On December 28, 2016, the Small Business Administration (SBA) released the final version of the Passive Business Rule (the New Rule) under § 107.720 of the small business investment company (SBIC) regulations.¹ Among other provisions, the New Rule expands the permitted use of holding companies when investing in qualifying small businesses. The New Rule is effective on January 27, 2017.

Background

Business development companies (BDCs) utilize wholly owned subsidiaries, which are structured as Delaware corporations, to hold interests in certain BDC portfolio companies for a variety of reasons. A primary use of these blocker subsidiaries by a BDC is to hold certain investment assets that are structured as pass-through tax entities (such as partnership interests or limited liability company interests) in order to allow a BDC to continue to qualify as a regulated investment company (RIC) for tax purposes (the Tax Blocker Subsidiaries). The investment assets held by the entities can potentially generate types of taxable income that, if received or deemed received directly by the BDC, could disqualify the BDC from maintaining RIC status and prevent it from obtaining the favorable tax treatment potentially available to it under Subchapter M of the Internal Revenue Code of 1986, as amended (the Code). These Tax Blocker Subsidiaries are structured as corporations in order to block operating income from investment portfolio companies (structured as limited partnerships or limited liability companies) held in the Tax Blocker Subsidiaries from passing through to the BDC parent. These Tax Blocker Subsidiaries must be separate entities taxed under Subchapter C of the Code in order to serve their income blocking purpose. 

What the New Rule Means for BDCs with SBIC Subsidiaries

The New Rule permits wholly owned SBIC subsidiaries of BDCs to use Tax Blocker Subsidiaries for certain SBIC investments where the eligible small business is structured as a partnership or a limited liability company in order to block income from flowing up to the BDC through the SBIC, which may disqualify the BDC parent from continuing to qualify as a RIC and obtaining favorable tax treatment available to it under Subchapter M of the Code.

In order to rely on the New Rule, the SBIC must certify to the SBA that the holding company was formed for the purpose of ensuring the BDC’s continued qualification as a RIC, and must identify at least one instance where direct financing would result in the BDC receiving such income.

In addition, each financing under the New Rule must satisfy certain conditions, including:

• The blocker entity must pass at least 99% of the financing proceeds down to a qualifying small business, after deducting actual application fees, closing fees and expense reimbursements, which may not exceed those permitted by
  § 107.860.
• Any fees charged to the blocker entity and any qualifying small business by the BDC or SBIC pursuant to § 107.860 or § 107.900 may not exceed the amount of fees that would have been permitted if the financing had been directly provided to the qualifying small business. The blocker entity and qualifying small business must pay all such fees in cash within 30 days of receipt.
• Each financing under the New Rule will be considered a portfolio concern, and the terms of the financing must provide the SBA with access to information about the portfolio concern with respect to record keeping and reporting obligations.

The form or content of the certification that the SBA will request in connection with the formation of a holding company under the New Rule remains uncertain. Sutherland will continue to monitor and report on any further developments regarding the preferred method of compliance with the conditions set forth above.
                         

¹ Small Business Investment Companies: Passive Business Expansion and Technical Clarifications, 81 Fed. Reg. 249 (December 28, 2016).