Recent Developments in the Private Funds Industry

1. SEC's OCIE Announces 2018 Examination Priorities

2. Tax Reform: Impact on Funds

3. New DOJ Approach to Remote Data Storage — Go Get It!

SEC's OCIE Announces 2018 Examination Priorities

By: Cheri L. Hoff, Chelsea L. O’Donnell

On February 7, 2018, the Office of Compliance Inspections and Examinations (OCIE) of the U.S. Securities and Exchange Commission (SEC) released its 2018 examination priorities.1 The examination priorities indicate that the SEC will continue its existing examination focus from prior years with additional emphasis on investor protections in the retail market and are organized in five general categories:

1. Retail Investors The protection of retail investors, particularly seniors and those saving for retirement, is a continuing priority for the agency. In its efforts to protect retail investors, OCIE will continue to examine how fees and costs are disclosed by private advisors that manage funds with a high percentage of investors investing for the benefit of retail clients. OCIE also will focus on the adequacy of compliance programs of automated or digital platforms, such as robo-advisers. In addition, OCIE will focus on newly registered or never-before-examined investment advisors based on a risk-based assessment. Moreover, examiners plan to assess whether broker-dealers have implemented policies and procedures to ensure best execution for municipal and corporate bond transactions. To address the rapid growth of the sale of crypto currency and initial coin offerings, examiners will review whether adequate controls are employed to protect assets from misappropriation or theft and provide investors with disclosure concerning risk and potential fraud.


2. Compliance and Risks in Critical Market Infrastructure
 OCIE will continue to focus on clearing agencies that the Financial Stability Oversight Council has designated as systemically important. National security exchanges, transfer agents, and regulation systems compliance and integrity (SCI) entities fall within this focus area.

3. Financial Industry Regulatory Authority (FINRA) and Municipal Securities Rulemaking Board (MSRB) 
OCIE will continue to monitor FINRA regarding the quality of its operations and regulatory programs, as well as how the agency examines the entities within its purview. OCIE also will examine the MSRB to evaluate the effectiveness of certain operational and internal policies, procedures and controls.

4. Cybersecurity 
Cybersecurity is an ongoing priority for OCIE. In particular, OCIE’s examination programs will emphasize: (a) governance and risk assessment; (b) access rights and controls; (c) data loss prevention; (d) vendor management; (e) training; and (f) incident response.

5. Anti-Money Laundering (AML) Programs
 AML is a continued focus for the agency, with examinations that will focus on whether regulated entities are appropriately adapting their AML programs to address their obligations and making timely filings.

Regulated entities should ensure they have addressed these priority areas. These priorities are not exhaustive. If you receive notice of an OCIE examination or if you have questions regarding OCIE’s 2018 examination priorities, please call Cheri Hoff at (212) 508-6175.
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1 The Examination Priorities are available in full here.

Tax Reform: Impact on Funds

by Michele Alexander and Ryan Davis

The Tax Cuts and Jobs Act (TCJA) contains many provisions impacting private equity funds, which we explore below.

Lower Corporate Rate for Blocker Corporations


The most significant change in law brought by the TCJA is the reduction in the corporate tax rate to 21%. While most funds are organized as partnerships, funds with foreign investors often utilize blocker corporations to “block” the taint of income that is considered to be (a) effectively connected with the conduct of a U.S. trade or business (ECI) for foreign investors and (b) unrelated business taxable income (UBTI) for tax-exempt investors. Given this change, particularly where the investment strategy does not rely on dividend payments (also mitigating double taxation, which is consistent with most funds’ planning), blockers actually may be a sought after planning strategy for funds going forward.

