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Moderator: Michael Hirschfeld, Partner, Dechert LLP

Cross-Border Investing: Tax Opportunities and Tax Traps. Moderator: Michael Hirschfeld, Partner, Dechert LLP Panelists: Steven D. Bortnick, Counsel, Dechert LLP Anthony Castellanos, Partner, Chief Tax & Administrative Officer, Softbank Capital. July 19-20, 2005.

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Moderator: Michael Hirschfeld, Partner, Dechert LLP

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  1. Cross-Border Investing: Tax Opportunities and Tax Traps Moderator:Michael Hirschfeld, Partner, Dechert LLP Panelists:Steven D. Bortnick, Counsel, Dechert LLPAnthony Castellanos, Partner, Chief Tax &Administrative Officer, Softbank Capital July 19-20, 2005 Materials have been abridged from laws, court decisions, and administrative rulings and should not be considered as legal opinions on specific facts or as a substitute for legal counsel.

  2. General Tax Considerations in Cross-Border Investing • Minimize taxes in foreign jurisdiction • Avoid taxation before cash receipts (“phantom income”) • Maintain capital gain on exit/partial exit and qualified dividend income on distributions • Avoid/minimize foreign withholding taxes • Avoid UBTI 2005 Private Equity Strategic Financial Management Conference

  3. General Tax Considerations in Cross-Border Investing • Maintain VCOC status • Will a buyer like the structure or be able to restructure on a tax efficient basis? • What does it take/cost to implement and maintain structure? 2005 Private Equity Strategic Financial Management Conference

  4. Avoiding Current U.S. Taxation on Investments Abroad • General Rule: No taxation with respect to an investment in stock in a foreign corporation until receipt of distribution or sale of stock • Significant Exceptions • CFCs • PFICs 2005 Private Equity Strategic Financial Management Conference

  5. Controlled Foreign Corporations (“CFCs”) • Consequences of CFC Status: • Phantom Income to the extent CFC has “Subpart F Income” and current earnings and profits • Phantom income always ordinary income • CFC required to compute earnings pursuant to U.S. tax accounting principles • Capital gain may be converted into ordinary income upon sale or redemption of shares of a CFC by a “10% U.S. Shareholder” to the extent of untaxed E&P accumulated while corporation was CFC • No UBTI except for Subpart F Insurance Income 2005 Private Equity Strategic Financial Management Conference

  6. What is a CFC? • A foreign corporation will be a CFC if: • “10% U.S. shareholders” (determined by vote) collectively own • More than 50% of stock in the foreign corporation (determined by vote or value) • Attribution rules apply for determining stock ownership; for example: • Stock owned by a partnership is considered to be owned proportionately by its partners • Stock owned by a partner (including a general partner) is considered to be owned by the partnership 2005 Private Equity Strategic Financial Management Conference

  7. What is a CFC? • If a person owns 10% or more of the value of the stock of a corporation (or any portion of a foreign corporation), that person will be considered to own its proportionate share of any stock owned by the corporation • An individual will be considered to own stock owned by his or her spouse, children, grandchildren, and parents • Rule of thumb: If a fund complex will own, in the aggregate, 10% or more of any non-U.S. corporation, the fund should consider CFC issues 2005 Private Equity Strategic Financial Management Conference

  8. Who is a U.S. Shareholder? • Any U.S. person who owns 10% or more of voting stock of foreign corporation • U.S. person includes partnerships formed under the laws of a state (e.g., funds formed as Delaware limited partnership) • Attribution rules apply for determining stock ownership 2005 Private Equity Strategic Financial Management Conference

  9. Delaware Fund: CFC Example • Delaware Fund is a “10% U.S. Shareholder” of the CFC • All U.S. LPs subject to CFC rules regardless of ownership percentage GPs LPs DelawareFund > 10% interest CFC 2005 Private Equity Strategic Financial Management Conference

  10. Consider CFC Issues When Forming Fund • Foreign partnership – fund not 10% U.S. Shareholder – look through to partners • U.S. investors tolerance to invest in foreign partnerships has increased in recent years • U.S. tax reporting rules may apply to foreign partnership (e.g., Form 1065) or partners (e.g., Form 8865) 2005 Private Equity Strategic Financial Management Conference

  11. Offshore Fund: No CFC • Cayman Fund is not a 10% U.S. Shareholder of Foreign Corporation • Only U.S. LPs (or GP) which own indirectly or constructively 10% of Foreign Corporation counted in testing CFC status and potentially subject to CFC rules 2005 Private Equity Strategic Financial Management Conference

