Contract analysis

I. Executive Summary The purpose of this memorandum is to analyze how Internal Revenue Code ("IRC") Section 1061, enacted as part of the Tax Cuts and Jobs Act of 2017 ("TCJA"), applies to the carried interest allocations contemplated in connection with Harrowgate Private Equity Fund V LP ("HPE Fund V," "Fund V," or the "Fund"). This analysis has been prepared at the request of Harrowgate Capital Partners LLC ("HCP" o

Section 1061 imposes an extended holding period requirement on certain capital gains allocable to an "applicable partnership interest" ("API"). Specifically, Section 1061 recharacterizes net long-term capital gain with respect to an API as short-term capital gain unless the underlying assets generating such gain have been held for more than three years, rather than the standard one-year holding period that generally

II. Background — Fund V Carried Interest Structure A. Fund Economics Overview HPE Fund V LP is a Delaware limited partnership organized for the purpose of making private equity investments in North American mid-market and upper-mid-market companies. The Fund has a target hard cap of $2,000,000,000 in aggregate commitments. The general partner of the Fund is Harrowgate Fund V GP LLC, a Delaware limited liability compa

III. Statutory Framework — IRC Section 1061 A. Overview of Section 1061

Section 1061 of the Internal Revenue Code was enacted as part of the Tax Cuts and Jobs Act, Public Law 115-97, signed into law on December 22, 2017, and is effective for taxable years beginning after December 31, 2017. The provision is codified at 26 U.S.C. § 1061. It represents the most significant legislative change to the taxation of carried interest since the inception of the modern private equity industry, altho

Section 1061(c)(4) provides an important exception for capital interests. An interest in a partnership is not treated as an applicable partnership interest to the extent that the interest is held by a person who has contributed capital to the partnership on the same terms and conditions as are applicable to other partners who do not provide substantial services in the applicable trade or business. This exception is c

IV. Application to HPE Fund V LP's European-Style Waterfall A. European (Whole-Fund) Waterfall Mechanics Under the Fund V LPA, distributions to partners are made in accordance with a European-style (whole-fund) waterfall. This waterfall structure operates as follows: Tier 1 — Return of Capital. First, 100% of distributions are made to the limited partners until all contributed capital (including capital used to pay m

Section 1061 introduces a complication to the "net of taxes" clawback calculation. If carried interest was distributed and the carry recipients paid tax on that distribution at ordinary income rates (because Section 1061 recharacterized the gain as short-term capital gain), the "net of taxes" offset should reflect the higher tax rate actually paid. Conversely, if the carried interest retained long-term capital gain c

V. Recommended LPA and GP LLC Agreement Provisions A. Holding Period Tracking and Reporting The foundation of Section 1061 compliance is accurate and contemporaneous tracking of the acquisition date and holding period for each portfolio investment. We recommend including a specific provision in the LPA requiring the GP LLC and the Fund's administrator, Pinnacle Fund Services LLC, to maintain detailed records of the a

Section 1061(d) provides special rules for transfers of applicable partnership interests. Under Section 1061(d)(1), if a taxpayer transfers any API, directly or indirectly, to a person who is a related person with respect to the taxpayer, the taxpayer shall include in gross income (as short-term capital gain) so much of the taxpayer's net long-term capital gain with respect to such interest for the taxable year as is

Section 1061(d) Acknowledgment. The transferring carry recipient must acknowledge in writing that he or she has consulted with a personal tax advisor regarding the application of Section 1061(d) to the proposed transfer, and that the GP LLC, HCP, and the Fund shall have no liability for any adverse tax consequences arising from the transfer. Form of Transfer Agreement. The Form of Transfer (Assignment) Agreement, whi

VI. Impact on Predecessor Fund Analysis Before concluding our analysis of Fund V, we note briefly the relevance of Section 1061 to Harrowgate's predecessor funds. Section 1061 is effective for taxable years beginning after December 31, 2017, meaning that it has applied to all of Harrowgate's funds for taxable years 2018 through the present. HPE Fund I (2012 vintage) has been fully realized. Given the fund's vintage a