What’s A U.S. Trade Or Business? Analyzing The U.S. Tax Court’s Decision In YA Global

William McRae of Cleary Gottlieb discusses the U.S. Tax Court’s decision in YA Global Investments v. Commissioner and what it means for the private equity sector.

This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: dealer or no dealer.

In November 2023 the U.S. Tax Court released its decision in YA Global Investments v. Commissioner. The decision has sparked a lot of discussion in the tax community over the court’s view of a private equity company’s U.S. operations. The company was found liable for over $57 million, plus penalties and interest, for failing to withhold taxes on income that was effectively connected with a U.S. trade or business.

So why did the court rule the way it did, and what are the broader implications raised by this opinion?

Joining me now to talk more about this case and its impact is William McRae, a partner at Cleary Gottlieb. Bill, welcome to the podcast.

William McRae: Thanks, David. It’s great to be here.

David D. Stewart: So could you tell us about the company at issue in this case and what they were up to?

William McRae: Absolutely. So the company was called YA Global, and it was an investment fund, and it had a legal structure that’s very common for a lot of private equity funds and hedge funds and similar things, which was that they had a partnership that was the entity that held their investments or held their positions.

And I think it had originally been formed as a Delaware limited partnership and was then re-registered into the Cayman Islands. And then for foreign investors and tax-exempt investors that perhaps didn’t want to have any potential risk of effectively connected income or unrelated trade or business income, things like that, they had what was called YA Offshore, which was a Cayman entity treated as a corporation for U.S. tax purposes. And that effectively served as a blocker, which means that the investors who wanted to could come into the Cayman entity, the Cayman entity would then be a partner in the partnership down below. And then if there were, let’s say for example, any ECI risk or something like that, the partnership would be the one that would file tax returns and have to pay the taxes, but the investors up above would be shielded. And that’s a very typical structure.

Another thing that was very typical was they had a management agreement with a management company, Yorkshire Advisors, out in New Jersey. And in that sense, it was a structure that I see pretty much every day. The thing that these guys did a little bit different really came down to their business model and at least how the IRS was perceiving their business model.

So if you think about private equity or some sort of institutional investor, almost always the name of the game is you find an entity, a company that you think is undervalued, and you either buy the whole company or some kind of stake in the company, maybe you get involved in the board, but the plan is to sell the stock that you’ve acquired after some years at a large capital gain. And that’s really the standard model if you’re in venture capital. Maybe you invest in 100 companies and you hope that two or three of them are home runs and you’re playing the numbers that way. But the business model was always based on trying to achieve gains through investments over some period of time.

What these guys did was a little bit different. They, I guess, were actively soliciting business from all sorts of portfolio companies. Their typical company that they would invest in was a public company, usually not a huge company, but did have publicly traded stock, and they had a few different things they would do for the company.

The first is they would make loans, a lot of the time convertible loans. And when they did that, they would very much go and negotiate the terms of the loan, at least according to the way the court described and the IRS described it, with their potential borrowers. For people who don’t want to have ECI or don’t want to be treated as engaged in trade or business, one of the big hot-button issues is how do you do loan origination? How do you get in the business of making loans where you can take the view that you are an investor in debt and not someone who’s engaged in banking, financing, or similar business. And normally when you see funds that are investing in debt securities hoping to make money, they will have very sensitive guidelines about not negotiating the terms of the debt they invest in or not doing more than a certain number of loans a year, so if they’re not continuous in their activities, things like that.

At least according to the way the court was describing it, these guys went and they found the borrowers and they negotiated, I think they said 202 debentures in one year, although it wasn’t clear if that was 202 different borrowers or 202 loans made to one person as I think Jasper Cummings had pointed out in his article recently.

But they had this very active approach to the way that they lent money. And then when they were in the business of buying equity, it didn’t look like the kind of long-term investment model that I described. Instead, what they did was they had these things called SEDAs, standby equity distribution agreements I think is what it stood for. And the idea was when the company wanted to distribute equity, they could sell their equity to YA Global, not for a fixed price but for a discount to the current trading price based on some kind of weighted average over some period of time.

So let’s say YA Global would buy it at 95 percent of the current market price. Then the way that they were trying to make their money, at least the way the IRS described it, was they would then flip it as quickly as they could. So if they were buying it at 95 cents on the dollar and selling it at 100 cents on the dollar, that 5 cent spread was how they were making their money.

David D. Stewart: All right, so we have this unusual business model this company is dealing in. What did the IRS see when they were looking at it?

