Prepared for NVCA by Testa Hurwitz & Thibeault

Regulations recently issued by the Treasury Department significantly limit the scope of the “confidential transactions” category of transactions that taxpayers must disclose to the IRS as potential tax shelters. As a result of these new rules, under most circumstances private equity funds will no longer have to include tax carve-outs from confidentiality provisions in their fund agreements and investment documents.

In February 2003, the Treasury Department issued regulations requiring taxpayers that participate in any one of six categories of “reportable transactions” to disclose information about that transaction to the IRS. Reportable transactions include “confidential transactions,” and the February 2003 Regulations defined this category so broadly that even routine business transactions subject to standard confidentiality agreements — such as investments in private equity funds and investments by private equity funds in portfolio companies — could fall within their scope. In order to prevent the IRS disclosure requirements from applying to the fund and its investors, many private equity funds revised their confidentiality provisions to permit disclosure of the “tax treatment and tax structure” of their transactions.

As a result of numerous comments received by the IRS and Treasury Department (including comments submitted by the National Venture Capital Association), on December 29, 2003, the Treasury Department issued revised regulations substantially narrowing the definition of “confidential transactions.” Under these new rules, a confidentiality provision imposed by a party to the transaction acting in that capacity will not trigger the IRS disclosure requirements.

A transaction is a “confidential transaction” under the new definition only if: (1) an advisor limits disclosure of the tax treatment or tax structure of the transaction and this limitation protects the confidentiality of the advisor’s tax strategies, and (2) the advisor is paid a minimum fee. For this purpose, a “minimum fee” is $250,000 if the taxpayer is a corporation and generally $50,000 otherwise. Importantly, fees for this purpose do not include fees paid to a person in its capacity as a party to the transaction.

In most private equity fund transactions, confidentiality limitations are imposed only by a party to the transaction (for example, the private equity fund, its general partner or its management company), and not by a non-party advisor. The new regulations do not define the term “advisor” but, even if a fund, its general partner or its management company were treated as an advisor, any management fees or other fees typically received by these parties should be treated as received in their capacity as parties to the transaction. In most circumstances, therefore, private equity fund transactions should not fall within the new definition of confidential transactions, and providing special tax carve-outs from confidentiality agreements should not be necessary.

Although these new regulations have limited the scope of the confidential transactions category, it is important to note that several other categories of reportable transactions also may be relevant to private equity funds. These include “loss transactions” and “transactions with a significant book-tax difference,” and private equity funds should discuss these categories with their tax advisors or accountants.