Foreign Investment into Domestic Private Equity Funds: A Basic Individual Perspective

Foreign direct investment into the United States continues to increase year over year, despite the nation’s enormous cumulative deficit. Overseas investors still choose to purchase American investments for many reasons, including the U.S.’s highly developed, liquid and efficient financial markets, as well as its strong institutions and robust corporate governance. Those investors may also have close linkages with the U.S. generally or are resident in a politically or financially unstable country and wish to deploy their capital more safely. One popular route for U.S. investment among high-net-worth foreign citizens has increasingly become domestic private equity funds. Thus, CPAs with an international practice are now frequently confronted with an understandably perplexed foreign citizen client who forwards to them a package of dense documentation from their U.S. investment adviser, and the client then naturally wants to know how making this investment could affect their U.S. tax exposure.

Initial Tax Implications

Reviewing private placement memoranda, fund operating agreements and subscription documents (which is best done in conjunction with the client s domestic counsel) is critical, but the tax issues in this context can be straightforward. Typically, U.S. private equity funds are organized as partnerships for tax purposes, which ensures that the foreign investors in the fund will not, assuming the fund is not engaged in a U.S. trade or business, be subject to federal income tax on their distributive share of capital gains from the sale of fund investments (unless, importantly, a  U.S. real property interest is sold, but that is another discussion, as is the varied approach taken by the states in these situations). The fund’s status as a partnership also often allows for the tax-free distribution of appreciated stock and securities to the investors, and a foreign investor s sale of their interest in the fund itself should not, in most cases, be subject to federal income tax.

Difficulties can arise, however, when the fund is generating income that is effectively connected with the conduct of a U.S. trade or business. Foreign persons must pay federal income tax on any effectively connected income ("ECI"). If that person invests in a partnership that is engaged in a U.S. trade or business (an ETB partnership; what constitutes the conduct of a U.S. trade or business in this context is a factual question, but investment in active domestic operating companies, for example, will often qualify), they will be treated as engaged in a U.S. trade or business themselves. Under Section 875 of the Internal Revenue Code of 1986, as amended (the Code), a partnership s U.S. trade or business activities will be attributed to its foreign partners regardless of how many intermediate partnerships separate the foreign partner from the ETB partnership. An ETB partnership must withhold tax on any ECI of the partnership allocable to its foreign partners, and those partners are required to file U.S. federal income tax returns.

Use of a Blocker Corporation

A common method of avoiding the onerous consequences of ECI involves interposing a corporate blocker between the foreign individual investor and the ETB partnership. The blocker can be domestic or foreign, and the latter option is often particularly attractive because, assuming the blocker resides in a jurisdiction that has a tax treaty with the U.S., the blocker’s ECI will not be taxable unless attributable to a U.S. permanent establishment. The blocker, being a discrete taxpayer, will report and pay tax on the operating profits of the ETB partnership that would otherwise be reportable by the foreign investors, thereby avoiding the individual attribution of those activities under Code Section 875, as well as obviating the need for foreign investors to file federal income tax returns.

Blocker structures can be quite variable as they can be organized above or below the fund, or they may not even be offered by the fund, which might instead permit individual investors to invest in the fund through their own blocker in connection with investments in ETB partnerships. When analyzing the attendant U.S. tax consequences of investing in ETB partnerships through a blocker, it is especially important for CPAs to consider the initial funding of the blocker (debt or equity), any associated foreign currency issues, the nature of the distributions made by the blocker and whether the foreign investor will exit the investment by selling the blocker s shares. Therefore, great care should be taken to evaluate all fund investment documents and timely make any tax-favorable elections for foreign individual investors with the fund manager. In conjunction with this, CPAs should also review whether a tax treaty can benefit the investor at an individual level by reducing or eliminating withholding tax on certain types of income generated by investing in the fund.