Many foreign governments in private equity funds do not heavily negotiate and instead prefer to pursue side letter protections on key points, such as withholding and income from direct or indirect commercial activities. However, a foreign government is not a typical foreign investor and significant participation by foreign governments in a private equity fund has led to some unexpected tax issues.
These tax issues have recently become prevalent as more and more investments are made by private equity funds in portfolio companies that are pass-through entities, such as partnerships or limited liability companies.
Sellers of such companies retaining a portion of their ownership in the acquired companies have already enjoyed pass-through tax treatment and prefer to continue to take advantage of such treatment. In addition, U.S. taxable investors in private equity funds, including sponsors themselves, have become more cognizant of the tax efficiency of pass-through entities and prefer to take advantage of pass-through treatment when they can.
As a result, while most sponsors provide protection from UBTI (unrelated business taxable income) to their tax-exempt investors and from ECI (effectively connected income) to their offshore investors, sponsors frequently split their ownership in pass-through portfolio companies between corporate (i.e., “blocked”) and pass-through (i.e., “unblocked”) vehicles. The split provides protection from UBTI and ECI for sensitive investors and pass-through tax efficiency for non-sensitive investors. Let’s look at a few common situations you may find yourself in.
Case # 1: A foreign government is one of a few sensitive investors:
A private equity fund is investing in a portfolio company that is a pass-through entity (say, a partnership). For the UBTI and ECI reasons described above, a portion of the investment will be blocked (held through a domestic corporation) and a portion will be unblocked. Due to the mix of investors who wish to be blocked from ECI and UBTI, the foreign government ends up with 50 percent or more of the ownership of the corporate blocker.
Case # 2: A foreign government is a significant fund Investor:
A private equity fund is investing in a corporate portfolio company and the foreign government ends up with 50 percent or more of the ownership of the portfolio company because (a) the private equity fund is a captive fund (b) significant investors opt out of the particular investment or (c) the foreign government utilizes its co-invest opportunities more than other investors.
Case # 3: A foreign government is in a pledge fund or similar arrangement:
A sponsor is offering an opportunity for an investment in a corporate portfolio company but has no firm commitments. The foreign government ends up with 50 percent or more of the ownership of the portfolio company due the uncertain mix of investors.
The common theme of these cases is a foreign government controlling a domestic corporation with business activities. Ownership in a domestic corporation would not violate the UBTI and ECI protections offered by the sponsor to the tax-exempt and generic offshore investors but still presents an issue for the foreign government under Internal Revenue Code Section 892.
As an offshore investor, foreign governments are not subject to U.S. tax on the sale of stock in domestic corporations (other than U.S. real property holding corporations), even absent the protection offered by Code Section 892. In addition, as noted above, as an offshore investor in most private equity funds, foreign governments are typically already protected from ECI. The benefit of Code Section 892 is the protection from U.S. taxes on dividends and certain interest derived from portfolio investments made by the fund. These items are otherwise taxable for foreign investors but may be tax free for the foreign governments if Code Section 892 applies.
Code Section 892 exempts foreign governments from U.S. tax on income received from U.S. investments excluding income derived from controlled commercial entities. The term “controlled commercial entities” includes entities engaged in commercial activity that are owned 50 percent or more by a foreign government or under the effective control of the foreign government. Under the circumstances described in cases #1-3 above, certain interest and dividends received by the foreign government from the controlled portfolio companies are excluded from Code Section 892 and may be subject to U.S. tax.
There is a potential structural solution to the problem (particularly in case #1 above). Under proposed regulations, a controlled entity will not be considered engaged in a commercial activity if it owns nothing but a (a) limited partnership interest or (b) an LLC interest that has no right to participate in the management and conduct of the LLC’s business. Thus, when structuring a pass-through investment made by a blocker corporation for sensitive investors, using a limited partnership form for the pass-through entity held by the blocker corporation would be advisable. Alternatively, if an investment must be in LLC form, providing the controlled blocker with a non-managing interest that has full economic rights but only limited management and voting rights would also be prudent.
Isaac Grossman is a partner at Morrison Cohen and chair of its tax department.