Interest Deduction Limitation 


The TCJA repealed the so- called earnings stripping rules that limited interest deductions for many blocker utilizing related party debt, replacing them with a new limitation that applies to all taxpayers. Under the new rules, interest deductions generally are limited to the sum of business interest income and 30% of taxable income. Disallowed interest expense is carried forward indefinitely, and complex rules apply to partnership interest deductions. While most funds do not borrow directly given prohibitions relating to incurring UBTI, when they do it often is at the blocker level to reduce entity level tax. Funds with leveraged blockers, particularly those that are leveraged at less than 1.5:1 debt to equity to avoid the old earnings stripping rules, should be re-evaluating their structures in light of this change, especially taking into consideration the new lower corporate tax rate (discussed above).

International Provisions


The TCJA introduced comprehensive international tax reform, largely focused on (a) creating a territorial tax system for U.S. corporations and (b) combatting perceived abuses where U.S. taxpayers hold valuable assets offshore or make deductible payments to foreign affiliates in low tax jurisdictions. While funds were not specifically targeted, funds with a substantial U.S. investor base and non-U.S. corporate investments will be impacted, as such provisions affect the classification of such corporations as “controlled foreign corporations” (CFCs). “United States shareholders” of CFCs are required to include their shares of certain types of the corporation’s income (subpart F income) if the corporation is a CFC. A CFC is a foreign corporation more than 50% of the voting power or value of which is owned by one or more said United States shareholders. A United States shareholder is a “United States person” (as defined for U.S. tax purposes) who directly, indirectly or constructively owns 10% or more of either the vote or value of the stock in a foreign corporation. This is a significant departure from prior law, which only took into account voting power – under prior law, a United States person could own over 10% of the value of a corporation and not “count” as a United States shareholder. In addition, the TCJA allows for increased attribution of stock ownership from foreign persons to United States persons, by repealing the rule that “turned off” so-called downward attribution in certain circumstances where it would cause a United States person (including a corporation or partnership) to own stock held by a foreign person (including a shareholder or partner). When taken together, these changes could result in significant changes (and income recognition) for investors with respect to foreign portfolio companies held by funds, as many fund structures relied on the intricacies of the now-repealed or amended rules to avoid CFC status for portfolio company investments – and related income inclusions for sponsors as well as investors.

While these issues warrant more detailed discussion, it is important to note that funds with offshore investments may be disproportionately impacted by the complex new international provisions versus corporate shareholders, particularly if they are subject to the new Global Intangible Low-Taxed Income (or GILTI) rules (click here for more) and the new repatriation tax imposed on certain shareholders of certain foreign corporations. Moreover, funds will not benefit from the new dividends received deduction for actual distributions, which is an integral part of a territorial tax system for U.S. corporations. However, this may be mitigated in the private equity space where portfolio companies traditionally do not pay out dividends.

Inbound investments by non-U.S. partners into funds also is impacted by tax reform. The TCJA codifies an earlier revenue ruling concluding that foreign investors are subject to U.S. federal income tax on the sale of an interest in a partnership or LLC to the extent that a partner or member would be allocated ECI income as the result of such sale by the partnership or LLC of its assets. While this change eliminates the uncertainty swirling around the ruling, which commentators argued was outside Treasury’s authority, it also introduces practical uncertainty in application. The new provision (Code Section 1446(f)(3)) requires that the transferee of such an interest withhold at a flat rate of 10% and allows the IRS, at the request of either the transferor or transferee, to reduce the amount of withholding if it will not jeopardize the collection of tax imposed. However, there is no specific guidance as to when and how the transferor and transferee may request or otherwise obtain such a reduction. Presumably, new Code Section 1446(f)(3) provides the IRS with the authority to promulgate guidance regarding such procedures, but, until this is addressed, foreign investors selling interests in a fund that has ECI may find themselves waiting to file a tax return to obtain a refund.

