IRS Private Letter Ruling Offers Guidance to Hedge Funds Investing in Auction Rate Preferred Shares

The classification of interests issued by closed-end funds as debt or equity for tax purposes has significant ramifications for hedge funds that invest in such funds.  Interests that are classified as debt generally allow holders to treat payments received from the fund as interest income and nontaxable principal repayments.  By contrast, interests that are classified as equity generally allow investors to receive dividends, capital gains or a mixture of the two.  A recent private letter ruling (PLR) issued by the Internal Revenue Service (IRS or Service) addressed the classification of preferred stock issued by a closed-end fund as debt or equity.  The IRS determined that the preferred stock should be classified as equity for federal tax purposes.  The PLR is significant for a variety of reasons.  First, the fact that the PLR was issued at all represents a change in procedure for the IRS, which previously declined to issue rulings on the classification of financial instruments as debt or equity because of the fact-specific nature of such classifications.  Second, the PLR has implications for hedge funds interested in the auction rate preferred shares market.  This article examines the PLR, its background and its potential significance for hedge funds invested or considered an investment in auction rate preferred shares.

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