U.S. Tax Treatment of Limited Partners

More pertinent, why should a fund sponsor care?

The short answer, is “because prospective limited partners care”. A fund’s tax structuring is often the subject of fairly extensive due diligence and negotiation by prospective limited partners, and in extreme situations where the fund sponsor cannot accommodate a prospective investor’s tax structuring requirements can result in that investor declining to make an investment. It can also affect both the fund sponsor’s choice of jurisdiction to organize the fund as well as the structure of the fund. As such, it behoves a shrewd fund sponsor to take the time to understand the effects of the different tax treatment accorded to certain categories of prospective limited partners, and some of the common solutions used by fund sponsors and their counsel.

Before we embark on this somewhat torturous journey through the complications of the IRC, I must first address a few preliminary matters, lest this journey become lost as Odysseus was, after Troy.

The first thing to do is to narrow our focus. I will discuss only the U.S. federal income tax treatment of U.S. and non-U.S. investors in a PE/VC fund that invests in portfolio companies in the U.S. and outside the U.S. I will not discuss FIRPTA, since that is primarily an issue with companies that have real property interests. I will not discuss the effects of FATCA on fund structuring. I will also not discuss any other country’s tax regime on investment funds and their investors; there is enough in the U.S. tax code to fill a few books, after all.

Second, we must understand how the different rules promulgated by the IRS has divided limited partners into four broad categories:

U.S. tax-exempt investors: The IRS prescribes a fairly long list of entities that qualify as a tax-exempt organization, which I will not enumerate in toto here. These include corporations organized under an Act of Congress and that have been explicitly exempted from federal income taxes,1 religious, educational, charitable, scientific, literary organizations,2 chambers of commerce,3 social and recreational clubs,4 political organizations,5 farmers’ cooperatives,6 private foundations,7, federal, state, and local governmental plans,8 and employee benefit plans.9
U.S. taxable investors: Broadly speaking, taxable investors in the United States should be thought of as a “catch-all” category for any U.S. investor that cannot be categorized as a U.S. tax-exempt organization. Investors falling into this category include high net worth individuals, corporations, family offices and private trusts.
Foreign tax-exempt investors: Per the well-established principle of sovereign immunity, foreign governments, their political subdivisions, and their controlled entities are exempt from taxes on certain (but not all) forms of U.S. income (principally U.S. investment income). Foreign tax-exempt organizations (here more narrowly defined as IRC section 501(c)(3) equivalent organizations) are exempt from taxes on certain (but not all) forms of U.S. income (principally U.S. investment income). Foreign private foundations (equivalent to IRC section 509 private foundations) are tax-exempt on certain (but not all) forms of U.S. income, although they typically pay a nominal excise tax on U.S. sourced income. Certain international organizations designated by executive orders are exempt from taxes on all U.S. source income.
Foreign taxable investors: Like their American counterparts, foreign taxable investors should be thought of as a “catch-all” category for any foreign investor that cannot be categorized as a foreign government, tax-exempt organization, or designated international organization. Investors falling into this category include high net worth individuals, corporations, family offices and private trusts.

Each of these categories of investors have separate tax concerns that a fund sponsor must address through fund structuring or investment structuring.

Third, we should categorize the portfolio investments of a PE/VC fund into two broad categories:

U.S. portfolio investments: Businesses incorporated in the U.S. and having their principal places of business in the U.S.
Foreign portfolio investments: Businesses incorporated outside the U.S. and having their principal places of business outside the U.S.

Fourth, we should understand how a fund is typically structured, in the absence of any compelling tax structuring, in order to better understand how tax structuring for all these investors affects the basic structure.

A typical, plain-vanilla PE/VC fund will be structured as a limited partnership (as shown in Figure 1):

I have previously mentioned the reasons why the limited partnership is the preferred fund structure for most PE/VC funds, and shall not repeat myself here. It suffices to note that most funds organized in Anglo-American common law jurisdictions will use a limited partnership as their default approach.10

This examination of the U.S. tax treatment of limited partners in PE/VC funds will begin by first identifying the tax considerations each category of limited partner (U.S. tax-exempt investor, U.S. taxable investor, foreign taxable investor, and foreign tax-exempt investor) faces. As there are some commonalities across these categories, I will defer discussion of solutions until we have explored the tax considerations of each category of investor. I will then conclude by synthesizing all that has been discussed.

U.S. tax-exempt investors

U.S. tax-exempt investors are one of the largest investors in PE/VC funds. As their name implies, these investors are—as a general rule—not taxed on their share of a fund’s capital gains or ordinary income. The general rule is, however, subject to one significant exception: the U.S. federal government taxes the gross income of U.S. tax-exempt investors derived from commercial activities unrelated to their tax-exempt purpose, better known by its abbreviation, UBTI. The U.S. tax-exempt investor must file a U.S. federal income tax return and pay U.S. federal income taxes (UBIT) on investments that generate UBTI regardless of whether the investor has received any distributions from those investments.

U.S. tax-exempt investors can incur UBIT when a PE/VC fund invests in U.S. portfolio investments and foreign portfolio investments, so long as the income from that investment is connected with a trade or business unrelated to the U.S. tax-exempt investor’s tax-exempt purpose.

