The Tax Court ruled in favor of the government in its opinion released on Nov. 15, 2023, in YA Global Investments, LP v. Commissioner, 161 T.C. No. 11, finding that YA Global Investments, LP (YA Global) was both engaged in the conduct of a U.S. trade or business and also a dealer in securities. Although the facts are unique and aspects of the conclusion relate to the burden of proof, it nevertheless represents important precedent in both the areas of whether a fund is engaged in a U.S. trade or business and whether it’s a securities dealer.
At issue in the case was whether YA Global earned U.S. effectively connected income (ECI) from 2006 –2008. Partnerships are required to withhold and remit tax on ECI that is allocable to a non-U.S. partner, which YA Global failed to do. During the years at issue in the case, YA Global also failed to file Forms 8804, Annual Return for Partnership Withholding Tax (Section 1446).
The case concerned YA Global, a Cayman Islands fund with non-U.S. partners. YA Global provided capital to portfolio companies, primarily by purchasing convertible bonds and entering into standby equity distribution agreements (SEDAs). The SEDAs generally provided YA Global the right to buy stock in the portfolio companies at a discount. Portfolio companies paid fees associated with the convertible bonds and SEDAs to YA Global and its general partner Yorkville Advisors (“Yorkville”). Following a conversion of a convertible debt instrument into stock or other acquisition at a discount, YA Global often earned a spread by quickly disposing of the stock.
The facts of the case provided that a management agreement between YA Global and Yorkville enabled Yorkville to act as YA Global’s agent with authority to transact in securities on YA Global’s account. Yorkville’s activities were conducted through a U.S. office on behalf of YA Global. Notably, the management agreement empowered YA Global to give interim instructions to its manager. Yorkville was compensated under a typical 2% and 20% structure (i.e., it received a management fee of 2% based on gross assets and a 20% carried interest). YA Global and Yorkville also earned fees in connection with the aforementioned SEDAs and convertible bonds.
The Court’s opinion addressed a number of questions, including the following:
- Should activities of Yorkville be attributed to YA Global as its agent?
- Was YA Global engaged in a U.S. trade or business?
- Did YA Global qualify for the securities trading safe harbor as provided under Section 864(b)?
- Was YA Global a dealer in securities under Section 475 and thus required to use mark-to-market accounting to determine its income for U.S. federal income tax purposes?
- Was the income earned by YA Global characterized as effectively connected with a U.S. trade or business?
YA Global argued that Yorkville was not its agent but rather a service provider. However, the Tax Court looked specifically at YA Global's ability to provide interim instructions and concluded that they retained a degree of control over Yorkville, concluding that Yorkville was an agent of YA Global. As a result of the agency relationship, the Court determined that Yorkville’s activities could be attributed to YA Global. It also found that Yorkville’s activities rose to the level of a trade or business for U.S. federal income tax purposes. Certain structuring fees paid to Yorkville indicated that value was being provided to investors beyond the value of capital and were found to be outside of the scope of what qualifies for the securities trading safe harbor. The Court also held that YA Global was a dealer in securities under Section 475, making it subject to mark-to-market accounting and treating all income as ordinary in character. As a result of these conclusions, it was determined that YA Global failed to meet its withholding tax obligation under Section 1446 with respect to effectively connected income attributed to its non-U.S. partners.
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In the case, the court noted that YA Global might have been able to commence the running of the period of limitation on the assessment of its section 1446 withholding tax liability if it had filed a Form 8804 for each of the years in issue reporting zero liability, describing its activities and explaining the grounds for its belief that it was not engaged in a U.S. trade or business. As a result of this finding, foreign funds may consider the filing of “protective” Forms 8804 to run the statute of limitation on an associated Section 1446 withholding tax liability.
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