Background

The court held that (1) the YA was an agent of the fund and attributed YA's activities to the fund, (2) the fund did not qualify for the investment or securities trading safe harbors, and (3) the fund was considered a dealer rather than an investor. In turn, the fund was liable for USD 57 million in tax and penalties for failure to withhold tax on effectively connected income allocable to non-US partners.

YA Global was a hedge fund organized as a Cayman Islands limited partnership. YA was a Delaware LLC headquartered in New Jersey. The court examined tax years 2006-2009. For each of the years in question, the fund filed Form 1065 (its annual partnership return) but failed to file Form 8804 to report the amount withheld on effectively connected income. 

The fund and YA entered into a management agreement whereby YA was referred to (and in practice acted) as the fund's agent in buying, selling, and general transactional matters. The court found that YA conducted extensive duties on the fund's behalf for which it received compensation in the form of a 2 and 20 compensation arrangement (2% management fee based on gross assets plus 20% carried interest).

YA was the fund's agent and YA's activities were attributed to the fund

The court held that YA was the fund's agent and YA's activities were attributed to the fund. Key to the court's decision was the degree of control that the fund had over YA's performance of its services.

YA Global, the fund itself, had no employees. It engaged YA to provide investment management services pursuant to the investment management agreement. The agreement referred to YA as the fund's "agent" and provided that the fund would promptly advise YA of any specific investment restrictions.

The court's analysis focused on the appointment of YA as an "agent" under the investment management agreement and that the agreement empowered the fund to give YA interim instructions during the term of the agreement. The court distinguished the relationship from a service-provider service-recipient relationship by focusing particularly on the right of the fund to give YA interim instructions during the course of the agreement whereas the court believed that in a service-based relationship the service recipient provides instructions only at the beginning of the engagement.

The court further rejected the argument that YA was an independent agent even though it also managed several smaller funds. Because YA worked exclusively or almost exclusively for the benefit of the fund and did not proactively seek to provide services to other customers, it did not qualify as an independent agent.

The fund was engaged in a US trade or business

After attributing YA's activities to YA Global, the court determined that YA Global was engaged in a US trade or business because of these activities. The fund provided funding to portfolio companies through various types of financial instruments. A standby equity distribution agreement (SEDA) was one such instrument pursuant to which the fund would purchase stock of a portfolio company over a fixed period at a discounted price. In addition to providing a discounted purchase price, the portfolio company would pay various fees to the fund as part of the SEDA. The fund would exercise conversion features of convertible instruments only when it was ready to sell the stock on conversion and the fund's PPM described the fees as income for services, such as due diligence, structuring, and commitment fees. The fund's communication with investors highlighted the fund's expertise in managing transactions from start to finish including identifying, sourcing, negotiating, conducting due diligence, structuring, financing, and managing the deals.

The court held that: (1) the activities YA conducted on behalf of the fund were continuous, regular, and engaged in primarily for income or profit; (2) those activities were not limited to investment, and (3) the activities were not protected under the securities trading safe harbor for trading in stocks or securities. The court did not specifically describe or name the business that the fund was engaged in, but it didn't have to. It determined that the balance of the activities taken together constituted a US trade or business.

The court determined that the fees paid by the portfolio companies went beyond payments for the use of capital (which would indicate an investment rather than a trade or business). The materiality of the fees and the fact that they would be paid to both the fund and YA demonstrated to the court that the fund was not only being compensated for capital but was also engaged in trade or business activities and where therefore distinguishable from investment activities. The manager dealt with portfolio companies directly. The manager sourced, originated, structured, and negotiated deals and the court felt that this went beyond investing. The court then further held that the fund did not qualify for the securities trading safe harbor because the fund's activities went beyond trading in stock and securities and the income of the partnership went beyond returns on the fund's capital.

The fund was a "dealer" subject to the mark-to-market regime of Section 475

Dealers in securities are generally subject to the mark-to-market regime of Section 475. This rule requires securities held in a dealer's inventory to be marked to market annually, i.e., be treated as though they were sold on the last day of the tax year, and any gain is classified as ordinary income.

Whether a taxpayer is a dealer for Section 475 purposes depends on their day-to-day activities. A "dealer in securities" is someone who regularly offers to deal in positions in securities with customers. The court determined that the fund was a dealer because it regularly held itself out as being willing and able to purchase securities from portfolio companies. The court determined that the fund regularly purchased securities from portfolio companies who were "customers" in the ordinary course of its trade or business. However, in its analysis on this point the court noted that there was no doubt that the fund held itself out as being willing and able to provide capital to portfolio companies. This would rather seem to support the view that the fund was an investor which undermines the court's position as to trade or business and dealer status because it indicates the centrality of YA Global's capital at risk.

Securities held for investment are not subject to the mark-to-market regime. To qualify for this exception from the mark-to-market rule, a security must be identified as held for investment, held as a certain hedge, or acquired or originated in the ordinary course of a trade or business but not held for sale. Rev. Rul. 97-39, 1997-2 C.B. 62, 62 provides that the identification must be made on the dealer's books and records and must clearly indicate that the identification is made for purposes of Section 475. While various documents related to its investments indicated that the fund held investments for investment purposes the court took a narrow view of the identification requirement based on Rev. Rul. 97-39. The court held that the fund did not satisfy the identification requirement because none of those statements specifically referenced Section 475. As such, the fund was subject to the mark-to-market regime for the tax years in question.

The fund was liable for failure to withhold

A partnership that has income which is effectively connected with a US trade or business must withhold tax from the effectively connected income allocable to non-US partners. The court found that YA was an independent agent of the fund and the fund's gain was attributable to YA's US office and the US office was a material factor in generating that income. Accordingly, was required to withhold tax.