  12. LPs GPs >10% DelawareFund CaymanFund Investments in non-CFCs CFC Foreign Mirror Fund to Mitigate CFC Consequences • Cayman Fund not a U.S. person so not 10% U.S. Shareholder • Only U.S. LPs who own indirectly 10% of CFC subject to CFC rules (rarely an issue in larger funds) • U.S. GP and carried interest – might have CFC consequences • LPA must indicate how profits and losses offset for purposes of carry • ERISA Consideration: Is Cayman Fund a VCOC? • Delaware Fund still a 10% U.S. Shareholder for purposes of determining CFC status and reporting (Investments in CFCs made through mirror foreign partnership(s)) 2005 Private Equity Strategic Financial Management Conference

  13. CFC Planning Techniques – CTB Elections • If a fund is a 10% U.S. Shareholder of a CFC, there are further planning techniques to avoid phantom income • Avoiding Subpart F Income Through CTB Elections • Regulations (“check the box regulations”) provide for elective entity classification for most foreign entities • Election made by checking 2 boxes on Form 8832; effective up to 75 days retroactive from filing 2005 Private Equity Strategic Financial Management Conference

  14. CFC Planning Techniques – CTB Elections • A single-member entity which elects to be flow through for U.S. tax purposes is disregarded from its owner • Payments (e.g., dividends, interest, or fees) from or between disregarded entities are eliminated and not Subpart F income 2005 Private Equity Strategic Financial Management Conference

  15. CFC Planning Techniques – Earnings Reduction • Section 338 Election • If a non-U.S. portfolio company is a CFC generally worthwhile to make a “338” election with respect to the investment • If a 338 election is made, the company’s U.S. tax basis in its assets (including goodwill) is stepped up to a fair market value. Depreciation from the assets (including goodwill) will reduce the U.S. earnings and profits of the CFC • A 338 election causes the CFC to recognize gain on each of its assets. No U.S. tax paid in connection with the deemed sale if the CFC is not doing business in the U.S. 2005 Private Equity Strategic Financial Management Conference

  16. CFC Planning Techniques – Earnings Reduction • Section 338 Election • If a CFC will be paying material non-U.S. taxes and will not generate significant phantom income, a 338 election may harm Section 902 credit position • Check the Box Prior to Acquisition • If a 338 election cannot be made, it may be possible to “check-the-box” on the target prior to acquisition so that the transaction is treated as an asset purchase for U.S. tax purposes 2005 Private Equity Strategic Financial Management Conference

  17. CFC: Subpart F Income Pitfall • Interest and dividends paid by CFC 2 to CFC 1 are Subpart F income. Delaware Fund will include in gross income its share of such income, and U.S. investors will include in income their share of Delaware Fund’s Subpart F income • Service Fees from CFC 3 to CFC 2 may be Subpart F income with above results LPs GPs Delaware Fund > 10 % CFC 1 Interest and Dividends (Country X) CFC 2 CFC 3 (Country Y) (Country X) Service Fees 2005 Private Equity Strategic Financial Management Conference

  18. Check the Box Elections to Avoid Subpart F Income • CFC 2 and CFC 3 treated as branches of CFC 1 • Interest dividends and service fees (all potentially Subpart F income) eliminated for U.S. tax purposes, so no Subpart F income LPs GPs DelawareFund > 10% CFC1 (Country X) interest and dividends CFC 2Country Y CFC 3Country X service fees 2005 Private Equity Strategic Financial Management Conference

  19. Investment in U.S. Property by CFC • 10% U.S. Shareholders must include in income their share of the CFC’s increase in earnings invested in U.S. property • U.S. property includes: • U.S. realty and personal property • Investment in stock of U.S. corporations • Ownership of debt of U.S. related parties • Guarantee of indebtedness of U.S. related parties or pledge of > 66-2/3% of stock of CFC to secure such indebtedness 2005 Private Equity Strategic Financial Management Conference

  20. Investment in U.S. Property by CFC • U.S. partners in Delaware Fund taxed on increases in CFC’s earnings invested in U.S. subs • Consider acquiring U.S. subs separately • Potential issue on partial exit via foreign IPO • Look only to earnings of CFC • Foreign subs should not guarantee U.S. Subs’ debt (this is treated as an investment in U.S. property) LPs GP DelawareFund > 10% CFC USSubs ForeignSubs 2005 Private Equity Strategic Financial Management Conference

  21. Passive Foreign Investment Companies (“PFICs”) • What is a PFIC? • A foreign company is a PFIC if, in any taxable year, either: • 75% or more of its income consists of dividends, interest, rent, royalties, or other passive income, or • 50% or more of its assets are held for the production of passive income, or no income • PFIC rules do not apply to 10% U.S. Shareholders of a CFC • Subsidiaries • Look-through 25% owned subsidiaries and income in testing PFIC status • What about gain on sales of 25% owned subsidiary? 2005 Private Equity Strategic Financial Management Conference

