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In Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund [724 F.3d 129 (1st Cir. 2013)], the First Circuit held that one of two private equity funds (the two funds were Sun Capital Fund III and Sun Capital Fund IV) with an investment in a portfolio company managed and operated by such funds was a trade or business for purposes of withdrawal liability under the Employee Retirement Income Security Act of 1974 ("ERISA"), 29 U.S.C. §1001 et seq (as amended). In holding so, the First Circuit reversed the decision of the district court that Sun Capital Fund IV ("Fund IV") was not a trade or business and remanded the case to the lower court for further proceedings on the issue of common control and for additional fact finding to determine if Sun Capital Fund III ("Fund III") were a trade or business.The case is interesting from the international tax perspective because the "trade or business" analysis may have interesting implications for non-U.S. private equity funds and their non-U.S. investors, limited partners in such funds, that may include tax-exempt entities and sovereign wealth funds.The FactsSun Capital Advisors, Inc. ("SCAI"), a private equity firm, identified Scott Brass, Inc. ("SBI"), a manufacturer of coil and brass products, as a potential portfolio investment. In 2007, SCAI structured the investment and acquired SBI through two affiliated private equity funds, Fund III (30 percent ownership in SBI) and Fund IV (70 percent ownership in SBI). Fund III and Fund IV did not have any offices or employees of their own.The shareholders of SCAI were the sole members of the partnership that was a general partner ("GP") in both funds. Further, the GP wholly owned a management company that provided management services to SBI and the funds. The management company hired SCAI employees to provide those management services for the funds. The GP had very broad authority under the partnership agreement. Specifically, the GP had "exclusive and wide-ranging management authority," evidenced by the partnership agreements to make decisions and determinations relating to hiring, terminating and establishing the compensation of employees and agents of the funds or their portfolio companies. The fees that the funds were supposed to pay to the management company were offset by the fees that SBI paid to the management company, thus, effectively resulting in SBI covering the funds' management fee expense. SCAI employees were appointed to two out of three director positions of the SBI's board and were engaged in the operation of SBI.In 2008, due to worsened market conditions, SBI was unable to fund its pension plan. As a result, SBI creditors forced it into bankruptcy. Consequently, SBI withdrew from the pension plan, leading to unfunded liability, which, under ERISA, should be shared by the members of the SBI shareholder group that is Fund III and Fund IV. The New England Teamsters & Trucking Industry Pension Fund ("TPF") claimed that III and IV were liable for SBI's share of underfunded qualified pension benefits (if SBI became insolvent, TPF, and then federal Pension Benefit Guaranty Corporation ("PBGC") would be responsible for the related benefits to SBI workers)). The private equity funds were not happy to assume the liability and the litigation ensued. The district court ruled in favor of the funds on the issue of withdrawal liability, including the issue of trade or business. The First Circuit disagreed.According to the opinion, to impose withdrawal liability on Fund III and Fund IV — that is, on some party other than SBI, two conditions must be satisfied: Fund III and Fund IV must be under "common control" with SBI, and Fund III and Fund IV must be engaged in a trade or business. [724 F.3d at 138.]When holding on the issue of trade or business, the Court reviewed tax authorities, but did caution against relying on its holding for tax purposes. Notwithstanding that caution, we view the opinion as useful for tax practitioners.
ImplicationsSun Capital may have significant tax implications for non-U.S. private equity funds and their investors, limited partners in such funds. Notwithstanding the Court's explicit limiting of its holding for ERISA purposes, it reviewed the existing tax standards on the definition of trade or business and frequently cited an article that discussed the current and proposed tax treatment of private equity funds for tax purposes. Furthermore, according to a Treasury official's public comments at the recent ABA Section of Taxation meeting in San Francisco, the decision of the First Circuit may offer Treasury an opportunity to "reassess" what a trade or business is for tax purposes. If so, we are likely to see a significant change in the private equity industry. As a consolation, though, such a change in the current approach to taxation of private equity funds is unlikely to happen without Congress's blessing. Accordingly, private equity funds and their investors would have some time to adjust their existing structures to a new regime.
Information referenced herein is provided for educational purposes only. For legal advice applicable to the facts of your particular situation, you should obtain the services of a qualified attorney licensed to practice law in your state.
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RELATED LINKS: For more discussion of foreign persons' activities in the U.S. and private equity funds, see:
Lexis Tax Advisor -- Federal Topical § 4B:5.03 – Withholding on Passive Income: Persons Subject to Withholding
For more discussion of foreign persons' activities in the U.S. and retirement plans, see:
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