Tax Considerations for Direct Investments
Tax structuring can impact rate of return, making it important to consider the tax entity classification of both the investor and the investment entity.
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To minimize fees levied by third-party asset managers, certain investors, including tax-exempt organizations and sovereign wealth funds (SWFs), have significantly increased their investment allocation to direct investments. Both types of investors have specific tax structuring considerations that may often affect the rate of return on their investments. Thus, it is important to consider the tax entity classification of both the investor and the investment entity.
Considerations for U.S. Tax-Exempt Organizations
Internal Revenue Code Sec. 511 may tax otherwise tax-exempt organizations on their unrelated business taxable income. UBTI is income from a trade or business regularly carried on by a tax-exempt organization that is not substantially related to the organization’s exempt purpose. Additionally, although loan origination may be treated as a business, capital gains, interest and dividends are excluded from UBTI unless the underlying property is debt-financed property.
Furthermore, the unrelated trade or business activities of a partnership are imputed to its tax-exempt members. Accordingly, if a tax-exempt organization wants to invest directly in an entity that is taxed as a partnership for federal income tax purposes, a so-called blocker is often implemented to mitigate the UBTI.
A blocker is a corporation that is placed between the tax-exempt investor and the source of UBTI. The blocker incurs and pays tax on the operating income that is allocated to it from the partnership, and thus blocks the unrelated business income from reaching the tax-exempt investor. Any net after-tax proceeds distributed by the blocker to the tax-exempt and foreign investors should be non-UBTI distributions.
Considerations for Non-U.S. Sovereign Wealth Funds
IRC Sec. 892 grants an exemption from U.S. federal income tax for certain U.S. source investment income earned by foreign governments unless derived from the conduct of a commercial activity or received from or by a controlled commercial entity. An entity is a controlled commercial entity if it is controlled by the foreign government and is engaged in commercial activities anywhere in the world. Thus, while IRC Sec. 892 encourages foreign investment in the U.S., it is not intended to provide a tax exemption for active commercial activities.
Because the application of IRC Sec. 892 and the definition of controlled commercial entity are often unclear, sovereign wealth funds and other non-U.S. investors may consider the use of blocker corporations. Foreign investors may be subject to U.S. federal income tax on income effectively connected with the conduct of a trade or business within the U.S. With a blocker structure, the U.S.-sourced effectively connected income, or ECI, remains at the blocker, and the foreign investor will not be deemed to be engaged in a trade or business that is subject to U.S. federal income taxes.
The structure of any direct investment by a tax-exempt organization or SWF in the United States must be made after a case-by-case analysis. Tax-exempt organizations and SWFs should consult their tax advisers prior to any proposed U.S. direct investment.
This article originally appeared in the November/December 2018 issue of Middle Market Growth. Find it in the MMG archive.
Janice Kong is a tax director in DHG’s Private Equity practice. She leads cross-functional teams that execute tax due diligence and tax strategies for private equity groups and portfolio companies. She provides tax structuring services for M&A clients, successor liability transaction analysis and tax classification analysis of target companies.
