Grains of SALT for NAV Lenders

Cheers with “NAV-gronis”

If you were one of the Milken Institute Conference attendees who had a “NAV-gronis” cocktail at the rooftop party earlier this week, next time please try it with SALT on the rim! Here, SALT stands for state and local tax.

Today’s New York Times DealBook “Fear of Tariffs, and Hopes for a Reprieve, at CEO Conference” with Andrew Ross Sorkin [i] explains what a “NAV-gronis” is – a cocktail with a name which may be a reference to the NAV loans some P.E. firms use to boost liquidity. [ii]

NAV loans are backed by the net asset value of the select P.E. firm's investments, a diversified pool of assets. As such, a NAV loan may not only help diversify and reduce the lender’s risk but may also reduce the lender’s state effective tax rate. There are a number of state and local tax opportunities that NAV lenders may consider for optimizing their return on investment.

State sourcing of loan interest

For state and local tax purposes, interest on a secured loan is generally sourced to the location of the borrower or the location of the collateral, depending on whether the loan is secured by equity (i.e., the borrower’s stock / membership interest) or the underlying assets.

The primary borrowers on NAV loans are P.E. funds, which tend to be located in high-tax jurisdictions (e.g. NYC, Chicago). NAV loans are secured by interest in the P.E. funds’ portfolio companies, which are typically spread across the US or may be located outside of the US in low- or no-tax jurisdictions. Therefore, structuring a NAV loan where the P.E. fund’s portfolio companies are listed as co-borrowers (not just guarantors) on the loan may result in a lower state effective tax rate for NAV lenders and greater returns for their investors.

Interest on loans that are secured by equity

Interest on loans that are secured by equity is generally sourced to the location (i.e., commercial domicile or principal place of business) of the borrower. As such, the state sourcing may be different depending on whether the sole borrower on the NAV loan is the P.E. fund, or the underlying portfolio companies are listed as co-borrowers. In the former case, where the P.E. fund is the sole borrower, the interest on the NAV loan may be 100% sourced to the P.E. fund’s location. In the latter case, where the portfolio companies are listed as co-borrowers, the interest on the loan may be sourced to the portfolio companies’ location, potentially resulting in a lower state effective tax rate upon the interest income.

Interest on loans that are secured by assets

Interest on loans that are secured by assets is generally sourced based on the type of assets – intangible property, real property, or tangible personal property. Generally, if the assets comprise intangible property, the interest is soured to the location of the borrower similar to how interest on loans that are secured by equity is sourced. If the assets comprise real property, the interest is generally sourced to the location of the property. For loans that are secured by tangible personal property (i.e., chattels that are not permanently affixed to land), the sourcing is more nuanced and may depend on the tax jurisdiction. Some states source interest on loans that are secured by tangible personal property similar to interest on loans secured by real property. Other states source such interest similar to interest on loans secured by intangible property. A state-by-state analysis must be performed to determine the correct sourcing of interest income.

Whether the security on the loan is the portfolio company’s equity or its assets may affect how the interest on the loan is sourced. Let’s take a portfolio company (a Delaware LLC which is disregarded for federal tax purposes) that is domiciled in NYC and holds data centers in TN, TX, and WA as an example. If the loan is secured by the portfolio company’s LLC interest, the interest on the loan is generally sourced to NYC where the portfolio company is domiciled for most states. In contrast, if the loan is secured by the portfolio company’s assets – data centers located in TN, TX, and WA – the interest on the loan is generally sourced to the location of the assets for most states. Exceptions to these general rules exist in certain jurisdictions.

In instances where the portfolio company is located in a high-tax jurisdiction and the assets it holds are located in low-tax jurisdictions, consideration should be given whether the assets as opposed to the equity of the portfolio company should be used as collateral on the loan. That is because the collateral type affects the state sourcing of the interest income. Using one type of collateral may be more beneficial than another type of collateral for state and local tax purposes, assuming of course that this makes sense for business and legal purposes.

Place where the loan origination activities are performed

The above describes the general state and local tax market sourcing rules, under which loan interest is sourced to the location of the borrower / collateral. There are certain jurisdictions that use place of performance (or cost of performance) in lieu of market sourcing rules applicable for loan interest. For example, if the NAV lender is a pass-through entity that is located in New York City and New York State, for purposes of the NYC Unincorporated Business Tax and the NYS partnership withholding tax, the NAV lender sources interest on a loan (whether secured by equity or by assets) to the location where it performs the loan origination activities, rather than to the location of the borrower / collateral. The loan origination activities that are considered include solicitation, investigation, negotiation, administration, and approval. However, if the NAV lender is a corporation rather than a partnership, it sources interest under market sourcing rules (to the location of the borrower / collateral) for NYC and NYS corporate tax purposes. Unlike partnerships that generally use place of performance sourcing, corporations generally use market sourcing for the NYS and NYC corporate tax. Therefore, the lender’s legal entity type, and in some instances the borrower’s legal entity type, may affect the state and local tax sourcing of loan interest income.

Financial institution or not?

Another level of complication to the sourcing analysis is added by the industry classification (a financial institution or not?) of the NAV lender. Some jurisdictions define the term “financial institution” broadly and any entity that generates interest income exceeding 50% of the entity’s total gross income qualifies as a financial institution in those jurisdictions. Other jurisdictions define the term narrowly – e.g., only an entity that is a federal- or a state-chartered bank or owned by a bank may qualify, or the jurisdiction may require that the entity be in a direct competition with the business of national banks to qualify as a financial institution. In addition to affecting the sourcing of interest income, the financial institution classification may impact the apportionment formula and whether loans are included in the lender’s property factor for apportionment purposes. For example, California uses a single sales factor formula with market sourcing of receipts for financial institution and a three-factor formula (including receipts, property, and payroll) with market sourcing of receipts for non-financial businesses. Additionally, financial institutions include loans in the property factor and the loan principal balances are sourced to the location where the origination activities are performed rather than the location of the borrower / collateral.

The takeaway

Upon the structuring of loans, NAV lenders and their advisors should perform a detailed state-by-state analysis before the closing of the transaction. To the extent it is commercially feasible, any state and local tax optimization opportunities identified during the analysis should be incorporated in the loan structuring and legal agreements.

Footnotes:

[i] “Fear of Tariffs, and Hopes for a Reprieve, at CEO Conference” New York Times DealBook, May 8, 2025.   

[ii] “All the Rage in Private Equity: Mortgaging the Fund,” New York Times Business DealBook, May 11, 2024.