Generating excessive amounts of UBTI can jeopardize a U.S. tax-exempt investor’s tax-exempt status, as it may no longer be viewed as primarily organized for an exempt purpose. As such, most tax-exempt investors are extremely cautious about investing in investments that generate UBTI. They will typically request that the fund sponsor take action to minimize the risk that the fund will incur UBIT as a result of any investments made or activities undertaken.

A U.S tax-exempt investor that invests in a PE/VC fund can incur UBTI in one of three ways:

Investing in a flow-through entity that conducts a trade or business
Investing in investments financed by acquisition indebtedness
Investing in a PE/VC fund that earns transaction or advisory fees from portfolio investments

Before we go into the details of what circumstances can cause a U.S. tax-exempt investor to incur UBIT from an investment in a PE/VC fund, it is always instructive to understand why Congress, in its—ahem—infinite wisdom, decided that it was necessary to enact legislation imposing this tax on U.S. tax-exempt investors.

A brief history of UBTI

Taxation of UBTI had its origins in the entry of non-profit organizations into commercial ventures. In 1924, the U.S. Supreme Court had ruled that because all of the income from commercial and investment activities conducted by a U.S. tax-exempt organization was used to support the organization’s tax-exempt purpose, such income was not subject to tax. Following this decision, numerous tax-exempt organizations began incorporating “feeder” corporations to operate commercial businesses—including hotels, cattle ranches, fruit orchards, textile mills, departmental stores, and real estate leasing businesses—that were unrelated to these organizations’ tax-exempt purposes. These feeder corporations distributed all of their profits to the tax-exempt owners to use for their tax-exempt purposes. The income from these feeder corporations was exempt from U.S. federal income tax.

Commercial ventures owned by U.S. taxable investors, it must be said, were not sanguine about competition from commercial ventures owned by tax-exempt investors; they feared that competitors operated by tax-exempt organizations might undercut their prices or reinvest tax-free profits to expand more rapidly and thereby drive the taxable commercial ventures out of business. Congress and the Internal Revenue Bureau (the predecessor to the IRS) were concerned about both this unfair competition and the risk that the growth of such tax-exempt commercial ventures would inevitably shrink the tax base.

Moreover, some U.S. tax-exempt organizations engaged in a form of transaction referred to as a “charitable bootstrap”, which was a form of sale and leaseback in which the tax-exempt organization acquires an asset—typically real estate—from a U.S. taxable investor for a minimal amount of cash (the “seller”). The remainder of the purchase price is funded by a promissory note from the U.S. tax-exempt organization to the seller. The U.S. tax-exempt organization then leases the asset to the seller. The tax-exempt organization uses the rental payments from the seller to pay the principal and interest (if any) on the promissory note. These charitable bootstrap transactions were seem as a way by which the seller could reduce its tax burden (by expensing the rental payments for the use of the asset and by claiming the proceeds of the promissory note as capital gains), in a manner that the IRS and Congress found unpalatable.

As a result of this concern, in 1954 Congress imposed a tax on UBTI generated by the commercial activities of U.S. tax-exempt organizations, including income earned from charitable bootstrap transactions.

Income from a trade or business

PE/VC funds are typically considered as “investment partnerships”11 for U.S. federal income tax purposes, and are thus deemed not to be engaged in a trade or business. Thus, an investment in a PE/VC fund will not in itself result a U.S. tax-exempt investor incurring UBIT. This is not to say, however, that a U.S. tax-exempt investor can never incur UBIT from its investment in a PE/VC fund.

The most obvious way in which a U.S. tax-exempt investor in a PE/VC fund can incur UBTI is when the fund invests in a portfolio company that has been incorporated or organized as a flow-through entity (a partnership or LLC) for U.S. federal income tax purposes. The income earned by such a portfolio company is characterized as income from an active business, and retains that characterization in the hands of the PE/VC fund. If the fund is itself a flow-through entity—most funds are—then the limited partners of the fund will each receive a proportionate share of this income, which continues to retain its characterization as income from an active business. In the hands of a U.S. tax-exempt investor, this active income would result in the U.S. tax-exempt investor incurring UBTI.

This situation is more likely to occur when a U.S. tax-exempt investor invests in:

VC funds: Startups are often organized as flow-through entities to minimize the overall tax burden the founders bear. That being said, it is still rare to see a VC fund invest in a flow-through entity: most VCs will require the startups they invest in to either be incorporated as a corporation or convert to a corporation prior to the VC investment.
PE funds investing in the natural resources and energy sectors: Many privately-held companies operating in the natural resource and energy sectors will be structured as flow-through entities (partnerships or LLCs) to allow investors to take advantage of the tax benefits—deductions and tax credits—typically accorded to such companies.

Income from debt-financed investments

A U.S. tax-exempt investor in a PE/VC fund can also incur UBIT if the investment that produces income or gain is acquired with money borrowed by the U.S. tax-exempt investor or the fund. Debt-financed income is UBTI regardless of whether it was produced from assets acquired to produce passive investment income or from the conduct of an active business.12 This has its roots in the solution Congress enacted to deal with charitable bootstrapping, which has since been broadened legislative by amendments to include a much broader range of transactions.

Income from an investment is classified as “debt-financed” income to the extent that “acquisition indebtedness” exists with respect to the investment at any time during the fiscal year in which the income is realized or at any time during the 12-month period prior to the disposition of the investment.