William McRae: Well, I think, and this is all in the 2015 CCA [Chief Counsel Advice] that came out that I think has now been publicly described as describing this case. I think it’s 201501013. The IRS basically said YA Global is not in an investment business, it’s not a trader, it’s an underwriter because the way that they’re making their money off of stock is by buying at a discount to the current value and then selling at the current value.

And that’s more of an underwriting business model; that’s not investing, that’s providing intermediary services, if you will. And then the way that they were doing their lending activities looked much more active, like an active lender and not just an investor in debt. And I think those were the two things that got the IRS’s attention, at least that’s the impression one gets from the CCA.

David D. Stewart: And so this ends up in court. What was the argument in the court?

William McRae: The argument in the court came out very, very differently, and there were a few different things that happened, and I’m going to now go to the way that the judge’s reasoning came out because it was very different than, I think, what the IRS had been arguing.

Now, the first thing that the court focused on was agency. And the reason they did this was because as I’d mentioned, there was this management company sitting in New Jersey that was providing management services to the fund. And one of the questions is, can you attribute the activities of the management company to YA Global itself?

The IRS had taken this very interesting view, this very detailed view based on case law about were they an independent agent or not. And the reason why the IRS cared about this was if you’re going off and you’re doing loan origination and stuff like this for the fund, that activity gets attributed back to the fund.

So when they went into court, I think the IRS had probably been prepared to argue about the business model and earning spreads and things like that. The thing the court focused on, which was interesting, is they focused on the fact that the management company was charging amounts that were denominated as fees to the portfolio companies. So they had monitoring fees, structuring fees and things of that sort.

And it’s very common, I think, in the private equity world for management companies to charge fees to portfolio companies for different things. Sometimes you would view them as for services, sometimes maybe for provision of capital or other things, but very often those companies will view those fees as things that they can get and they can hold and that are not part of what they’re providing for the fund, or if they are provided for the fund, it might be as an offset to management fees and things of that sort, on the theory that if the fund is paying the management company some amount of some percentage of assets to keep the lights on and they know that the management company is getting money coming from somewhere else, maybe they don’t need that money and so people will negotiate offsets.

But I think very often when you have a management company receiving fees, they aren’t always attributed to the fund. Here, the court analyzed this question of agency for the purpose of deciding whether or not fees received by the management company could be attributed to the fund. And that was the first question is if the management company is out getting fees, is that the fund’s income?

And interestingly enough, the taxpayers came in and said, “If you want to talk about agency and should the actions of the agent be attributed to the principal, you should look under common-law principles.” The IRS took a different view. The IRS would’ve said, “If someone is out there doing something on your behalf, they are your agent,” or at least that’s, maybe that’s an oversimplified description of the IRS’s view, but that was how it was described in the case.

The court rejected the IRS’s view as almost certainly too broad but then went on to rule for the IRS really on two different grounds. The first one is in documentation in the case. The taxpayer, the fund, had hired the management company and said the management company shall act as your agent. And so the court said, “Well, if you’re describing it as your agent in your own documents, the burden of proof would then be on you to say that they are not your agent, and you haven’t done that.”

The other thing that the court focused on was the fact that there was this provision strongly suggesting that the fund could change its instructions to the management company in the middle of the fund term. And they put a lot of weight on this notion that if I hire you to do a job and I give you instructions at the beginning of the job and I’m not allowed to tell you anything ever again about the job until the job is done, then you are a service provider and not an agent. But if I’m allowed to call you up and change my instructions or tell you to do different things, apparently that is a very big factor in creating an agency relationship, or at least that’s what the Tax Court said in this case.

I think a lot of people thought that was not very intuitive. I’d never heard that distinction given so much weight before. And obviously, as a lawyer or any kind of service provider, you have people that you don’t think of as your principals, but if they hire you to do a job and they call you up when the job is halfway through and tell you that they have a different idea, you’re probably going to listen to them, and you’re probably going to do what they say. And I don’t normally think of that as creating an agency relationship or one otherwise would not have existed.

But what the court did is they said, “OK, there’s an agency relationship here. So what the agent does is attributed to the fund. The agent is out there receiving the structuring fees and monitoring fees and other kinds of fees. And so if they’re receiving those fees, that activity should be attributed to the fund as well. Also, because the agent, the management company, was using those fees to offset its own expenses and then when it had extra money, it had the ability to give some of that to the fund, which it did from time to time.”

And so the first thing the court said was, “OK, whatever the agent is doing we think should be attributed to the fund and the circumstance. And then what is the agent doing?” The agent is receiving all of these payments that are denominated as fees. If that’s the case, then it’s doing something for the portfolio companies other than just putting out its capital. It must be doing something else.

