A recent federal court ruling has raised some serious concerns in the private equity industry. In Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pensions Fund, the United States Court of Appeals for the Third Circuit held that two private equity funds were liable for pension liabilities incurred by a portfolio company in which they invested, based on the fact that the funds were effectively engaged in a “trade or business” for the purposes of the Employee Retirement Income Security Act of 1974 (ERISA).
The Court found that the funds were not mere passive investors, since they were actively involved in the development and management of the portfolio company in question (e.g., by appointing board members and participating in key strategic decisions).
This decision poses important implications on future private equity deals. When evaluating and structuring future acquisitions, private equity firms will have to be more cautious in taking into account the impact of pension liabilities within prospect target companies. Furthermore, this ruling has the potential of bringing even broader changes.
One of the main tax benefits in the private equity industry is that the profits made by the private equity firms are defined as “carried interest.” Carried interest is a percentage of the fund’s profit that is paid by investors to the fund manager in exchange for the management of the portfolio and is taxed at the capital gains rate (i.e., 20 percent), instead of being taxed at the ordinary income rate (i.e., up to 39.6 percent).
On one hand, the industry has long argued that these profits arise from an investment taxable at the capital gains rate and therefore the same rationale shall apply. Further, they argue, the lower tax rate rewards the risk that private equity firms take on starting, growing, and restructuring companies that ultimately benefit the economy as whole.
On the other hand, some commentators argue that the profits made by private equity firms come from their active participation in the acquisition, restructuring, development, management, and resale of portfolio companies and, as they represent an effective “trade or business,” they should be taxed at ordinary income rates.
For these reasons, the Sun Capital decision may bring a new viewpoint to the discussion. Since the tax code uses the same language (“trade or business”) when setting forth the requirements for the favorable capital gains treatment, the industry would certainly receive a significant impact if the same interpretation were applied to the tax provision.
So far, it is not possible to anticipate if the courts will interpret the tax law in the same way and/or if different facts could play a role in cabining the Sun Capital interpretation. Also, the federal government has not taken any clear position on the matter. A spokesman for the Treasury Department has simply stated that “there’s a recognition that the court’s decision may give us an opportunity to reassess what ‘trade or business’ means,” although “there won’t be any rush to issue guidance on this.”
The economic consequences of such a decision cannot be overlooked. Such a change in the tax treatment of the private equity profits might not only affect the industry’s own profits, but may also deeply impact the incentives for foreign investors and tax-exempt entities to invest in private equity funds, since that the current interpretation has been the reason for their own favorable tax treatment.