The IRC defines “acquisition indebtedness” as the unpaid amount of any indebtedness incurred in acquiring or improving the investment, incurred before the acquisition or improvement of the investment if such indebtedness would not have been incurred but for such acquisition or improvement, or incurred after the acquisition or improvement of the investment if such indebtedness would not have been incurred but for such acquisition or improvement and it was reasonably foreseeable at the time of the acquisition or improvement, that the indebtedness would be incurred.

A U.S. tax-exempt investor will include as UBTI the percentage of the income that is equal to the percentage of the acquisition cost of the investment that is financed by acquisition indebtedness.13 (This is, of course, a simplification. A more fuller treatment of this calculation is beyond the scope of this survey.)

There are two principal ways in which a PE/VC fund can incur debt-financed UBTI:

Subscription credit facility: It is increasingly common14 for fund sponsors to arrange for a subscription credit facility to provide to allow it to fund portfolio investments pending receipt of proceeds from capital calls.
Fund guarantees borrowings to acquire or improve portfolio investment and credit extended based on financial strength of fund: A fund may be treated as having borrowed amounts used to acquire or improve a portfolio investment if the lender extended credit on the strength of the fund’s guarantee of the loan rather than the financial strength of the portfolio investment that borrowed the money. This is comparatively rare: in most LBOs the lender extends credit on the strength of the LBO target’s assets and cash flows.

The consequence of tax laws deeming debt-financed income to be UBTI is to limit the ability of U.S. tax-exempt investors to directly hold interests in a PE/VC fund organized as a limited partnership or LLC if the fund makes use of leverage to acquire U.S. or foreign portfolio investments or that makes use of a subscription credit facility.

Transaction fees and advisory fees

Many PE fund sponsors charge various transaction, break-up, advisory, or monitoring fees to their portfolio companies.15 Such fees are paid from the assets of the portfolio companies and thereby reduce the returns to limited partners, and as such limited partners will try to compel the fund sponsor to share all or part of these fees with them.

It is possible, though, that the receipt of these fees by the fund could result in the IRS taking the view that the fund is not an investment partnership, but is carrying on an active business of providing advice or monitoring portfolio companies. This is especially the case for advisory and monitoring fees which involve a fee for services rendered by the general partner of the PE fund; transaction fees and break-up fees are arguably less likely to be so characterized as they are not in the nature of income.16 In any event, it is a non-trivial risk for U.S. tax-exempt investors and one that will often be negotiated before the U.S. tax-exempt investors make an investment in the fund.

U.S. taxable investors

U.S. taxable investors (typically HNWIs, family offices, and corporate investors such as insurance companies) are also substantial investors in PE/VC funds, though their relative size has declined substantially after pension plans and endowments increased their allocations to alternative assets.

For U.S. portfolio investments, U.S. taxable investors will prefer the fund to be structured as a flow-through entity, i.e. a limited partnership or LLC. There are two main reasons for this:

There will not be a double layer of taxation. As a flow-through entity, the fund does not pay U.S. federal income taxes; instead, each limited partner in the fund that is a U.S. taxable investor will pay U.S. federal income taxes on its pro rata share of the income and gains of the fund. By contrast, if the fund were incorporated as a corporation, it would pay U.S. federal income taxes on its investment income, and the U.S. taxable investors would pay U.S. federal income taxes when the fund makes a dividend distribution to them.
The nature of the income or gain is unchanged in the hands of the U.S. taxable investors. Such investors are taxed at the lower long-term capital gains tax on the disposal of investments held for more than one year. If the fund were incorporated as a corporation, only the fund will be taxed at the lower long-term capital gains tax; when proceeds are distributed to the U.S. taxable investors by way of a dividend, these investors will be taxed at ordinary income tax rates.

A U.S. taxable investor in a PE/VC fund that invests in foreign portfolio investments will also generally prefer the fund to be a flow-through entity under U.S. and foreign tax laws. This will allow the U.S. taxable investor to claim the benefit of any applicable tax treaty between the U.S. and the foreign country where the portfolio investment is based.

That being said, given that this is the U.S. federal income tax system, there are two complications for fund sponsors that invest in foreign portfolio investments. U.S. taxable investors will need to address the risk of a foreign portfolio investment being classified as either a controlled foreign corporation or a passive foreign investment company.

Controlled Foreign Corporations

The controlled foreign corporation regime, or CFC regime, was enacted in 1962 with the objective of reducing the ability of U.S. taxable investors to defer paying U.S. federal income taxes on certain forms of income earned by foreign corporations that they owned or controlled. To do so, Congress specified a category of foreign corporations that were to be subjected to this regime and certain categories of income, referred to as Subpart F income, that would be subjected to this regime.

To understand the CFC regime, I must set out the definitions of three key concepts: “U.S. shareholder”, “controlled foreign corporation”, and “Subpart F income”:

There are a number of attribution rules and constructive ownership rules that allow the IRS to aggregate the shareholdings of certain related individuals to determine whether a U.S. person should be classified as a U.S. shareholder. A U.S. citizen or resident’s shareholding will be aggregated with the shareholdings of his or her parents, spouse, children (including by adoption), or grandchildren (including by adoption), because it is presumed that these people will share a common interest and purpose in deferring taxes. The constructive ownership rules18 also provide that if a U.S. person indirectly owns stock in a foreign corporation, A, through a foreign holding company, partnership, estate or trust, that U.S. person will be deemed to hold a stake in A proportionate to its share in the foreign holding company, paratnership, estate or trust.

