Tax Court Holds Fund Engaged in U.S. Business via Investment Manager, Owes Withholding Tax

The Tax Court in a November 15 decision held that an investment fund partnership was engaged in a U.S. trade or business through the activities of its investment manager that acted as its agent, and consequently the partnership was liable for withholding taxes for the portion of its effectively connected income allocable to its foreign partners (YA Global Investments LP V. Commissioner, 161 T.C. No. 11).

Investment Partnership and Management Agreement

Investment fund partnership YA Global Investments (YA Global) was formed as a Delaware limited partnership in 2001. In 2007, YA Global registered under the law of the Cayman Islands. YA Global had no employees. Yorkville Advisers, which had its headquarters in New Jersey, was YA Global’s sole general partner from its formation until early 2007. 

A 2005 investment and management agreement stated that YA Global retained Yorkville Advisors to render management services and manage its securities investment account. The agreement further appointed Yorkville Advisors as YA Global’s agent with full authority to buy and sell on the partnership’s account. The parties entered into a new agreement in 2007 that substantively retained these provisions. Under the terms of each management agreement, YA Global had the right to give interim instructions to Yorkville Advisors regarding the management of YA Global’s investment account.

In exchange for its services to YA Global, Yorkville Advisors received a management fee equal to a specified percentage of the partnership’s assets and an incentive fee based on profits. 

YA Global and Yorkville Advisors Receipt of Fees from Portfolio Companies

Both YA Global and Yorkville Advisors received certain fees from portfolio companies in connection with the acquisition of securities. For example, Yorkville Advisors received structuring fees and YA Global received commitment fees. For debenture transactions, fees were paid by portfolio companies in exchange for a reduction in the applicable interest rate.

Withholding Tax Dispute

For each of the years in issue (2006–2008), YA Global filed a Form 1065, “U.S. Return of Partnership Income.” It did not file Form 8804, “Annual Return for Partnership Withholding Tax (Section 1446),” in any of these years. An accounting firm had advised YA Global that it was not engaged in a U.S. trade or business; however, YA Global subsequently filed suit against the firm for malpractice and negligence. 

In 2015, the IRS issued YA Global notices of final partnership administrative adjustments (FPAAs) for tax years 2006, 2007, and 2008. The FPAAs asserted YA Global was engaged in the conduct of a U.S. trade or business and that all of YA Global’s taxable income was effectively connected with that business. Accordingly, per the FPAAs, YA Global was liable under Section 1446 for withholding tax on the portion of its effectively connected income that was allocable to foreign partners. 

The FPAAs also imposed additions to tax under Section 6651(a) and 6655 for failure to file Form 8804 and failure to pay estimated taxes and section 1446 withholding tax.

Tax Court’s Analysis of Withholding Tax Liability

Analysis of Whether Yorkville Advisors Was an Agent of YA Global

The principal issue before the Tax Court was whether YA Global was engaged in a U.S. trade or business during the years at issue. If YA Global was, it was required under Section 1446, as the IRS asserted, to withhold and pay tax on the portion of its income that was effectively connected with its U.S. trade or business and allocable to its foreign partners. 

The threshold issue for the court was whether the activities of Yorkville Advisors, the manager of YA Global’s assets, could be attributed to YA Global. The court noted that in both the 2005 and 2007 management agreements, YA Global manifested its assent to Yorkville Advisors’ acting on its behalf and managing its assets, and Yorkville Advisors took on that role. The parties had an agency relationship because YA Global had the ability under each management agreement to give interim instructions that would restrict Yorkville Advisors' discretion in managing the partnership's assets. As a result, the court determined that the parties’ relationship could not be viewed as one of service provider and recipient. Furthermore, in each investment management agreement, YA Global retained a degree of control over Yorkville Advisors that prevented Yorkville Advisors powers as having been given to secure some unidentified interest in the partnership or its assets apart from Yorkville Advisors’ role as YA Global's investment manager. Therefore, Yorkville Advisors’ activities under the management agreements were attributed to YA Global for purposes of determining whether YA Global was engaged in a U.S. trade or business during the years at issue. 