And it’s also interesting, the court found that the fees are being paid to the management company, not to the fund itself, even though the fund was the one providing the capital. And so that was also viewed as evidence that these fees were for something other than just an investment. And so the taxpayers came in and they argued very strongly that was not the case, that these fees were not for services.

Some of the arguments they made, I think, were less persuasive. They had said there was something called a monitoring fee, and they said, “How could it be a monitoring fee? There was nothing to monitor,” which I think led the court to say, “You’re basically telling us that your labels are,” I think the language was, “at best misleading, at worst downright deceptive.” But they also had various executives from the portfolio companies who showed up, and they basically said, “We didn’t view the fees as something extra. We were just trying to raise capital, and we viewed all of these costs as part of our cost of capital.”

In any event, the court effectively said, “There is a burden of proof that has to be met by the taxpayer that these fees are not for services. The taxpayer did not meet that burden, and therefore we think that you’re providing services.” And that was really how they found a trade or business in the U.S.

So all the things I’d mentioned before about the business model and the underwriting and the lending and all of that really didn’t seem to play into the court’s logic. It was more based on this notion of fees. And I think that’s one of the aspects of the case that a lot of people have found, I don’t want to say disturbing, but has definitely gotten some attention because there are a lot of things out there that are labeled as fees that are treated for tax purposes very often as amounts for capital.

Commitment fees for example, very often are treated as just reducing the issue price of debt, and there are fees that might be given to someone for providing a service. There are other fees that might be given to someone for providing capital if they’re standing ready to provide capital, and the court didn’t really get into any of that. They just used the word fee and found that something other than investing must be going on. And therefore, the taxpayer had business activity in the United States.

David D. Stewart: Now, you mentioned that there’s been a fair amount of discussion. What are the biggest issues people are talking about out of this case?

William McRae: I think one thing people ask a lot about is this notion of fees. Because a lot of times, again, if you have a management company that might receive fees, sometimes they might be reduced fees for services, sometimes they might not. If you’re part of a loan syndication, for example, you might take what are called points or fees for standing ready to buy a loan. And I don’t think anyone thinks that’s for providing a service other than making your capital available.

But I think one thing people are thinking about is what are we calling fees these days and should we be more careful about that? The other point about agency, I think, was also interesting because I think that if, for example, you have a management company that is giving you recommendations as a fund and picking investments and then they’re also getting other kinds of income from the side, you might not necessarily view that activity as attributable to the fund unless it’s integral to what they were doing for the fund.

And in this case, it’s possible that it could have been. I don’t know enough about the specific deals they did and how the fees related to the investments, but I think there’s also that notion of the agency relationship. And I think a lot of people, after the case went out, went and tried to make sure or see if they had anything in their documents stating that the management company was the agent of the fund.

And I think usually the documents say the opposite, or at least a lot of them do. I think some of the feedback that I’ve gotten from people is just the facts in the case were just very, very different than what a lot of people that I talk with view as their standard operating model. And so for that reason, I think what people are more interested in is the way the court came to these conclusions, like you have ECI because you had fees, you had agency in this sort of situation. And I think that’s given people some pause.

The other thing that the court held that I actually have an article coming out in Tax Notes in a couple of weeks describing was that the fund also should be treated as a dealer, as a securities dealer, subject to mark-to-market under 475. And that is something that I don’t think has gotten as much worry.

I don’t think there are that many private equity funds or richer capital funds out there that are worried about getting put on mark-to-market because of this case. But I do think the court’s reasoning there could certainly be criticized, I think, of misapplication of the regulations and the rules.

David D. Stewart: Yeah, I’d like to hear more about this. So this is to do with this unique business model this company was engaged in, and is it that other companies don’t do that because that’s just not their line of business? Or do they do it specifically to avoid these rules?

William McRae: I think most companies have it as not their line of business. When you look at what they were doing with equity, for example, the IRS, I think, called it very plainly, “This is an underwriting business. This is not investing. You are underwriters. You are helping companies access the market by buying their stock and finding purchasers for it.” And an underwriting business is not the same thing as what somebody does when they come and they buy equity with the intention of making a long-term bet on it.

Now, one of the people for the company had made the statement they usually held their positions for 12 to 24 months, which is perhaps not an incredibly short term, but if you look at the case, they had lots and lots of short-term capital gains, at least in the first couple of years, dwarfing their long-term capital gains.

And as I’d understood it from the case, they would require an issuer to register the stock in the public markets before they would agree to buy it. So it seemed like they clearly had the idea of just touching the stock for a short period of time in the interest of making this, I’ll call it wholesale retail spread. And that is a very different business model than what a lot of investment funds do. I don’t know anyone else who has that model in that legal form.