If a foreign corporation is a CFC for an uninterrupted period of 30 days during the taxable year,19 the U.S. taxable investors face a number of consequences:

The U.S. taxable investors will owe U.S. federal income taxes on Subpart F income earned by the CFC, regardless of whether the CFC has made any distributions of such Subpart F income to these investors.
The Subpart F income attributed to a U.S. taxable investor will be taxed as ordinary income rather than the lower rates that typically apply to dividends and capital gains.
When the fund disposes of its interest in the CFC, an amount of the capital gains equal to the accumulated earnings of the CFC during the holding period of the fund will be treated as a dividend and taxed as such rather than as capital gains.

As one might imagine, paying U.S. federal income taxes at a marginal rate of 35% (for corporations) or 39.6% (for individuals) rather than 20% has quite an impact on the returns that a U.S. taxable investor will obtain from an investment in a PE/VC fund. Avoiding CFC status and the receipt of Subpart F income are therefore goals that most U.S. taxable investors will pursue when negotiating the terms of their investment in the fund.

For the most part, U.S. taxable investors in a PE/VC fund will find that a portfolio investment that is deemed to be a CFC can generate Subpart F income in the following ways:

Acquiring U.S. real or personal property—stock in U.S. corporations, debt obligations of U.S. persons, real estate, mineral rights, or intellectual property—with undistributed earnings
Transactions between a CFC and its related corporations (e.g. subsidiaries, affiliates, or parents)
Dividends or interest paid by a related corporation to a CFC
Passive income earned by a CFC from investing its retained earnings

For the avoidance of doubt, the income of a CFC from a trade or business conducted outside the U.S. and not done with related parties is not Subpart F income. For example, if a company in the UK manufactures leather shoes and sells them to independent retailers who then sell these to customers in the UK, the earnings from this investment will not be Subpart F income and will not be subject to U.S. federal income tax in the hands of the U.S. taxable investors until it is repatriated to the U.S.

Passive Foreign Investment Companies

If a fund sponsor, through some clever structuring, manages to avoid its foreign portfolio investments being classified as CFCs, it will still have to contend with another headache generated by the U.S. IRC: the passive foreign investment company (PFIC) regime. The rationale for the PFIC regime, which was enacted by Congress in 1986, was to reduce the incentive for U.S. investors to make investments in foreign investment funds.20

By way of background, most U.S. mutual funds must distribute substantially all of their income and gains annually to their investors in order to comply with the provisions of IRC Subchapter M, which treats a mutual fund as a flow-through entity if it distributes substantially all of its income and gains annually to its investors. As such, Congress perceived a disparity between the position of U.S. taxable investors in U.S. mutual funds, who are taxed annually on their share of the income and gains from their investments in these U.S. funds, and the position of U.S. taxable investors in foreign mutual funds, who—but for the PFIC regime—would be permitted to defer paying taxes on the income and gains from these foreign funds until such time as the fund makes a distribution to them. (This would typically have had the effect of permitting investors in foreign mutual funds to pay the lower long-term capital gains rates on such distributions.)

To prevent this situation from happening, Congress enacted the PFIC regime, which created an overly broad and extremely draconian set of tax rules for U.S. investors in foreign investment funds.

What is a PFIC? It is a foreign corporation where either 75% or more of its gross income for the year is passive income (the “income test”) or 50% or more of its assets produce passive income or are held for the purpose of producing passive income (the “asset test”).21 A foreign corporation that is treated as a PFIC for any year included in the holding period of a U.S. taxable investor will be treated as a PFIC with respect to that U.S. taxable investor for all subsequent years, i.e. “Once a PFIC, always a PIFC”.

When a U.S. taxable investor invested in a PFIC and receives distributions or sells its interest in the PFIC, it is subject to the following tax treatment:

As we can see, the overall impact of the PFIC regime is to convert what might otherwise have been capital gains from disposing of an interest in a PFIC into ordinary income taxed at the highest marginal income tax rate and with an interest penalty, and tax “excess” distributions at the same punitive rate. Not exactly something guaranteed to endear the IRS to U.S. taxable investors.

For a VC fund investing in foreign startups, there is a risk that these foreign portfolio investments could be classified as PFICs, because during the first few years of a startup’s operations, it may only have passive income in the form of interest on a working capital bank account.

To alleviate this risk, the IRS has implemented a startup exception to the PFIC regime, which exempts a startup that meets all of the following criteria from being treated as a PFIC:

No predecessor corporation of the startup was a PFIC
The startup can establish to the satisfaction of the IRS that it will not be a PFIC in either of the two years following the startup year
The startup is in fact not a PFIC in either of the two years following the startup year

Because a startup that is classified as a PFIC in its first year of operations will forever be a PFIC for U.S. taxable investors that invested in its first year, it is essential that fund sponsors take due care to ensure that the foreign startup is able to rely on the startup exception when investing in foreign startups.

Where a foreign corporation falls within the definition of both the CFC and PFIC regimes, the CFC regime will apply. Because a U.S. taxable investor in such a foreign corporation is currently taxed on its Subpart F income per the CFC regime, there is no need for the PFIC regime; the anti-deferral objective is accomplished through the CFC regime.

