On April 10, 2012, Mayor Michael Nutter signed legislation, which, effective for tax years beginning on or after January 1, 2012, excludes an "investment company" and its owners from the Philadelphia Business Income and Receipts Tax (until recently, known as the Business Privilege Tax) ("BIRT") and exempts net profits from "investment company" activities from the Philadelphia Net Profits Tax ("NPT").1 The legislation is part of an initiative by the City of Philadelphia (the "City") to bring jobs and investment into the City.
Background
The BIRT is comprised of a 1.415 mill tax on the gross receipts and a 6.45 percent tax on the net income of an entity engaged in "business" in Philadelphia.2 The NPT is a 3.928 percent resident (3.4985 percent nonresident) tax on the net profits earned from business, professions or other activities carried on in Philadelphia.3 The NPT is not imposed on corporations.4 In addition, a taxpayer subject to the BIRT and the NPT may take a credit against the net income portion of the BIRT equal to 60% of its NPT liability.5
Legislative Changes to BIRT/NPT Treatment of Investment Companies
Effective for tax years beginning on or after January 1, 2012, the legislation exempts net profits derived from the activities of an "investment company," as that term is defined in the Investment Company Act of 1940, 15 U.S.C. § 80A-3 (the "1940 Act"), from the NPT. Also effective for tax years beginning on or after January 1, 2012, the legislation adds the definition of "investment company," as defined in the 1940 Act, to the list of exclusions from the BIRT definition of "business." The exclusion from the BIRT definition of "business" extends to a non-publicly traded entity or natural person which directly or indirectly owns a general partnership interest or a managing member interest in a limited liability company which meets the definition of "investment company" if the owner's: (1) activities are limited to the management responsibilities of a general partner or managing member; and (2) income is based on the financial performance of the partnership or limited liability company. Thus, effective January 1, 2012, the City excludes an "investment company" and its owners from BIRT and exempts net profits derived from the activities of an "investment company" from NPT.
The Investment Company of 1940 Act
In order to have a fuller sense of what this change means, a brief description of the 1940 Act is warranted. Congress enacted the 1940 Act to regulate the organization and operation of investment companies, including mutual funds, that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public. The 1940 Act is the last in a series of federal legislative acts designed to eliminate certain abusive practices in the securities industry (e.g., failure to provide adequate information and management of portfolios in the interests of management rather than shareholders), which were found to have contributed to the stock market crash of 1929 and the resultant economic depression of the 1930's.6
Under the 1940 Act, an "investment company" is defined to include an "issuer" which:
"(A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities;
(B) is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or
(C) is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer's total assets (exclusive of Government securities and cash items) on an unconsolidated basis."7
For these purposes: (1) an "issuer" includes a "person" who issues or proposes to issue any security or has an outstanding security which is issued;8 (2) a "person" includes a natural person, corporation, partnership, association, joint-stock company, trust, etc.;9 (3) a "security" includes, but certainly is not limited to, a note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, etc.;10 (4) a "face amount certificate of the installment-type" includes a certificate, investment contract, or other security, which represents an obligation on the part of its issuer to pay a stated or determinable sum or sums at a fixed or determinable date or dates more than twenty-four months after the date of issuance, in consideration of the payment of periodic installments of a stated or determinable amount;11 and (5) "investment securities" include all securities except for government securities, securities issued by employees' securities companies and securities issued by majority-owned subsidiaries of the owner which are not, among other things, investment companies.12
Definition of Investment Company for BIRT/NPT Purposes
The definition of "investment company" set forth in the enacted Philadelphia BIRT/NPT legislation is more expansive than the 1940 Act definition of "investment company," as such term encompasses all investment companies defined under the 1940 Act, plus the following types of companies or activities which are excepted from the definition of "investment company" under the 1940 Act:
A person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who is primarily engaged in the business of acquiring mortgages and other liens on and interests in real estate;13
An issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are "qualified purchasers" (i.e., an investor with at least $5 million in investments) and which is not making and does not at that time propose to make a public offering of such securities;14
A person substantially all of whose business consists of owning or holding oil, gas, or other mineral royalties or leases, or fractional interests therein, or certificates of interest or participation in or investment contracts relative to such royalties, leases, or fractional interests;15
" A company organized and operated exclusively for religious, educational, benevolent, fraternal, charitable, or reformatory purposes: (a) no part of the net earnings of which inures to the benefit of any private shareholder or individual; or (b) which is or maintains a pooled income fund, collective trust fund collective investment fund or similar fund which meets certain requirements;16
Certain employees' stock bonus, pension, or profit-sharing trusts which meet the requirements for qualification under Internal Revenue Code ("IRC") § 401, certain governmental plans, and a collective trust fund maintained by a bank consisting solely of assets of one or more of such trusts or government plans;17 and
Certain church plans described in IRC § 414(e), if under the plan, no part of the assets may be used for, or diverted to, purposes other than the exclusive benefit of plan participants or beneficiaries.18
For example, the following types of companies or activities may be exempted or excluded from BIRT and NPT even though they are not subject to regulation under the 1940 Act: (1) a person primarily engaged in the business of acquiring real estate; (2) hedge funds; (3) a person whose business substantially consists of holding or owning oil, gas or other mineral royalties or leases; (4) a pooled income fund, collective trust fund, collective investment fund, or similar fund maintained by a charitable organization; and (5) an employee pension plan.