David D. Stewart: Is there any bright line that distinguishes between somebody who’s working as a securities dealer versus someone who’s just merely trading?

William McRae: Yes, there is, and it’s been around for a long time. I think the seminal case that discussed this is a case called Kemon. And effectively, what you need to understand about dealers is they’re doing what the IRS accused the taxpayer in this case of; they’re basically buying securities as a service.

So if I’m a dealer in stock of certain companies, what that usually means is that if someone wants to sell their stock, they can come to me and I will buy it. And if someone wants to buy the stock from me, I will sell it to them. And it’s not because I think the stock is going to go up and down. I don’t sell when I think it’s about to drop or buy when I think it’s going to up in value.

I’m basically doing this to provide a service of giving liquidity to my counterparties, in the same way with a car dealer. If you go to the Toyota dealership to sell your Tercel, they’ll buy it from you, not because they think necessarily it’s going to go up or down in value, but that’s what they’re there for and they will sell you cars. In a way, it’s the same model applied to securities.

And so the point of that is that if you are someone who basically is in the business of transacting with all comers, you’re standing out there as willing to buy or sell securities to anyone who wants to do a deal with you, then that implies a very, very different kind of business model than an investor. The biggest point is if you’re going to be in the business of dealing like that, dealing in securities, you need to manage your economic risk. Imagine someone who’s in the position of just buying and selling stock, and one day everybody and their dog shows up and they make them buy some massive position in XYZ stock and no one wants to buy it from them.

If they sit there and they provide that service without covering their own risk, that’s a very, very dangerous business model. And you’re almost certainly going to go out of business at some point when the market turns against you because you’re not even buying securities based on your view that they’ll go up in value. You’re buying it because someone wants to sell it to you. And the same on the other side.

And this is something that’s also true for dealers in commodities, things like cotton and wheat and so forth. And so when you’re in that business, very often what you will do is you will hedge your position. So if I end up buying a whole bunch of stock of XYZ company, I want to protect myself if the stock goes down, so I will maybe try to sell a whole bunch of the shares the same day and buy and sell in large volumes. That’s one way to do it.

If I can’t do that, maybe I go to someone and I buy a put option so I have the right to sell that stock to them for a fixed price, so I’m at least protected from falls below the level of that price. Or maybe I’ll enter into forward contracts where I know that I can buy the stock in the future if I need it.

And the interesting thing about that business model is once you’re in the business of transacting with people for their convenience and then you need to have these other positions to hedge yourself, to hedge against economic risk, a realization-based system of taxation may not really work that well for you.

Imagine that you have a bunch of stock, again an XYZ company, and you, let’s say, have a put right to sell that stock, and you put those two positions together and as XYZ stock goes down, the value of the put right goes up and vice versa. What happens if you sell one of those positions but not the other at the end of the year? You might trigger a lot of gain or a lot of loss in one position and have unrealized offsetting gain or loss in the other position.

When taxpayers used to do this for their own benefit, it was called straddles. And the IRS has rules to prevent that kind of gaming of the system. But what’s also interesting is if you go back to the earliest times of the tax code, you had commodities dealers, I think dealers in cotton discussed it in the article, who wanted to be on mark-to-market because they said, “Look, we have a whole bunch of positions, and we have a whole bunch of hedges, and we want to be able to get in and out of the different positions without worrying about triggering taxable gain but not triggering taxable loss in a given year or vice versa. And so why don’t you just look at our entire positions together, all the pluses and minuses, and every year just take our book of business, value it as an aggregate and then we can pay tax based on the changes in value or at a lower cost of market,” I think is what they got at the time.

And so in doing that, you create a system that avoids whipsaws, either for the government or for taxpayers. And what people don’t realize is that mark-to-market, at least some people don’t realize, is that mark-to-market began as something that the taxpayers could elect into because it gave them a more rational way of taxing their offsetting positions.

And the reason I’m mentioning all of this is because when you look at 475, which then talked about dealers and made this regime mandatory for dealers, they talk about people who buy and sell securities to customers in the ordinary course of business or enter into derivatives with customers in the ordinary course of business. And the point there is that when they say two customers are with customers, what they mean is you’re doing this as a service to somebody else, and that, by its nature, implies that you have this hedged business model or this way of not actually taking an actual position overall in the underlying securities. And that because you were in that situation, the mark-to-market tax model is what would make sense for you.