Foreign taxable investors

Foreign taxable investors, including foreign private pension plans, corporations, and HNWIs, are another major category of investors in PE/VC funds. As such, it is often necessary for fund sponsors to structure their investments to take into account the unique requirements of such investors, which include minimizing income effectively connected with a U.S. trade or business, minimizing income and gains subject to the provisions of the Foreign Investment in Real Property Tax Act of 1980, and—to the extent possible—permitting the foreign taxable investor to make use of applicable tax treaties between the foreign taxable investor’s country of tax residence and the U.S. to reduce withholding taxes on U.S. investment income.

Foreign taxable investors are not typically taxed on capital gains from the U.S. portfolio investments of U.S. PE/VC funds.22 They are, however, subject to withholding taxes on certain forms of passive income—called FDAP income—from U.S. investments. FDAP income include dividends, interest, rents, royalties, and annuities. As of June 2015, the withholding tax rate on FDAP income is 30%, unless reduced by an applicable tax treaty23 or by the portfolio interest rule.

The generally favorable U.S. treatment of foreign taxable investors is, however, subject to one very significant exception, the tax on income effectively connected with a U.S. trade or business (ECI).

Income effectively connected with a U.S. trade or business

A foreign taxable investor will be required to file U.S. federal, state and municipal income tax returns and be subject to U.S. federal, state, and municipal income taxes if it receives income effectively connected with a U.S. trade or business. These taxes are similar to the rates applied to U.S. taxable investors, consisting of taxes on ordinary income and capital gains. As of June 2015, the highest marginal U.S. federal income tax rate for corporations is 35% and for individuals it is 39.6%, while the maximum long-term capital gains rate is 20%.

For foreign taxable corporate investors, however, there is one further consideration that arises from ECI, the application of the “branch profits tax”. The “branch profits tax” is imposed on the “dividend equivalent amount” of the earnings and profits (less any reinvestment of earnings in the U.S.) of each U.S. branch (in this case a U.S. flow-through entity conducting a U.S. trade or business) held by the foreign taxable corporate investor. This amount is subject to a tax of 30%, unless reduced by an applicable tax treaty. As a consequence of the branch profits tax, in addition to paying U.S. federal corporate income taxes at the rates applicable to U.S. corporations on its share of the income from the ECI generating U.S. portfolio investment, the foreign taxable corporate investor will pay a further 30% on the dividend equivalent amount of any distributions made by that investment. Taken together with the highest marginal corporate tax rate of 35%, therefore, the branch profits tax can result in a foreign taxable corporate investor being subject to an effective tax on ECI of up to 54.5%.

A foreign taxable investor in a PE/VC fund can incur U.S. federal and state income taxes on ECI in one of three ways:

Investing in a flow-through entity that conducts a U.S. trade or business
Investing in a PE/VC fund that earns transaction or advisory fees from portfolio investments in the U.S.
Originating loans in the U.S. and earning loan commitment fees on such loans

An astute reader will of course notice that the first two of these three ways of incurring taxes on ECI are remarkably similar to the way that U.S. tax-exempt investors can incur UBIT. As I have already discussed these two situations in the context of UBTI, I will not repeat myself here. The only qualification I would add to what I have already stated is that while UBTI can be generated by foreign portfolio investments, ECI by definition is generated only from U.S. portfolio investments (or, sometimes, from foreign portfolio investments that are effectively connected to a U.S. trade or business and that are treated as flow-through entities for U.S. federal income tax purposes).

Loan commitment fees earned from originating loans are expressly excluded from UBTI, but are considered to be ECI. As such, most foreign taxable investors will seek to limit the ability of the PE/VC fund to originate loans and earn commitment fees from such activities. This can lead to some interesting structuring gymnastics for mezzanine funds investing in the U.S., but I will refrain from going into this in any detail, given that mezzanine funds are not within the scope of this survey.

Foreign tax-exempt investors

There are two main categories of foreign tax-exempt investors:

Foreign tax-exempt charitable organizations: Organizations that fall within the IRC section 501(c)(3) exemption for charitable organizations. For these organizations to claim tax-exempt status and be eligible to be exempt from withholding taxes on FDAP income, they must obtain either an IRS private letter ruling on their tax-exempt status or (more commonly) a tax opinion from reputable (in the opinion of the withholding agent) U.S. tax counsel attesting that they satisfy the criteria to claim tax-exempt status.24
Foreign governments and sovereign wealth funds: Governments and certain instrumentalities of foreign governments, e.g. pension funds and sovereign wealth funds owned by foreign governments.

Foreign tax-exempt charitable organizations

Foreign tax-exempt charitable organizations are essentially treated identically to their U.S. tax-exempt counterparts once they have either an IRS private letter ruling on their tax-exempt status or a tax opinion attesting that they qualify for tax-exempt status. Unlike foreign taxable investors, which are subject to a 30% withholding tax on FDAP income, foreign tax-exempt charitable organizations are not subject to tax on FDAP income once their tax-exempt status has been confirmed.

The one sticking point for foreign tax-exempt charitable organizations is that they, like their U.S. tax-exempt counterparts, are subject to tax on UBTI generated from their investments in PE/VC funds. Like their U.S. counterparts, they can incur UBIT from portfolio investments in a flow-through entity that conducts a trade or business, portfolio investments financed by acquisition indebtedness, or through the transaction fees and advisory fees received by the fund from portfolio investments.

As I have discussed each of these three situations in the context of U.S. tax-exempt investors, I will not repeat myself here.

