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SBIC Client Alert: Changes to Passive Business Rule

John Gilson, John Evans, Ryan Smith
October 22, 2014

Earlier this week, the revised and final “Passive Business Rule” (13 CFR 107.720(b) of the Small Business Investment Act of 1958, as amended) was released by the U.S. Small Business Administration (the “SBA”).

SUMMARY:  

Prior to the revised rule, Small Business Investment Companies (“SBICs”) were generally prohibited from investing in “passive” businesses.  The regulations continue to define a business as passive if: (1) it is not engaged in a regular and continuous business operation; (2) its employees do not carry on the majority of day-to-day operations, and the company does not exercise day-to-day control and supervision over contract workers; or (3) the business passes through substantially all financing proceeds to another entity.  Prior to the revised rule, the regulations permitted an SBIC to structure an investment utilizing one passive small businesses under specific circumstances (e.g. a holding company).  This revised rule now permits an SBIC to structure an investment utilizing two levels of passive small businesses (e.g. two holding companies) under specific circumstances. 

WHAT THIS MEANS FOR OUR SBIC CLIENTS:  

If an SBIC is directly financing a passive holding company (“Holdco 1”), the revised rules now permit Holdco 1 to pass the proceeds of that financing through another passive holding company (“Holdco 2”) to a non-passive operating subsidiary (“Opco”), so long as Holdco 1, by virtue of its ownership of Holdco 2, indirectly owns at least 50% of the outstanding voting securities of Opco.  Also, as further discussed below, the revised rule indirectly expands the permitted use of blocker corporations by SBICs in cases where the blocker corporation indirectly owns at least 50% of the outstanding voting interests of Opco.

DISCUSSION OF THE REVISED AND FINAL RULE:  

Prior to revised §107.720(b), there were two exceptions to the general prohibition on SBICs investing in “passive” businesses.  These exceptions allowed SBICs to employ certain structures in which the direct recipient of financing is a passive business, but the end recipient is an active business.

The first exception, identified in §107.720(b)(2), provided that an SBIC could make an investment in a passive small business that in turn passes the investment proceeds to one or more “subsidiary companies”, each of which must be a non-passive small business.  Prior to the revised rule, a “subsidiary company” was defined only as a company in which at least 50% of the outstanding voting securities were directly owned by the financed passive business.  The revisions to §107.720(b)(2) expand the definition of “subsidiary company” to allow financing proceeds to pass through a second passive business before reaching a non-passive subsidiary.  As revised, “subsidiary company” means a company in which the passive business being financed either (i) directly owns at least 50% of the outstanding voting securities; or (ii) indirectly owns at least 50% of the outstanding voting securities (by directly owning the outstanding voting securities of another passive small business that is the direct owner of the outstanding voting securities of the subsidiary company).  It should be noted here that the SBA confirmed that “outstanding voting securities” is intended to refer to both the “securities” of a corporation and the “interests” of a limited liability company or limited partnership.

The second exception, identified in §107.720(b)(3), governs the formation and use of blocker corporations by SBICs to shield their investors from unrelated business taxable income (“UBTI”).  The revised rule does not include any expansion of §107.720(b)(3), nor does it expand the use of a blocker corporation for any purpose other than the avoidance of UBTI as permitted by the existing regulation.  Notwithstanding the foregoing, the exception contained in §107.720(b)(3) is indirectly impacted (albeit in limited circumstances) by the revisions to §107.720(b)(2).  As revised, §107.720(b)(2) does not specify any purpose for which a passive entity may or may not be utilized.  Accordingly, as stated by the SBA, so long as the financing proceeds are passed through only to one or more non-passive “subsidiary companies” as permitted by §107.720(b)(2), the revised rule would also allow an SBIC to create a blocker corporation as one of the two permitted levels of passive businesses under §107.720(b)(2), (i) to protect an SBIC’s foreign investors from the taxation imposed on income that is considered to be “effectively connected” (“ECI”) to a U.S. trade or business; and (ii) in the case of an SBIC that either is a BDC licensed under the Investment Company Act of 1940 or is owned by a parent BDC, to avoid jeopardizing the BDC’s qualification under the Regulated Investment Company (“RIC”) regulations.  The SBA went on to say, however, in transactions where an SBIC is creating a blocker corporation as one of the two permitted levels of passive businesses under revised §107.720(b)(2), such blocker corporation would be required to directly or indirectly own at least 50% of the outstanding voting interests of the non-passive subsidiary.

NOTABLE ITEMS WHICH DID NOT CHANGE:  

The SBA received comments suggesting additional changes to further liberalize permitted financings to passive businesses under §107.720(b).  The following are notable changes which were suggested but not ultimately adopted:  (i) eliminate the requirement for SBA prior approval to form a blocker corporation under §107.720(b)(3); (ii) permit an SBIC to form a blocker corporation to enable its foreign investors to avoid ECI (though see discussion in immediately preceding paragraph); and (iii) allow SBICs to structure financings in which proceeds may pass through an unlimited number of passive entities before reaching an eligible, non-passive small business.

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