Analysis of Whether YA Global Was Engaged in a U.S. Trade or Business

Having concluded that Yorkville Advisors’ activities were attributed to YA Global, the court considered whether those activities amounted to a U.S. trade or business. In this regard, the court concluded that the activities of Yorkville Advisors were sufficiently continuous, regular, and directed to derive a profit. 

Furthermore, Yorkville Advisors did not limit its activities to the management of investments. It received fees from portfolio companies intended to cover the costs of the activities that Yorkville Advisors conducted on YA Global’s behalf (e.g., identifying, sourcing, and negotiating transactions, conducting due diligence, and structuring and managing the transactions). The form of the transactions thus indicates that the portfolio companies received something of value from Yorkville Advisors above and beyond the capital they received from YA Global.

Accordingly, the activities that Yorkville Advisors conducted for YA Global during the years in issue were not covered by either the judicially created safe harbor for managing of investments or the statutory safe harbor for trading in securities provided in Section 864(b)(2)(A). Traders, like investors, simply earn returns on the capital they invest. Because the portfolio companies compensated Yorkville Advisors and YA Global for benefits that went beyond the use of invested capital, YA Global was neither an investor nor a trader. Therefore, the trading safe harbor in Section 864(b)(2)(A) did not apply. As a result, YA Global was engaged in a U.S. trade or business during the years at issue.

Analysis of Withholding Obligations Under Section 1446

Because YA Global was conducting a trade or business in the U.S. as the court determined, then it was liable under section 1446 for withholding tax on the portion of its taxable income that was effectively connected with the U.S. trade or business and was allocable to foreign partners. The court determined that YA Global failed to establish that any portion of its taxable income was not effectively connected with its U.S. trade or business. Accordingly, the court held that YA Global was required under Section 1446 to pay withholding tax on the portion of that income allocable to foreign partners. 

After addressing some additional issues, discussed below, the court concluded that YA Global was liable for Section 1446 withholding tax of approximately $16 million for 2006, $28 million for 2007, and an amount yet to be determined by the parties for 2008. 

‘Dealer in Securities’ Issue

In considering the amount of YA Global’s income that was effectively connected with its U.S. trade or business, the court also reviewed whether the partnership’s reported taxable income had to be adjusted to reflect the application of Section 475 mark-to-market rules. The court held that YA Global was a “dealer in securities” under Section 475(c)(1)(A) and was subject to the mark-to-market rule under Section 475(a)(2). Accordingly, the court determined that YA Global was required to recognize mark-to-market gain of approximately $13.8 million in 2008.

Dismissed Arguments

After determining that YA Global was required to pay withholding tax on the portion of its effectively connected income allocable to foreign partners, the court also considered, and dismissed, YA Global’s argument that its withholding tax should be adjusted to reflect stipulated expenses beyond non-partnership deductions because YA Global did not receive certifications under Treas. Reg. § 1.1446-6.

The court similarly dismissed YA Global’s argument that the statute of limitations under Section 6501(a) bars the IRS from assessing the partnership’s Section 1446 liabilities for two of the years at issue. The court stated that the limitations period had not begun to run because YA Global had not filed Form 8804 disclosing that it was engaged in a U.S. trade or business. Moreover, even if it had begun to run upon the Form 1065 filings, the parties had executed extensions. 

Additions to Tax

Finally, the court also held YA Global was liable for additions to tax under Section 6651 for its failure to file Form 8804 and pay withholding tax. The court determined the failure was not due to reasonable cause. While YA Global did receive advice from an accounting firm that it was not engaged in a U.S. trade or business, the court noted that YA Global’s filing of a negligence claim against the firm suggests that YA Global realized at some point that the firm’s advice should not be relied upon; and YA Global failed to establish that this point did not occur until after the filing omissions making the partnership subject to additions to tax.