation, it will need to attach an
  informational return (on Form 5471) to its tax
  return for each year in which it held the control
  position. The information required on the return
  is basic financial information (assets,
  liabilities and stock structure) of the
  controlled foreign corporation as well as
  information about any transactions between the
  Fund and the Non-U.S. corporation.
• The IRS generally requires a U.S. person who
  transfers cash or property to a Non-U.S. business
  entity, in a transaction that would be tax-free
  if the transfer occurred between two U.S.
  persons, to file an informational statement. The
  contents of the statement can vary based on the
  type of transfer, but will normally include
  general information about both parties as well as
  a description of the property transferred, the
  property received and the transaction as a whole.
  An additional information statement may be
  required in certain transfers of intangible
  property.

72
Best Tax Compliance Practices for Funds with U.S.
Investors (Cont.)

• Sample Representation to be Obtained from
  Non-U.S. Portfolio Companies with respect to
  Miscellaneous Information Requirements
• The Company shall make due inquiry with its
  tax advisors (and shall cooperate with Investors
  tax advisors with respect to such inquiry) on at
  least an annual basis regarding whether
  Investors or any Investors Partners direct or
  indirect interest in the Company is subject to
  the reporting requirements of either or both of
  Sections 6038 and 6038B of the Code (and the
  Company shall duly inform the Investor of the
  results of such determination), and in the event
  that Investors or any Investors Partners
  direct or indirect interest in Company is
  determined by the Companys tax advisors or the
  Investors tax advisors to be subject to the
  reporting requirements of either or both of
  Sections 6038 and 6038B Company agrees, upon a
  request from Investor, to provide such
  information to Investor as may be necessary to
  fulfill Investors or Investors Partners
  obligations thereunder.

73

• Thank You

74
IRS Circular 230 Disclosure

• This presentation was not intended or written to
  be used, and it cannot be used, by any taxpayer
  for the purpose of avoiding penalties that may be
  imposed on the taxpayer under U.S. Federal tax
  law.