  22. Key Consequences of PFIC Status • Time value (or “interest”) charge imposed on “deferred tax amount;” income deemed to accrue ratably • Gain from sale of PFIC shares is taxed at ordinary income rates • Dividends from PFIC taxed as ordinary income • PFIC rules do not generate UBTI unless PFIC stock debt financed • Foreign company must keep books and records on U.S. income tax basis if QEF election is made 2005 Private Equity Strategic Financial Management Conference

  23. Elections to Ameliorate PFIC Consequences • Qualified Electing Fund (“QEF”) Election • U.S. shareholder elects to include annually in income his share of the PFIC’s ordinary income and capital gains • Character of capital gains flows through, but PFIC’s qualified dividends, losses and foreign tax credits do not • PFIC must agree to compute its earnings under the U.S. tax accounting principles, report its earnings annually to its U.S. shareholders, and allow its U.S. shareholders to inspect its books and records • First “U.S. Person” in the chain of ownership files QEF Election • QEF election presumably does not give rise to UBTI 2005 Private Equity Strategic Financial Management Conference

  24. Elections to Ameliorate PFIC Consequences • Mark-to-Market Election • Rarely available for private equity investments • U.S. shareholder may elect to mark PFIC shares to market annually if PFIC shares are publicly traded • Resulting gain or loss is ordinary, and is generally U.S. source. Mark-to-market loss may be claimed only to extent of prior mark-to-market gain 2005 Private Equity Strategic Financial Management Conference

  25. PFIC Covenant in Fund LP Agreement • [Commercially] [Reasonable] [Best] Efforts by General Partner to: • Identify PFICs prior to investing • Monitor investments that may become PFICs • Obtain annual information statements from PFIC investments • Make QEF election • Excuse/opt-out provision 2005 Private Equity Strategic Financial Management Conference

  26. Qualified Dividends • Dividends received by U.S. individuals from U.S. corporations and “qualified” foreign corporations are taxed at a 15% rate • A foreign corporation is qualified if it is publicly traded or is incorporated in a jurisdiction that has a tax treaty with the U.S. and the corporation is eligible for benefits of the treaty • Dividends from non-U.S. companies located in treaty jurisdictions that are held through funds with mostly U.S. investors should qualify 2005 Private Equity Strategic Financial Management Conference

  27. Qualified Dividends • LOB – Difficult for funds with investors from multiple countries • Dividends for this purpose include amounts deemed to be dividends under Section 1248 (from the sale of a CFC) • Dividends from a PFIC are never qualified • 1248 gain treated as dividends which may be qualified 2005 Private Equity Strategic Financial Management Conference

  28. Using Shareholder Debt • Use in transaction structure to minimize capital duties and reduce foreign taxes • Must consider applicable thin capitalization, debt versus equity and other deductibility rules • Shareholder debt gives rise to phantom income (i.e., OID) to taxable investors in fund • OID is ordinary income 2005 Private Equity Strategic Financial Management Conference

  29. Avoiding Phantom Income Hybrid Instruments and Entities • Loans to disregarded entities • Hybrid instruments – treated as debt in country of issuance but equity for U.S. tax purposes 2005 Private Equity Strategic Financial Management Conference

  30. Loan to Disregarded Entity • Interest on shareholder loan deductible in Bidco’s Country • Shareholder loan (and interest thereon) ignored in U.S. because Bidco is 100%-owned and elected for U.S. tax purposes to be disregarded PE Fund 100% > 10 % Shareholder loan Bidco Cash to Seller for target 2005 Private Equity Strategic Financial Management Conference

  31. HYBRID Instruments • Treated as debt for local tax purposes, but equity for U.S. tax purposes • Very high debt: equity ratio if respected as debt • Long maturity (e.g., 49 years), preferably extendable by issuer • Subordinated to present and future debt, including trade payables • Payable only out of surplus or earnings • Payments deferred if would result in insolvency • Lack of creditors rights (e.g., acceleration of payments or financial covenants) • Name of instrument (e.g., preferred equity certificates) • Be mindful of Section 305(c) 2005 Private Equity Strategic Financial Management Conference

  32. Non-U.S. Investments “Offshore” Investee • Parent company is formed in “offshore” non-tax jurisdiction • Avoids direct investment in taxable foreign portfolio co-jurisdiction • Generally requires restructuring of target portfolio company • Capitalization taxes • Jurisdiction selection • Exit strategy 2005 Private Equity Strategic Financial Management Conference

