Effectively Connected Income and Penny Warrants

Guest post by Nicholas Jacobus and Sung Hwang – Venable LLP

There is a case currently proceeding in the U.S. Tax Court (TELOS CLO 2006-1, Ltd. v. Commissioner, T.C., No. 6786-17, petitions filed 3/22/17) that deals with the question of whether non-U.S. investors inadvertently realized “ECI” from the sale of “penny warrants” (a/k/a “hope notes”).  This is a reminder that careful deal structuring is crucial for funds that have a significant non-U.S. investor base or otherwise have a covenant to avoid income that is “effectively connected” with the conduct of a U.S. trade or business (ECI). 

ECI in the hands of a non-U.S. investor is taxed on a net basis at the federal level (and, often, state and local levels as well), in a manner similar to the taxation of a U.S. investor of the same item of income.  This can significantly reduce the return on investment.  In addition, ECI compels the non-U.S. investor to file a nonresident income tax return in the U.S. (often including in the U.S. state and/or locality where the income was sourced).  Thus, many funds will have a covenant to avoid ECI and/or strict investment guidelines to achieve the same.

In this Tax Court case, two collateralized debt obligation funds (CLOs), TELOS CLO 2006-1 Ltd., and TELOS CLO 2007-02 Ltd., organized as limited companies in the Cayman Islands, and managed by a common investment adviser, were engaged the business of investing in loans from U.S. issuers.  As is typical of such investors, the CLOs were organized to operate in a manner to avoid ECI, and had adopted an elaborate set of investment guidelines intended to assist them in this regard.

In early 2009, the CLOs acquired pieces of a syndicated loan in the secondary market.  Several months later, the debtor, a U.S. LLC, defaulted on the loan.  As part of the subsequent loan restructuring, the CDOs received warrants convertible into equity of the borrower for $0.01 per unit of the borrower equity.  The petitions filed by the CDOs with the Tax Court claim that the warrants had no value upon receipt (“speculative”), and they could be transferred only to other lenders in the same loan.    

In 2011, the borrower was sold and the purchaser paid the CDOs cash for the warrants.  The IRS audited the CLOs and issued notices of deficiency claiming that the gains from the sale of the warrants constituted ECI, and the CLOs are seeking a contrary holding in the Tax Court. More facts will need to be developed to give a fuller color to the picture but, with the benefit of a rearview mirror, it might have been prudent to use a corporate “blocker” to hold the warrants as customary CLO investment guidelines would dictate. 

This case also reminds us of the IRS’s aggressive stance on penny warrants after the issuance of the regulations under Section 761 of the Internal Revenue Code in 2013 (which were issued after the issuance of the warrants in this case).  Under these regulations, investment (i.e., non-compensatory) warrants with an insignificant strike price, such as the warrants at issue in this case, are under significant scrutiny and are likely to be labeled as equity by the IRS. 

In particular, the regulations set forth a two-prong test to determine if a warrant with a nominal strike price will be characterized as equity.  The holder of a warrant will be treated as the holder of a partnership interest if: (1) the warrant provides the warrant holder with rights that are substantially similar to the rights afforded a partner, and (2) there is a strong likelihood that the failure to treat the holder of the investment warrant as the owner of the underlying security would result in a substantial reduction in the present value of the aggregate federal tax liabilities of the partners of the entity and the warrant holder.

If these regulations were to apply to the facts of this case, for U.S. federal income tax purposes, it seems that the CLOs acquired equity interests in a U.S. partnership upon receipt of the warrants, and the gains from their sale would have constituted ECI in the pockets of the CLOs.

Nicholas Jacobus is an associate in the Tax and Wealth Planning practice in the Los Angeles office. Sung Hwang is a partner in Venable’s Tax and Wealth Planning practice in the New York office. For more information, visit www.venable.com.

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