December 27th, 2023

This article, which will be expanded in the next issue of Corporate Taxation, discusses a recent Tax Court decision that raises the question whether hedge funds and private equity firms segregating large capital investments by non-U.S. persons, foreign countries, and exempt organizations, for investment in the U.S. in foreign feeder groups, are imputed the status of being engaged in one or more U.S. trades or businesses through the activities of their agents.

In YA Global Investments, LP, 161 TC No. 11 (2023), the Tax Court recently held that a limited partnership, a hedge fund which engaged in a "season-and-sell" inbound lending business in the United States, that provided funding to portfolio companies in the form of convertible debentures, standby equity distribution agreements (SEDAs), and other securities in exchange for its stock, convertible debt, notes, and warrants, was engaged in a U.S. trade or business. The court found that all of the Partnership's taxable income was effectively connected with respect to such U.S. trade or business and that the Partnership was liable for withholding under Section 1446 on the portion of its effectively connected income (ECI) attributable to its foreign partners.

The decision raises the question whether other hedge funds and private equity firms segregating large capital investments by non-U.S. persons, foreign countries, and exempt organizations, for investment in the U.S. in foreign feeder groups, are imputed the status of being engaged in one or more U.S. trades or businesses through the activities of their agents in managing, promoting, or dealing in stocks or securities of U.S. portfolio companies in which they invest. 1

The Partnership had made various arguments rejecting the Service's proposed deficiencies in income tax, withholding tax, penalties, and interest for the tax years 2006-2009. Of greatest importance was its contention that it was simply a passive investment fund, which was, by definition, not engaged in a U.S. trade or business. Therefore, none of its income for the years in issue was ECI, and the Partnership was not responsible for Section 1446 withholding on its foreign partners' distributive share of U.S. effectively connected income. Judge James Halpern, who issued the opinion on behalf of the Tax Court, held that the Partnership failed to meet its burden of proof on the primary issue as well as all other material issues.

On the U.S. trade or business question, the court emphasized that while YA Global Investments, LP (the "Partnership") had no employees, the Partnership's sole general partner, YA Global Advisors, LLC, ("YA"), a Caymanian Islands corporation, was responsible for the management of its assets subject to its directions which were set forth in the operative documents, including an investment management agreement, as amended. Indeed, the opinion would further note that the underlying portfolio companies paid management fees to both the Partnership and YA. Based on the facts, YA's activities, as the manager of the partnership's assets, were attributed to the Partnership based on the principal-agent relationship in contrast to merely a "provider and recipient" of services arrangement. The court cited Restatement (Third) of Agency, § 1.01, cmt. F (ALI 2006) ("The power to give interim instructions distinguishes principals in agency relationships from those who contract to receive services provided by persons who are not agents").

Additional holdings were announced by the court, inter alia: (1) that the Partnership was a dealer in securities subject to the mark-to-market rules under Section 475 ; (2) the filing of partnership returns for the years in issue did not commence the statute of limitations on the assessment of withholding tax under Section 1446 because such returns did not put the government on notice of the Partnership's liability for such tax; (3) in the alternative, even if the period of limitations on the assessment of the Section 1446 withholding commenced with the filing of the Partnership's returns, the Partnership's signing of Forms 872-P for two of the relevant years extended the applicable period of limitations; (4) the filing of partnership returns did not shield the Partnership from failure to file Forms 8804 and pay over the required withholding; and (5) the Partnership failed to fall within the statutory exception from the mark-to-market rules under Section 475(b)(2) . As a result of the entire set of findings made by the court, the offshore hedge fund would, subject to its right of appeal, be subject to over $55 million in tax, plus penalties and interest. The Tax Court, per Judge Halpern, stated that a subsequent opinion would be issued for additional issues for the last tax year in issue, 2009.

Extensive coverage of and the potential impacts of the YA Global Investments LP case will be forthcoming in an article to be published in the next issue of Corporate Taxation.

1 See InverWorld Inc., TCMemo 1996-301 ; August, "The Inbound Foreign Corporation: Knowing When Its Income Is U.S. Effectively Connected Income," Corporate Taxation (Parts 1 and 2) (May/June and July/August 2023).