  33. Domestic China Deal Offshore Fund L.P. Fund’s investment (e.g., 15% preferred shares) Holdings Limited (BVI, Cayman, etc) • Transactions in BVI stock are outside China • Payments from WFOE to BVI (dividends, interest, etc.) are not anticipated. If so, subject to Chinese withholding tax • Caution re: China local tax consequences relating to “offshoring” local company (i.e., restructuring issues) 100% China Co., Ltd. (WFOE) 2005 Private Equity Strategic Financial Management Conference

  34. Qualified Dividends • Dividends received by U.S. individuals from U.S. corporations and “qualified” foreign corporations are taxed at a 15% rate • A foreign corporation is qualified if it is publicly traded or is incorporated in a jurisdiction that has a tax treaty with the U.S. and the corporation is eligible for benefits of the treaty • Dividends from non-U.S. companies located in treaty jurisdictions that are held through funds with mostly U.S. investors should qualify 2005 Private Equity Strategic Financial Management Conference

  35. Qualified Dividends • LOB – Difficult for funds with investors from multiple countries • Dividends for this purpose include amounts deemed to be dividends under Section 1248 (from the sale of a CFC) • Dividends from a PFIC are never qualified • 1248 gain treated as dividends which may be qualified 2005 Private Equity Strategic Financial Management Conference

  36. Domestic China Deal Offshore Fund L.P. Fund’s investment (e.g., 15% preferred shares) BVI Holdings Limited China Technology Co., Ltd. (Domestic Chinese Shareholders) 100% China Co., Ltd. (WFOE) Contracts to capture economic benefits Sometimes used to address local Chinese restrictions 2005 Private Equity Strategic Financial Management Conference

  37. Intermediate Holding Company • Many foreign jurisdictions impose tax to the extent the Fund has a PE in that country • Even if no PE, disposition of foreign target companies may be subject to tax in the foreign country • Tax treaty exemptions to the fund are not always clear or available 2005 Private Equity Strategic Financial Management Conference

  38. Intermediate Holding Company • Foreign tax reduces cash available to be distributed by Fund • Tax credit in home jurisdiction often not available • Intermediate holding company can provide treaty benefits where otherwise not available to the Fund 2005 Private Equity Strategic Financial Management Conference

  39. Domestic China Deal Onshore Fund L.P. • China/Mauritius tax treaty reduces or eliminatesChina withholding taxes on dividends from Portfolio Co. and China capital gains taxes on disposition of Portfolio Co. stock • Mauritius local tax is generally low or nil • Hold Co. generally elects to be a disregarded entity for U.S. tax purposes in order to preserve character of Portfolio Co. gains to Fund LPs 100% Hold Co. (Republic of Mauritius) Fund’s investment China Portfolio Co. (WFOE) Other Investors 2005 Private Equity Strategic Financial Management Conference

  40. Domestic India Deal Onshore Fund L.P. • India/Mauritius tax treaty reduces or eliminates Indian withholding taxes on dividends from Portfolio Co. and India capital gains taxes on disposition of Portfolio Co. stock • Mauritius local tax is generally low or nil • Hold Co. generally elects to be a disregarded entity for U.S. tax purposes in order to preserve character of Portfolio Co. gains to Fund LPs 100% Hold Co. (Republic of Mauritius) Fund’s investment India Portfolio Co. Other Investors 2005 Private Equity Strategic Financial Management Conference

  41. Ancillary Issues with Holding Companies • OID • Phantom interest income on shareholder loans, PECS, CPECS? • Check the Box Elections • Local tax treatment for foreign investors in the Fund? Conflict of interest? Information reports prepared exclusively on U.S. tax basis? • Debt-financed UBTI • Capitalization taxes 2005 Private Equity Strategic Financial Management Conference

  42. Ancillary Issues with Holding Companies • Substance – Anti-Treaty Shopping Rules • Unexpected change in exit strategy • Administration 2005 Private Equity Strategic Financial Management Conference

  43. Management PE Fund equity equity PEC Lux Co (or other HoldCo) equity 100% Shareholder loan HoldCo GmbH Exit 100% Organschaft equity NewCo 1 GmbH 100 % Organschaft Bank Loan NewCo 2 Target GmbH 100% Sub Sub Sub German LBO Transaction 2005 Private Equity Strategic Financial Management Conference

  44. Comments on Illustration • The UBTI corporate blocker in this chart is NewCo 1 • LuxCo avoids German tax on exit gain and on partial exit • Phantom interest/OID income is avoided through use of: • PECs at the Luxco level • Shareholder loan to a DRE (HoldCo) • Only equity issued by the blocker (NewCo 1) • If NewCo 1 is a CFC • Any intercompany Subpart F income is eliminated as a result of all companies below NewCo 1 filing CTB elections to be DREs 2005 Private Equity Strategic Financial Management Conference

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