Foreign tax-exempt charitable organizations do differ from their U.S. counterparts in one crucial way, though. Like foreign taxable investors, they are exempt from taxes on capital gains, even if such gains would have constituted UBTI for a U.S. tax-exempt investor. They may also claim the benefit of the portfolio interest rule.

Foreign private foundations

Foreign private foundations, which are equivalent to U.S. private foundations under IRC section 509, are subject to an additional 4% excise tax on gross income from U.S. sources, other than income that is treated as UBTI. This excise tax is to be withheld by the U.S. paying agent. Incongruously, this excise tax applies even to capital gains25 and portfolio interest income, which are not taxed for foreign taxable investors or foreign tax-exempt charitable organizations.

Foreign governments and sovereign wealth funds

The U.S. follows the generally accepted public international law doctrine of sovereign immunity: one sovereign government does not have the power to tax another sovereign government. This has been codified into law by way of provisions in the IRC, primarily section 892 and the regulations made pursuant to this section.

By default, foreign sovereigns are be treated as foreign corporations26 and be entitled to exemption from taxes on U.S. sourced capital gains. They would also be subject to the 30% withholding tax on FDAP income.

IRC section 892 takes this one step further, exempting foreign governments and their controlled entities (i.e. wholly-owned sovereign wealth funds) from U.S. federal income taxes on investment income27. This essentially eliminates the 30% withholding tax on FDAP income for foreign governments and their controlled entities.

That being said, to maintain their exemption from U.S. federal income taxes, foreign governments and their controlled entities must not engage in commercial activities anywhere in the world,28 i.e. it must have no commercial activity income (CAI) whatsoever. Because of the way that IRC section 892 is drafted (particularly the distinction drawn by the U.S. between an “integral part” of a foreign government and a “controlled entity”), if a foreign sovereign wealth fund earns any CAI, all its income, even investment income that would otherwise be exempt from taxes under IRC section 892, will be “tainted” and subject to U.S. federal income tax.

A foreign government or sovereign wealth fund can generate CAI from:

Conducting commercial activities directly29
Holding—directly or indirectly—more than 50% of the total interest (by value or by voting rights) in an entity that conducts commercial activities30
Holding—directly or indirectly—a interest that grants the foreign government or sovereign wealth fund control of an entity that conducts commercial activities31

For a sovereign wealth fund invested in a PE/VC fund, prior to the 2011 Treasury Regulations, it was possible that the investment in the fund might give rise to CAI, because the commercial activities of a partnership would be attributed to its general partner and limited partners. If any of the activities of the fund any where in the world constituted commercial activities, it would result in the sovereign wealth fund being treated as having commercial activities and being a controlled commercial entity that cannot rely on the IRC section 892 exemption. This position was, to be blunt, extremely draconian, and resulted in a lot of extra work for tax and fund structuring attorneys to ensure that the investment structure used by the sovereign wealth fund would ring-fence each potential CAI generating investment.

Since 2011, this position has been relaxed slightly by the “limited partner exception”. A sovereign wealth fund that is not otherwise engaged in commercial activities will not be treated as engaged in commercial activities solely because it holds an interest as a limited partner in a fund, provided that the sovereign wealth fund does not hold 50% or more of the interest in the fund (which would be extremely unusual for any limited partner). Instead, the sovereign wealth fund would lose its IRC section 892 exemption from taxes only on its pro rata share of the income derived from commercial activities.

Nevertheless, it is still essential for most fund sponsors to carefully consider the fund structure if they intend to raise capital from sovereign wealth funds and governmental pension plans.

Tax structuring solutions

Now that we have an understanding of the different concerns that investors in a PE/VC fund face, it is time to turn to the question of providing solutions to these concerns. For reasons of brevity and to consolidate similar solutions, I have divide the solutions into four major categories:

Solutions for UBTI, ECI, and CAI
Solutions for CFCs
Solutions for PFICs
Solutions for withholding taxes on FDAP income

Solutions for UBTI, ECI, and CAI

The solution for U.S. and foreign tax-exempt charitable organizations concerned with taxes on UBTI, foreign taxable investors concerned with U.S. federal income taxes on ECI, and foreign governments and sovereign wealth funds worried about generating CAI share certain similarities. As a general rule, some form of blocker corporation that is not treated as a flow-through entity for U.S. federal income tax purposes will be interposed between these investors and the investment that might otherwise generate UBTI, ECI, or CAI.

Income from trade or business

A blocker corporation can be interposed between the fund and the portfolio investments that generate UBTI, ECI, or CAI in one of three principal ways:

The fund sponsor can interpose a blocker corporation between the fund and the U.S. tax-exempt investors, foreign tax-exempt investors, and foreign taxable investors, i.e. a “feeder fund” structure
The fund sponsor can interpose a blocker corporation between the portfolio investments and the fund, i.e. a “subsidiary blocker” structure
The fund sponsor can establish a blocker corporation to invest alongside the fund, and allocate the capital commitments of the U.S. tax-exempt investors, foreign tax-exempt investors, and foreign taxable investors (as necessary) to the blocker corporation, i.e. a “parallel fund” or “alternative investment vehicle” structure

This blocker corporation is taxed as a corporation. As such, when it receives income that would be UBTI or ECI, it pays U.S. federal income taxes on the income. This has the effect of “cleansing” the otherwise UBTI or ECI ”tainted” income from the portfolio investment, since when the blocker corporation pays a dividend to the investors, that dividend is not income from a trade of business but rather is simply a dividend paid from retained earnings for which corporate taxes have already been paid. For the U.S. and foreign tax-exempt charitable organizations, this blocks UBTI (at the expense of a reduction in the returns from the portfolio investment due to the taxes paid). The same applies to foreign taxable investors in respect of an investment that generates ECI. For CAI, the blocker corporation does not, strictly speaking, ”block” CAI. It does, however, ring-fence the CAI generating portfolio investment from any non-CAI generating portfolio investments that the foreign sovereign wealth fund may have.