And that’s why it’s mandatory for dealers, although actually not all dealers, if you’re a loan originator, if you just buy loans and don’t hold them for sale, the code doesn’t require you to be on mark-to-market, I think because you don’t have this hedge situation so mark-to-market doesn’t have the same kind of logical sense for you that it might for someone running a hedged book.

But also, traders and others who may not be dealing with the market as a service provider but who get in and out of positions very, very quickly trying to take advantage of swings in the market price, they also could have hedged positions, and they’re allowed under 475 to elect into mark-to-market taxation.

And so the reason I’m mentioning all this again is that when the court decided or was trying to decide whether or not this taxpayer in YA Global was a dealer subject to 475, effectively what they did was they looked at some regulations, and the regulations said, “If you’re standing ready to enter into a position, then you are a dealer.” And then they said, “Well, they were clearly standing ready to enter into these positions to buy this equity or to make these loans because they went around to conferences and they did all sorts of marketing and stuff to try to meet people to lend money to or to buy equity from.” And so they were clearly holding themselves out to do that.

And that specific portion of the regulations didn’t actually mention the word customer. And so they said, “Well, then we think that the customer is the person for whom you stand ready to do this. That person is by definition your customer and therefore, you have customers and therefore, you are a dealer.”

And that was, I think, in a nutshell how they concluded that YA Global was a dealer and should be mark-to-market. And my problem with that logic is I think it reads out what it really means to have a customer. It reads out the implication of what that business model is, why mark-to-market is appropriate. And it’s interesting that when the IRS in their brief was making this point, they made it very clear that in their view, in the government’s view, to understand what the term customer meant, you had to understand the business model of the person interacting with the “customer.”

So I think there was a whole bunch of context about the dealer regime and why mark-to-market is there that the court effectively overlooked. And part of the article was just to set the record straight on that because I think it’s context that shouldn’t be lost.

David D. Stewart: We have this opinion out here, and this company has its own unique business model. Are there other impacts we might find for the tax community at large?

William McRae: I think it’s too soon to say at this stage, and I think a lot of people, as I say, have looked at it. There were also points about their procedural issues. YA Global had filed 1065s where it didn’t seem to record any ECI. And the Tax Court held that because they hadn’t filed the withholding Forms 8804, the statute of limitations hadn’t run.

Those are sorts of things that people can probably correct if they really don’t think they have a trade or business. They can file the forms. And I imagine the IRS may see a lot more of those forms than they had seen in the past, now that it’s been clear that you need to do that, I guess, to get such limitations to run.

In terms of the way most of my clients view their business model, I don’t think they’ve felt a huge need at this stage to retool. I think most of them would say, “Look, when we invest in companies with an idea towards making a gain, we normally don’t buy publicly traded stock at market discount with the intention of flipping it. If we make loans, we’re very, very careful. We either acknowledge that it’s a trader business and we block it and we tell people that we’re in a trader business, or if we don’t want to be in a trader business, we are very careful about the number of loans we might make or careful not to negotiate the terms of loans with specific borrowers and things of that sort.” So I think a lot of the things that the taxpayer had done that got the IRS’s attention were things that a lot of people view as not what they do.

When you get into this other point about you had things called fees and you had this agency relationship and so forth, I think that did get people’s attention. People can probably change how things are labeled. They can document what payments are for and things like that.

But I think there’s also a view that — my view is that you shouldn’t take the court’s reasoning to any great extreme for a couple of reasons. First of all, when they said you received fees and that was a business activity, they didn’t get into the question of what kind of fees were they or could the fees have been viewed as outputs for capital or anything like that. They just said, “We have these amounts that are labeled as fees. The burden of proof is on the taxpayer. The taxpayer did not meet that burden of proof.” And they didn’t really get into the substance of what the fees might have been for in a way that would’ve allowed someone to distinguish different kinds of fees.

And I think for that reason, maybe people view the reasoning as maybe incomplete in that sense. If I am buying into a syndicated loan and I get to buy at a slight discount and they call it points, I don’t think there’s anyone, because of this case, that thinks that they’re engaged in a trade or business if they invest in a syndicated loan on that basis.

So I think at this stage, I don’t think it’s changing a lot of behavior in the market. I think people are interested in the case, they’re looking at it. I guess the case is still subject to appeal. It’s been 90 days since it came out, but it’s not final yet, I guess, because they’re still deciding questions about the 2009 taxable year, but maybe at some point the case will be appealed and some of these points will be discussed more thoroughly.

David D. Stewart: Well, it’s definitely going to be an interesting case to keep an eye on. Bill, thank you so much for walking us all the way through that.

William McRae: My pleasure.