By David Gerogosian, Executive Vice President, PEF Services

David Gerogosian at PEF ServicesOn August 18, 2017, SBA published revised final regulations on structuring investments through the use of holding companies (passive businesses).  The U.S. Small Business Administration (SBA) is withdrawing the final rule concerning Small Business Investment Company (SBIC) investments in passive businesses that was originally published on December 28, 2016 (and delayed numerous times).

This final rule expands SBIC permitted investments in passive businesses and includes new reporting and other requirements for passive investments. Additionally, SBA made some technical amendments. The final rule will be effective starting September 18, 2017.

This final rule has some significant changes from what was originally published in December 2016.  Most importantly, it removed the exemption to permit an SBIC to form a blocker corporation to avoid adverse tax consequences to an investor (typically a parent BDC) that has elected to be taxed as a Registered Investment Company (“RIC”).

We have summarized some of the key points covered in this regulation below but we encourage you to click here to read the final rule in detail.

Structure of investments:

  • Changes to Blocker Corporation Exception—§ 107.720(b)(3):
    • Removing the requirement to obtain SBA’s prior approval to form a blocker corporation;
    • Permitting an SBIC to form a blocker corporation to enable any foreign investors to avoid effectively connected income (ECI) under the Internal Revenue Code;
    • Permitting a blocker corporation to provide financing to a second passive small business that passes the proceeds through to a non-passive small business in which it owns at least 50 percent of the outstanding voting securities (effectively permitting an investment structured with two levels of passive companies, one of which is the blocker corporation);
  • The final rule includes guidance of the substantially “All” definition and fees charged by Associates:
    • Clarifying that SBA deems that “substantially all” means at least 99 percent of the total Financing proceeds after deduction of actual application fees, closing fees, and expense reimbursements which may not exceed those permitted by § 107.860.
  • If an Associate charges fees permitted by § 107.860 and/ or § 107.900, the total amount of such fees charged to all passive and non-passive businesses that are part of the same Financing may not exceed the fees that would have been permitted if the Financing had been provided directly to a non-passive Small Business. Any such fees received by an Associate must be paid to the SBIC fund in cash within 30 days of the receipt of such fees (fee offsets will not be allowed in this circumstance).

Additional reporting requirements for these investments:

  • Clarifying that SBICs should report the non-passive Small Business Concern information in the Form 1031. 
  • SBA has clarified that SBICs should report data on the non-passive Small Business Concern when reporting information on financings using passive businesses in the Form 1031 Part A—the Small Business Concern; Part B—the pre- financing data; and Part C—the financing information, with the exception of the financing dollars in Question 29. The amount of financing dollars provided by an SBIC should be the total amount of such financing.
  • SBA has  also added a requirement under the new Part D for SBICs to upload a file in Portable Document Format (PDF) that contains the following information, which SBA will use to help assess whether the financing meets regulatory compliance, including, but not limited to, if the non-passive business has received “substantially all” of the financing and that the passive business owns at least 50% of the outstanding voting securities of the non-passive business:
  • Qualifying exception: Identification of the passive business exception under which the financing is made (i.e., § 107.720(b)(2) Exception for pass-through of proceeds to subsidiary, or § 107.720(b)(3) Exception for certain Partnership Licensees). If the SBIC indicates that the financing is made under § 107.720(b)(3), it would also indicate the qualifying basis for the financing (i.e., financing would cause an investor in the fund to incur unrelated business taxable income or effectively connected income).
  • Passive Business Entities: Identification of the name and employer ID number for each passive business entity used within the financing. This is needed so that SBA can identify all Portfolio Concerns involved in the financing.
  • Financing Structure Description: A description of the financing structure, including the flow of the money between the SBIC and the non-passive Small Business Concern that receives the proceeds (including amounts and types of securities between each entity), and the ownership from the SBIC through each entity to the non-passive Small Business Concern.

On a positive note, this revised final rule also includes a conforming change which increased the maximum amount of Leverage from $225 million to $350 million for SBICs under common control.

If you have any questions, please contact your PEF Client Services representative.