Holding Period for Carried Interest


Finally, the TCJA modifies the holding period necessary for gains attributable to carried interests to qualify as long-term capital gains, subject to federal income tax at a rate of 20%, from greater than one year to greater than three years. Otherwise, such would be subject to tax at federal ordinary income tax rates at a maximum rate of 37%. The three-year holding period applies to gains from the sale or redemption of an applicable partnership interest, as well as gains attributable to such partnership’s direct or indirect sale of assets to the extent allocated to the owner of the applicable partnership interest. An applicable partnership interest is an interest in a partnership transferred to a taxpayer in exchange for services performed in connection with the raising or returning of capital, and either investing in (or disposing of) or developing, specified assets. Specified assets include securities, commodities, real estate assets, cash and derivatives. An applicable partnership interest does not include a partnership interest held by a corporation (but likely not an S corporation per Secretary Mnuchin’s public comments), nor does it include a partnership interest, commonly referred to as capital interest, that constitutes a right to share in capital based on the amount of the taxpayer’s contributed capital or the value of the interest taxable to the taxpayer upon receipt or vesting.

The three-year holding period applies to capital gains the taxpayer recognizes on or after January 1, 2018, regardless of when the taxpayer acquired the applicable partnership interest; there is no grandfathering rule.

New DOJ Approach to Remote Data Storage — Go Get It!
by Phil Bezanson and Shannon Wolf

In December 2017, the Department of Justice’s Computer Crime and Intellectual Property Section, Criminal Division (“CCIPS”) issued new guidance advising prosecutors seeking enterprise customer data stored “in the cloud” to attempt to collect responsive information from the enterprise first, instead of serving information requests directly on the enterprise’s cloud data service provider. The guidance represents a departure from recent investigation trends to serve information requests directly on the cloud data service provider to the exclusion of the impacted enterprise and reflects a recognition by DOJ of the limits and inconvenience of data extraction at the cloud storage level. The new approach is likely welcomed by cloud data service providers. CCIPS’s guidance also serves as a warning to enterprises that rely on their cloud data service provider to respond to information requests. Enterprises should be aware of where and how their data is stored, and be prepared to respond to a direct data request regardless of where that data is stored.

CCIPS’s recommendations reflect the practical considerations of cloud data services used by enterprises (defined as companies, academic institutions, non-profit organizations, or the like but not individuals), and the challenges that cloud data storage poses for law enforcement officials conducting investigations. The government articulated that obtaining information directly from cloud data service providers typically takes longer, results in overly broad information dumps, and there is varied level of ability and skill among cloud providers to respond to targeted information requests especially if the information stored is encrypted by the enterprise. Additionally, some cloud data service providers act only as storage facilities allowing the enterprise to control access, deletion, preservation and extraction.
In an effort to improve the efficiency of investigations by avoiding delay and overly broad responses to information requests, CCIPS suggests that prosecutors “should seek data directly from the enterprise, if practical, and if doing so will not compromise the investigation.” Before going directly to the enterprise, prosecutors are instructed to consider:

• whether the enterprise or the cloud data service provider is the best source for the information sought;
• whether there is an appropriate contact at the enterprise who can secure the data such as a general counsel; and
• whether approaching the enterprise increases the risk that an employee of the enterprise will purposefully destroy the data.

CCIPS further recommends that the prosecutor should consider whether to, before approaching the enterprise, first request that the cloud data service provider preserve the data.

The guidance recognizes that certain circumstances weigh against going directly to the enterprise. For example, if the enterprise itself is engaged in criminal activity, there is evidence that the enterprise would not willingly comply with the request, or there simply is not a trained or appropriate individual at the enterprise to facilitate response to the information request.

DOJ’s approach to investigations in the wake of the ever-changing technological landscape, continues to evolve. For some, the new guidance represents a positive step toward transparency and engagement between DOJ and businesses to facilitate law enforcement investigations. For others who rely on cloud data services for email and other information storage, CCIPS’s guidance is a gentle nudge to consider how effective it might be, or whether it has the right personnel and technology to responsibly collect data and provide timely and complete responses to a direct request from the government. Specifically, companies that rely on cloud storage as a cost-savings mechanism may be in a position to see that savings erode, if required to expend resources on responses to government requests for electronic information.