Of the three approaches, the one that offers the greatest flexibility—though with an increase in cost and complexity—is the alternative investment vehicle (AIV) structure. It is also, usually, the best option for a foreign sovereign wealth fund that seeks to avoid cross-contamination of CAI and non-CAI income.

In the interest of brevity, therefore, I will focus my attention on the use of AIVs to hold portfolio investments that would otherwise generate UBTI, ECI, or CAI. A simplified example is shown in Figure 3:

Here, the fund sponsor creates a new blocker corporation for each investment that generates UBTI, ECI, or CAI. Only the affected investors invest through the blocker corporation, and only for the affected investment. All other investments are made through the fund and without using a blocker corporation. Moreover, because investors can be allocated to different AIVs, this structure offers the fund sponsor the opportunity to ensure that an AIV is used only when strictly necessary. Since there is only partial overlap among investments that generate UBTI, ECI, and CAI, there will be times when only U.S. and foreign tax-exempt charitable organizations need to invest through a blocker corporation, and times when only foreign sovereign wealth funds must avoid contaminating their other investments with CAI. Recall that often there are negative tax consequences from the use of blocker corporations, since the blocker corporation will typically suffer some measure of tax leakage from paying corporate income taxes on its income from the portfolio investment. As such, a wise fund sponsor will use a blocker corporation only when no other commercially reasonable option presents itself.

Moreover, in some cases it may be more tax advantageous for foreign taxable investors to invest in U.S. investments that generate ECI through a U.S. blocker corporation rather than a foreign blocker corporation, if the foreign taxable investors can claim the benefit of a tax treaty with the U.S. that reduces the withholding tax on dividends paid by the blocker corporation to the foreign taxable investors. This would, of course, require careful consideration by the fund sponsor, since not all foreign taxable investors would be able to claim the benefits of a tax treaty with the U.S., but where the investor base is able to rely on this, it may be better to incorporate a blocker corporation in the U.S. rather than in a tax haven jurisdiction like the Cayman Islands.

Income from debt-financed investments

A PE/VC fund can incur UBTI from debt-financed investments if the fund either borrows money under a subscription credit facility or guarantees the borrowings to acquire or improve a portfolio investment, and the lender extends credit based on the creditworthiness of the fund rather than the borrower.

Where the fund borrows money under a subscription credit facility in order to bridge the gap between the time an investment in a portfolio company closes and the time the fund receives capital called from its limited partners, it may be possible to avoid having the IRS characterize distributions from the portfolio company as UBTI by ensuring that the following conditions are met:

The indebtedness that would have given rise to UBTI was repaid more than one year prior to the disposal of the debt-financed investment
The debt-financed investment made no distributions of income during the year that the investment was disposed of32

As a general rule, this approach is preferable where the majority of the gains from the portfolio investment is likely to be in the form of capital gains, and the indebtedness is short-term under a subscription credit facility that will be repaid at least a year before the portfolio investment is disposed of.

Alternatively, the fund may use a subsidiary blocker corporation formed in a tax haven jurisdiction to borrow money under a subscription credit facility, with the borrowings being secured by “cascading” pledges of the uncalled capital commitments of the limited partners in the fund (see Figure 4). (In a cascading pledge scenario, the fund secures its capital commitment to the subsidiary blocker corporation by pledging the unfunded capital commitments of its limited partners. The subsidiary blocker corporation in turn pledges these unfunded capital commitments to the lender to secure its obligations under the subscription credit facility.)

Transaction fees and advisory fees

U.S. tax-exempt investors, foreign tax-exempt charitable organizations, and foreign taxable investors have a vested interest in ensuring that the fund does not earn advisory fees from advising its portfolio investments, in order to minimize the risk of incurring UBIT or taxes on ECI or CAI.

The longstanding practice of PE fund sponsors is to arrange for any transaction, break-up, advisory, or monitoring fees to be paid to the general partner or investment adviser of the fund. The general partner or investment adviser then credits some or all of the fees it receives to reduce the next period’s management fee. If there is any excess of fees received over the management fee payable by the limited partners, this excess will typically be carried forward to be applied against future management fees.

Since the fees are earned by the general partner or investment adviser, the fund is not engaged in the business of providing advice to its portfolio investments, and therefore is not engaged in a trade or business that could trigger UBIT or taxes on ECI or CAI.

Solutions for CFC

As mentioned in my survey of the key principles of the CFC regime, the CFC regime applies when a U.S. person owns more than 50% of the voting rights of a foreign corporation or 50% of the total value of the stock of the foreign corporation.

Per the definition of a U.S. person under the IRC, a partnership organized in the U.S. will be treated as a single U.S. person for the purpose of determining if a foreign corporation is a CFC. Assuming that the PE/VC fund is organized as a limited partnership in a U.S. state, it will be treated as one U.S. person. For many PE funds that engage in a buyout strategy, this will result in the fund’s foreign portfolio investments being treated as a CFC, since the fund will hold a majority interest in the foreign corporation.

