November 21, 2023
On Wednesday, November 15, 2023, the U.S. Tax Court (“Court”) served its opinion regarding YA Global Investment, LP (“YA Global”), a Cayman Islands partnership. The opinion was primarily unfavorable to YA Global, holding that YA Global was engaged in a U.S. trade or business due to the activities of the partnership’s asset manager. The U.S. Tax Court held that YA Global's income should be treated as ordinary and as effectively connected income. One of the central issues addressed in this opinion is the agency relationship between YA Global and its asset manager. YA Global had no employees of its own. The asset manager had a U.S. office with over 50 employees. During the issues under examination, the asset manager discontinued or merged its other funds with the result of YA Global as the only fund managed by the asset manager. The U.S. Tax Court examined the degree of control YA Global had over its asset manager, finding that the asset manager was an agent of YA Global. The Court held that the activities of the asset manager can be attributed to YA Global. After holding that the activities of the asset manager can be attributed to YA Global, the opinion then focuses on whether YA Global was engaged in a U.S. trade or business. YA Global funded portfolio companies through convertible debentures, Standby Equity Distribution Agreements (SEDAs), and other securities. In one of YA Global’s SEDAs, the partnership committed to purchasing up to a specified dollar amount of a portfolio company’s stock over a fixed period. YA Global acquired more than 100 convertible debentures a year during the years under examination. The terms of some of the convertible debentures allowed YA Global to receive stock of the issuer upon conversion at a discount. The opinion noted that YA Global would generally exercise the conversion feature of the debenture only when it was ready to sell the stock it would receive on conversion. Most of the net income reported on YA Global’s Form 1065 was interest and short-term capital gains. The U.S. Internal Revenue Service (“IRS”) contended that YA Global was engaged in lending activities, noting that “YA Global made hundreds of loans directly to companies in exchange for promissory notes and convertible debentures.” The SEDAs usually required the portfolio company to pay YA Global and its asset manager various fees upon executing the SEDA and additional fees upon each advance of funds. The fees paid by the portfolio could include commitment, structuring, and transactional fees. The asset manager could remit excess fees to YA Global or apply them in satisfaction of the management fee owed to the asset manager by YA Global. The IRS contended that fees paid by the portfolio companies reinforced that YA Global was engaged in a services business. The attorneys for YA Global argued that YA Global because YA Global was simply an investor and it met the trading safe harbor from a U.S. trade or business. The U.S. Tax Court held that YA Global did not meet the trading safe harbor from a U.S. trade or business. The U.S. Tax Court cited that it did not meet the trading safe harbor “because the income the partnership earned from portfolio companies went beyond returns on invested capital.” Further, the U.S. Tax Court held that YA Global was engaged in a U.S. trade or business and that YA Global should be treated as a dealer in securities. The U.S. Tax Court further held that YA Global, as a dealer in securities, did not properly identify which assets were held as investments. The Court further held that YA Global's income was ordinary income that should be treated as effectively connected with a U.S. trade or business. The Court’s holdings were mainly in favor of the IRS. The IRS has reportedly been auditing investment funds for U.S. trade or business risk. This case is likely to bolster the IRS’s efforts in this area. U.S.-based funds and non-U.S. investors should review their funds' U.S. trade or business risk. A U.S. trade or business determination is based on a taxpayer's particular facts and circumstances. U.S. trade or business income generally creates U.S. federal and state income tax filing obligations for non-U.S. taxpayers. There are steps that funds can take to reduce U.S. trade or business income risk to non-U.S. investors. Please contact International Capital Associates, LLC if you need help with inbound tax planning and structuring , U.S. investment tax reviews , or other tax services .