In a widely anticipated opinion,[1] on November 15, 2023 the U.S. Tax Court ruled that a fund was engaged in a U.S. trade or business through the activities of its investment manager, and that the fund was also a “dealer in securities” subject to the mark-to-market accounting rules of Section 475.[2] Because the facts of the case are unusual, we do not anticipate that the opinion should materially impact current market practices of most private funds, including credit funds. But the opinion nevertheless is interesting because it touches on several important issues that currently have very little guidance, including the agency relationship between a fund and its manager, whether lending is within the trading safe harbor, the scope of the dealer exception to the trading safe harbor, and fees received from portfolio companies.

Background

YA Global Investments, LP (the “Fund”) was a Cayman Islands exempted limited partnership, treated as a partnership for U.S. federal income tax purposes, that provided funding to small-cap and micro-cap portfolio companies in the form of convertible debentures, standby equity distribution agreements, and other securities. The Fund’s investments were managed by New Jersey-based Yorkville Advisors, LLC, a Delaware limited liability company (“YA”), which received substantial fees from portfolio companies in connection with the Fund’s investments. YA largely performed investment management services solely for the Fund. The Fund filed a U.S. federal income tax return on Form 1065 for each of the years in question (2006-2008) but took the position that it was not engaged in a U.S. trade or business and did not withhold taxes under Section 1446 on the portion of any income that was effectively connected with its U.S. trade or business and allocable to any foreign partners.

Agency and U.S. Trade or Business

The Tax Court ruled that YA’s activities can be attributed to the Fund and, in turn, the Fund was engaged in a U.S. trade or business through YA. On the threshold question, the Tax Court held that YA was properly classified as an agent of the Fund, and not as a service provider that furnished services to the Fund, largely because (i) the relevant investment management agreements allowed the Fund to give interim instructions to YA regarding the management of the Fund’s investments, rather than specifying from the outset all the restrictions that would apply to YA’s investment management activities during the term of the investment management agreements, and (ii) the powers given to YA under the investment management agreements were not given in order to protect an economic interest that YA possessed outside of its interest in receiving management fees under the investment management agreements, and thus YA’s exercise of those powers could not be viewed as being exercised by YA for its own benefit in its capacity as a principal.

On the next question, the Tax Court held that the Fund was engaged in a U.S. trade or business through YA because the activities that YA conducted on behalf of the Fund satisfied a three-prong test: (1) they were continuous, regular, and directed at income or profit; (2) they went beyond the management of investments; and (3) they were not within the statutory safe harbor for securities trading. Regarding the first prong, the Tax Court noted that because YA had 50+ employees at any given time who devoted themselves to YA’s activities, and because YA was acting as an agent of the Fund, there was no basis for denying that those activities undertaken by the agent on behalf of the Fund were regular and continuous, and the facts left no room for doubt that YA, acting as agent of the Fund, sought to generate profits. Regarding the second and third prongs, the Tax Court focused on the fees that YA received from portfolio companies, concluding that such fees were not additional payments for the use of capital. (If they were, then they should have been paid entirely to the Fund rather than YA). Rather, the fees were for the performance of services. The Tax Court also noted that YA did not act like a typical investor in that it dealt directly with portfolio companies rather than purchasing securities on the open market.

Takeaways Although this opinion was highly anticipated, it is not surprising that YA and the Fund were found to be engaged in a U.S. trade or business. Thus, in the case of lending funds, the use of treaty structures, leveraged blockers and “season and sell” should not change. However, fund managers (including hedge, PE and VC fund managers) should be aware that charging substantial and continuous fees from portfolio companies could create a U.S. trade or business risk to the fund, even if the fund uses a typical “management fee offset.” Moreover, the IRS’ win in this case may embolden it to litigate more aggressive fund structures, such as “season and sell” where the offshore fund is in substance sharing in all fees realized by the onshore fund and/or short seasoning periods.

[1] YA Global Investments, LP v. Commissioner, 161 T.C. 11 (2023), available here.

[2] All Section references are to the U.S. Internal Revenue Code of 1986, as amended.