Commentary
The legislation, which was adopted as part of the City's initiative to raise revenue and bring jobs and investment into the City, is expected to create an estimated $500 million in investible capital for the City.19 Prior to the enactment of the legislation, hedge funds and other institutional investors avoided locating in the City and instead chose to locate outside the City where taxes are comparatively lower.20 The bill provides hedge funds and other institutional investors an incentive to relocate to the City.
The City becomes a more attractive relocation option for hedge funds and other institutional investors if relocating to one of the City's Keystone Opportunity Zones ("KOZ"). A KOZ is an economically distressed area which has been designated for revitalization. The benefits of relocating to a KOZ are substantial Pennsylvania state and local tax incentives, which are presently set to expire December 31, 2018. For example, a hedge fund or other institutional investor that relocates to a KOZ may reduce its Pennsylvania state and local tax burden to zero for the benefit period via exemptions, deductions, abatements, and/or credits for the following: (1) Pennsylvania taxes, including the Corporate Net Income Tax, Capital Stock & Foreign Franchise Tax, Personal Income Tax, Sales & Use Tax, Bank Shares Tax, and other taxes; and (2) City taxes, including real property tax and sales and use tax.
In addition, due to the "inadvertent investment company" provision in the 1940 Act's definition of "investment company" and the BIRT/NPT legislative exceptions to the 1940 Act's "investment company" definition exceptions, the BIRT and NPT exemption/exclusion extends beyond hedge funds and institutional investors. For example, a company whose investment securities exceed 40% of its total assets, a company that primarily holds interests in real estate or a business that is substantially comprised of holding oil, gas (e.g., Marcellus shale), or other mineral interests may come under the bill's exemption or exclusion from BIRT and NPT. But any company that is considering planning in order to come within the exemption or exclusion should first consider whether a restructuring would subject the company to 1940 Act regulation and, if so, whether the benefit of the BIRT and/or NPT exemption or exclusion outweighs the cost of 1940 Act regulation.
Footnotes
1 Phila. City Council Bill No. 120007, enacted April 10, 2012.
2 PHILA. ORD. 19-2603. A "mill" is equal to one-tenth of one percent.
3 PHILA. ORD. 19-2803.
4 PHILA. REGS. §§ 101 (definitions of "Association," "Business," "Non-resident" and "Resident") and 202.
5 PHILA. ORD. 19-2604(4).
6 15 U.S.C. § 80a-1(b).
7 15 U.S.C. § 80a-3(a)(1). Subparagraph (A) generally applies to an "orthodox" or "traditional investment company" (i.e., a company engaged in the business of issuing securities and obtaining capital with the express purpose of purchasing securities – usually stocks and bonds – on behalf of its shareholders). Subparagraph (C) generally applies to an "inadvertent investment company" (i.e., a company which does not set out to become an investment company; however, events may unfold so as to change an operating company to an investment company without the intent of management). The 40% "inadvertent investment company" test is calculated on an unconsolidated basis and is calculated using a fraction the numerator of which is investment securities and the denominator of which is total assets, excluding government securities and cash items. See United States SEC v. Nat'l Presto Indus., 2005 U.S. Dist. LEXIS 25794 (N.D. Ill. Oct. 30, 2005).
8 15 U.S.C. § 80a-2(22).
9 15 U.S.C. § 80a-2(8), (28).
10 15 U.S.C. § 80a-2(36).
11 15 U.S.C. § 80a-2(15).
12 15 U.S.C. § 80a-3(2).
13 15 U.S.C. § 80a-3(c)(5)(C); PHILA. ORD. § 19-2601 (definition of "Business").
14 15 U.S.C. § 80a-3(c)(7); PHILA. ORD. § 19-2601 (definition of "Business").
15 15 U.S.C. § 80a-3(c)(9); PHILA. ORD. § 19-2601 (definition of "Business").
16 15 U.S.C. § 80a-3(c)(10); PHILA. ORD. § 19-2601 (definition of "Business").
17 15 U.S.C. § 80a-3(c)(11); PHILA. ORD. § 19-2601 (definition of "Business").
18 15 U.S.C. § 80a-3(c)(14); PHILA. ORD. § 19-2601 (definition of "Business").
19 Jeff Blumenthal, City tax break is aimed at luring investment funds, PHILADELPHIA BUSINESS JOURNAL (April 13, 2012), "http://www.bizjournals.com/philadelphia/print-edition/2012/04/13/phila-taxbreak- aimed-at-luring.html" (last visited April 24, 2012).
20 Id.
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