Entities engaging in capital raising activities need to understand the implications of the domicile of their investors. As part of their capital formation strategies, private equity and venture capital funds routinely raise significant capital from tax-exempt organizations and non-U.S. investors. Those funds must take special care to shield their tax-exempt and foreign investors from a large bill from the IRS when investing in companies subject to certain domestic tax structures.
A commonly used tool to provide advantageous results for tax-exempt organizations and non-U.S. investors is the “blocker” corporation. A blocker corporation is formed by the PE or VC fund to invest on behalf of foreign and tax-exempt investors. As the name suggests, the blocker entity acts as a barrier between the investors and the investment and, most importantly, converts any gains from that investment into corporate dividends distributed by the blocker entity. Dividends, interest, and capital gains are generally not subject to federal taxes for non-U.S. and tax-exempt investors.
The blocker corporation itself must pay U.S. taxes, but the blocker structure permits the non-U.S. and tax-exempt investors from giving up their tax-advantaged status—something they are understandably anxious to retain.
PASS-THROUGH PROBLEMS
The need for a blocker structure is usually triggered when a fund invests in a limited liability company or any other company that is designed as a pass-through for tax purposes (i.e., the tax liabilities of the company are passed through to its owners). Since the 1990s, the LLC has become an increasingly common organizational structure under various state laws and is often used in lieu of the C-corp structure because of its potential tax benefits.
For a tax-exempt organization, proceeds from a direct investment in a pass-through entity may be classified as “unrelated business taxable income,” or UBTI. Under 26 U.S. Code, Sect. 513, “unrelated trade or business means…any trade or business the conduct of which is not substantially related…to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption.”
Non-U.S. investors face a similar issue. Under 26 U.S. Code, Sect. 864, a non-U.S. resident or foreign corporation “engaged in trade or business within the United States” may be taxed on income “effectively connected with the conduct of trade or business within the United States.” In other words, “effectively connected income,” or ECI, forces the foreign investor to file a U.S. tax return and pay taxes just like a U.S. company or individual.
ECI can also be generated in other circumstances, such as specific real estate investments. The Foreign Investment Real Property Tax Act of 1980, for example, treats gains realized by a foreign investor on real property interests in the United States as effectively connected income. A fund that invests in a real property holding company—one with more than half of its gross assets in real property interests—may require a blocker structure to shield foreign investors from tax liabilities.
A COMMON ISSUE
Given the LLC’s popularity, the blocker structure has become a widely used tool for funds and their foreign and tax-exempt investors. Language protecting the rights of those investors is often added directly to a private equity or venture capital firm’s governing documents or partnership agreements.
While a blocker structure may be a necessary capital formation strategy to secure investment from a tax-exempt organization (like a large pension fund) or a foreign entity (such as a sovereign wealth fund), funds must also consider the downsides to the structure. Funds investing in a pass-through entity like an LLC usually sell stock in the blocker corporation to exit the investment. If the blocker corporation sells its equity in the underlying pass-through, taxes may be collected inside the blocker entity and at the time any proceeds are distributed to the fund.
In addition, if the fund sells stock in the blocker corporation, the acquiror may see tax advantages reduced because the sale of blocker stock does not produce the same tax benefits as selling LLC equity. In this scenario, private equity and venture capital funds routinely negotiate terms that allow them to exit the blocker without additional tax burdens.
As a PE or VE firm may ponder investments that involve foreign or non-U.S. investors and pass-through portfolio companies, the firm should work closely with its legal counsel to structure blocker corporations in a fashion that allows it to exit an investment without putting the fund at a significant tax disadvantage.
To learn more about blocker corporations and other capital formation strategies, contact us for a consultation.