Tax Considerations for Funds with Tax-Exempt and Foreign Investors
Articles by: Richey May, Jan 07, 2020
By Alex Navran, Tax Supervisor and Eric Essian, Senior Tax Manager
When creating and structuring a prospective alternative investment vehicle or family of entities, it is important to consider the tax impact that both tax-exempt and foreign investors may have on your fund. At Richey May, we provide resources to help determine the impact of these investors, as there are certain tax rules to navigate to provide the most tax efficient result for all investors. Unrelated business taxable income, effectively connected income, withholding agent responsibilities, and proper U.S. tax classification are important items you should take into consideration when forming a fund structure, so we have provided more detail on each of these areas below.
Unrelated Business Taxable Income (UBTI)
Unrelated Business Taxable Income (“UBTI”) is income that is taxable to tax-exempt entities. It is the product of those entities engaging in taxable activities, that are not substantially related to the purpose of the organization in which they are invested. Income from investment activities carried on within an alternative investment fund (interest, dividends and capital gains) is generally not taxable to tax-exempt entities. However, there are instances in which UBTI are generated by investing in an alternative investment fund.
Several common activities can trigger UBTI in a fund. Funds that have tax-exempt investors need to be aware of these triggers:
- The most notable trigger is trading on a margin account (or the use of other debt/leverage to purchase portfolio assets). Funds may from time to time strategically use leverage in their trading strategy. There can be tax consequences to doing this, however.
- The other main trigger of UBTI is investing in underlying partnerships (or any other “U.S. Trade or Business”). If lower tier partnerships incur UBTI or generate income that would be considered UBTI to an upper tier partnership, it will ultimately be passed through to the fund. UBTI is something for fund managers to consider before they bring tax-exempt investors into their funds.
There are ways to mitigate UBTI from within certain fund structures. Various offshore blockers can be employed in certain cases to block the UBTI from flowing to tax-exempt investors. Alternatively, tax-exempt investors could be placed into a side pocket within the existing fund (away from the UBTI generating investments).
Excise tax derived from UBTI is generally reported on form 990-T. The account custodian normally prepares this form, with certain exceptions.
Effectively Connected Income (ECI)
While UBTI relates to tax-exempt investors, Effectively Connected Income (“ECI”) is income that is “effectively connected” to, or generated from, a U.S. Trade or Business and is taxable to foreign investors in U.S. alternative investment funds.
Like UBTI, portfolio income (interest, dividends, capital gains, etc.) is generally not subject to ECI tax, but some of the same triggers of UBTI can also trigger ECI for foreign investors in U.S. funds. Generally, ordinary income from running a business, as well as real estate income are subject to ECI when passed through to the fund. Underlying partnership investments (private partnerships, publicly traded partnerships, and master limited partnerships) have the potential to pass through ECI. This is something for fund managers to consider before bringing foreign investors into their funds.
The most common way for fund structures to avoid ECI to its foreign investors is to create a foreign blocker vehicle. This can be accomplished in both a master-feeder fund and a mini-master fund, among other strategies, but these two are most common within the industry.
From a reporting standpoint, the fund is responsible for withholding on ECI on behalf of their investors and filing forms 8804 and 8805 with the IRS timely.
Fixed, Determinable, Annual or Periodic (“FDAP”) Income
Similar to ECI, withholding also applies to foreign investors in U.S. funds who are allocated FDAP income. The most common sources of FDAP income are interest, dividends, rents, and royalties, and the standard withholding rate is 30%. However, for countries that have tax treaties with the United States, there may be a lower withholding rate that would be applied if foreign investors were domiciled in such countries.
There are exceptions to the required 30% (or lower) withholding rate for certain income activities or foreign entities. The income earned must be U.S. source in nature; for example, foreign interest, dividends, rents, royalties, etc. do not fall under the U.S. taxing regime. There are also exception codes on form 1042 and 1042-S that reduce or remove entirely withholding obligations.
FDAP income withholding is reported on Forms 1042 and 1042-S. Under the recently enacted Tax Cuts and Jobs Act (“TCJA”), there have been changes to the rules and deadlines for filing form 1042, which the fund, as a withholding agent, must comply with.
Foreign Fund Structures and the “Check the Box” election
Form 8832 is a multi-purpose form that allows domestic and foreign entities to change their entity classification for U.S. tax purposes, but without changing the entity type for legal purposes. It can also allow a foreign fund that is registered offshore (Cayman Islands, British Virgin Islands, etc.) to elect to be treated as a U.S. Taxpayer. This can be desirable for master-feeder fund structures who want to open the offshore funds to U.S. investors. If an offshore fund elects to be treated as a partnership for U.S. tax purposes, that entity will file a U.S. partnership return (Form 1065) and will issue a K-1 to the domestic feeder fund, as well as any U.S. investors within the offshore master fund.
The main benefit of treating an offshore entity making the check-the-box election as a U.S. entity for tax purposes is for the flow through of income generating activities to reach their investors via Schedule K-1. Alternatively, without making the check-the-box election, U.S. investors may be subject to Passive Foreign Investment Company (PFIC) or Controlled Foreign Corporation (CFC) rules, which are more disadvantageous to U.S. investors.
If you have any questions about forming a fund structure, determining the impact of these investors, or minimize the tax impact for investors, please contact Stephen Vlasak.