However, if the fund is organized as a limited partnership in a foreign jurisdiction such as the Cayman Islands, the UK, or the Chanel Islands, under the CFC rules the fund is not a U.S. person. Instead, the CFC rules would require the IRS to determine whether each partner in the fund separately is a U.S. person for the purpose of testing whether a foreign corporation is a CFC.

To make this more concrete, consider the following two examples, as shown in Table 2:

As such, if a fund sponsor expects to invest in foreign portfolio investments, and expects to include U.S. taxable investors among the limited partners of the fund, the fund sponsor often structure the fund as an “offshore” fund in a suitable jurisdiction like the Cayman Islands or the UK to minimize the risk of its foreign portfolio investments being deemed to be CFCs.

Solutions for PFIC

Recall that once a foreign corporation is treated as a PFIC with respect to a U.S. taxable investor, it retains that characteristic for as long as that investor holds an interest in the foreign corporation. To avoid the incredibly punitive PFIC tax regime, a U.S. taxable investor can either make a qualified electing fund election (QEF) or a mark-to-market election. For most U.S. taxable investors in PE/VC funds (and hedge funds that trade in illiquid securities), the QEF election is the only real option, since marking to market would require there to be a regularly traded market for such securities.

The QEF election must be made in the first year that a foreign corporation is classified as a PFIC, otherwise the U.S. taxable investor will have to apply for a private letter ruling from the IRS to allow it to make a retrospective QEF election.

A U.S. taxable investor that makes a QEF election must file a tax return reporting its pro rata share of the ordinary income and capital gains of the PFIC for that fiscal year, and pay the applicable ordinary income and capital gains taxes on that amount regardless of whether the PFIC has made any distributions to it. When the PFIC does make a distribution to the U.S. taxable investor, the investor will not be taxed on the portion of the distribution which relates to amounts for which the investor has already paid taxes. As for the portion for which taxes have not already been paid during a prior fiscal year, the U.S. taxable investor will be taxed on this amount in accordance with the tax rates for ordinary income and capital gains.

To calculate its pro rata share of ordinary income and capital gains attributable to its investment in a PFIC a U.S. taxable investor will require certain information from each foreign corporation that is classified as a PFIC. This information would need to be provided on an annual basis in a “PFIC Annual Information Statement”. As such, U.S. taxable investors will typically require the fund sponsor to use reasonable efforts to obtain such information for any investment in a PFIC.

Solutions for minimizing withholding taxes on FDAP income

There are two principal methods used by foreign taxable investors to minimize withholding taxes on FDAP income:

The portfolio interest exemption
Tax treaties between the foreign taxable investor’s country of residence and the U.S.

Portfolio interest

While interest income is typically FDAP income and subject to a 30% withholding tax, there is a way for foreign taxable investors to reduce the withholding tax due on certain forms of interest income to 0% by using the “portfolio interest rule”.

The portfolio interest rule applies to interest income where all of the following conditions are satisfied:

The debt instrument to which the interest income relates is in a registered form
The debt instrument to which the interest income cannot be transferred to U.S. persons or transferred directly between two non-U.S. persons
The interest on the debt instrument cannot be determined by reference to contingent events such as income, cash flow, or the value of property held by the borrower
The foreign lender is not a CFC, is not a bank, and is not conducting a U.S. trade or business
The foreign lender holds less than 10% of the equity of the borrower (after giving effect to the attribution rules and constructive ownership rules in the IRC) 34

Unless there are countervailing considerations, a shrewd fund sponsor will typically structure its investments such that foreign taxable investors can use the portfolio interest rule to reduce the amount of taxes paid on at least some part of its investment in a U.S. portfolio investment. This can be done by structuring part of the investment in the U.S. portfolio investment to be in the form of interest-bearing debt lent to an intermediate holding company, which reduces the taxable income of this company and minimizes the withholding tax on interest paid to the foreign taxable investors. This structuring will often involve balancing thin capitalization considerations, especially in light of the IRS’s interest in ensuring that intercompany debt is not used in an abusive manner.

Tax Treaties

As of June 2015, the U.S. has tax treaties with 68 countries. These treaties frequently reduce the applicable withholding tax on dividends to 10 – 25%, while the withholding tax on interest is reduced to 0 – 17.5%. As such, to the extent that a foreign taxable investor is resident in a tax treaty jurisdiction, and provided that the U.S. portfolio investment will not generate ECI or be subject to the FIRPTA rules for real property holding companies, the foreign taxable investor will likely find it preferable for the fund to invest directly in the U.S. portfolio investment, such that the foreign taxable investor can make use of the preferential tax treaty rate for dividends and interest, while also relying on the general exemption of foreign investors from long-term capital gains taxes on the disposal of a U.S. investment.

Conclusion

Structuring a PE/VC fund that satisfies the tax structuring needs of the diverse U.S. and foreign investors that form the typical PE/VC limited partner base is not an easy task. It will often be the case that a fund sponsor with a global investment strategy will have no choice but to develop a complex set of investment vehicles tailored to the different needs of its investors.

It is for this reason that a wise fund sponsor will find that a good fund structuring team consisting of attorneys familiar with securities laws, private equity investments, and tax laws will be worth their weight in gold.