Press Room: Tax Release

February 15, 2011

Tax Developments Affecting Alternative Investment Funds

This edition of Fund Watch provides a potpourri of recent tax developments that may be of interest to alternative investment funds, their clients and managers.

I. QUALIFIED SMALL BUSINESS STOCK – CAPITAL GAIN EXCLUSION

As indicated in a prior 2010 Alert, the capital gain exclusion available for investments in qualified small business stock (QSBS) is of particular interest to venture capital funds.  It is great news for the VCs (and others who may qualify) that President Obama recently announced a proposal to make permanent the temporary exclusion presently available for stock issued through the end of 2011. We will keep you advised on the fate of this Administration proposal.

II. MARK-TO-MARKET ELECTION – LATE FILING RELIEF

In Ltr. Rul. 201043030, Internal Revenue Service (IRS), for the first time, granted Sec. 9100 relief for a late-filed Sec. 475 “mark-to-market” election. Under the ruling, all the taxpayers (two foreign and one domestic partnership) experienced technical partnership terminations that, in effect, required new mark-to-market elections to be made. The taxpayers did not realize they would be treated as new taxpayers and that new elections were required. Based on the facts submitted, IRS granted a reasonable extension of time to make the Sec. 475(f)(1) election. This ruling represents a reversal of prior IRS policy on this issue which had been to deny such requests.

III. LONG DATED OPTION CONTRACTS – TAX OWNERSHIP

In a generic legal advice memorandum (GLAM) (AM 2010-005), IRS concluded that long-dated option contracts with terms that were inconsistent with option status represented tax ownership of the referenced basket of securities. Some hedge funds utilized “basket option contracts” to defer and convert short-term capital gain to long-term capital gain on some or all of their investment portfolios. Under IRS' view, such deferral and conversion would be unavailable to the hedge fund as it would be considered the owner of the securities. The GLAM should be viewed as, in effect, a litigation memorandum and not as guidance for taxpayers.

IV. FOREIGN INVESTMENT IN U.S. STOCK AND SECURITIES – HR 62

In HR 62, Representative Byron Dorgan (D-ND) introduced a proposal targeting U.S.-managed investment entities—for example hedge funds and private equity funds—that are classified under current law as foreign corporations. The proposal does this by treating trading or investing by foreign investors in stocks, securities or commodities in the same manner as other "business" activities. The proposal, in effect, eliminates the present trading “safe harbor” in the Code and represents the reversal of nearly 80 years of U.S. tax policy favoring foreign investment in the U.S. capital markets. Prospects for the proposal would appear dim—but who knows since this is the third time this proposal has been offered—“three times may be the charm."