YA Global Investments, LP (“YA Global”), a foreign investment fund that provided funding to portfolio companies in exchange for stock, convertible debentures, promissory notes and warrants, engaged U.S.-based Yorkville Advisors LLC (“Yorkville”) to manage its portfolio. YA Global took the position that it did not have any income that was effectively connected with a U.S. trade or business.  Upon audit, the IRS adjusted YA Global’s tax returns for its taxable years 2006 through 2009 on the basis that it was in fact engaged in a U.S. trade or business and therefore was liable for withholding taxes on income that was allocable to its foreign partners.  YA Global strongly contested this determination.

The Tax Court agreed with the IRS that YA Global was engaged in a U.S. trade or business and thus should have been withholding on allocations to foreign partners.  The court also held that YA global was a dealer under Code Section 475 and thus should have been marking its assets to market.

Set forth below are the court’s key findings.

Yorkville Acted as YA Global’s Agent

In a threshold inquiry, the court determined that Yorkville was acting as an agent for YA Global and therefore attributed Yorkville’s U.S. activities to YA Global for purposes of determining whether it was engaged in a U.S. trade or business. The court followed the Restatement (Third) of Agency in finding that Yorkville was the agent of YA Global because YA Global had the power to give interim instructions to Yorkville after the onset of the parties’ relationship.  The court also found it to be significant that the management agreements between the parties used the word “agent” in describing the relationship of Yorkville to YA Global.

Portfolio Companies’ Fees to YA Global Were More Than Additional Payments for Use of Capital

YA Global was in the business of providing funding to portfolio companies in the form of convertible debentures, standby equity distribution agreements (SEDAs) and other securities. In addition to typical investment returns, YA Global received fees from the portfolio companies it funded. The court rejected YA Global’s contention that these fees were merely additional compensation for the use of capital. Instead, the court found that the fees were intended to cover the costs of additional services that Yorkville provided to the portfolio companies and that the portfolio companies received benefits from YA Global beyond the use of capital. Once again, the court attached significance to labels, noting that some of the fees were called “monitoring” and “structuring” fees. The court also rejected YA Global’s contention that  SEDA commitment fees were essentially the same as premiums paid in typical put options, explaining that, unlike in an option, the price YA Global would pay for stock issued for a SEDA advance would always be at a discount to market price.

YA Global Was Engaged in a U.S. Trade or Business

The court found that the partnership’s activities produced taxable income that was effectively connected with its U.S. trade or business. The court reasoned that YA Global’s activities (conducted through Yorkville as its agent) were continuous, regular and engaged in for profit, and that its activities went beyond the scope of a typical investor who invests capital or manages investments, specifically finding that YA Global’s activities did not qualify for the securities trading safe harbor under Code Section 864(b)(2)(A).

YA Global Was a Dealer in Securities and Subject to the Mark-To-Market Rules

The court concluded that YA Global was a “dealer in securities” because it held itself out as being willing and able to provide capital to portfolio companies who were its “customers” within the meaning of Code Section 475. The court explained that “customers” under the regulations are “those with whom the taxpayer does what it regularly holds itself out” to do. Additionally, the court held that YA Global did not satisfy the identification requirement of the exception for securities held for investment because its agreements failed to explicitly state, or clearly identify, that the security was described in the relevant Code sections.

Lesson Learned

This was a lengthy and complicated case, and there is more to say about it than space allows, but here are some key points of caution.  The court held the parties to their own labels.  The court construed the securities trading safe harbor narrowly and was skeptical of activities that went beyond the mere provision of capital and buying and selling based on market swings.  The court viewed fees as being paid for services rather than for the use of capital.  The court applied the dealer regulations under Section 475 in an expansive manner. 

While the facts of this case may seem extreme, taxpayers who are engaged in activities that extend beyond typical investment and trading activities would be well advised to heed these lessons to ensure that they don’t end up on the wrong side of the U.S. trade or business (or dealer) line.