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Structuring Foreign UBTI Blocker Corporations

for Exempt Orgs: Offshore Blockers to

Hold Alternative Investments Nonprofit Entities Owning Private Equity, Hedge Funds and Offshore Funds

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

TUESDAY, DECEMBER 19, 2017

Presenting a live 90-minute webinar with interactive Q&A

Marguerite R. Lombardo, Senior Counsel, Proskauer Rose, Boston

Brian D. Huber, Senior Counsel, Proskauer Rose, Boston

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35.

FOR LIVE EVENT ONLY

Structuring Foreign UBTI Blocker

Corporations for US Tax-Exempt

Organizations

Brian Huber Senior Counsel, Proskauer Rose LLP

Marguerite Lombardo Senior Counsel, Proskauer Rose LLP

Strafford Webinar December 19, 2017

5

Not Tax Advice

THE INFORMATION CONTAINED IN THIS PRESENTATION IS FOR INFORMATIONAL PURPOSES ONLY AND IS NOT TAX ADVICE. ORGANIZATIONS SHOULD CONSULT THEIR OWN TAX ADVISORS WITH RESPECT TO THEIR PARTICULAR SITUATIONS.

December 19, 2017 Strafford Webinar

6

Agenda

1. UBTI and UBIT impact on private equity and hedge funds

2. Foreign and Domestic Blocker Corporations

Assets commonly held, capitalization and tax leakage

3. Required US federal income tax filings for US Tax-Exempt

Investors Related to Foreign Blocker Corporations

4. Certain tax and operational risks/considerations


UBTI and UBIT Impact

on Private Equity and Hedge Funds

8

UBTI and UBIT Impact on Private Equity and

Hedge Funds

• US Tax-Exempt Investors: Include US organizations such

as universities, endowments, private foundations, charities

and pension funds

• What about state and local government “super tax-exempt”

pension plans?

Conference Committee Bill*: does not include provision

addressing, although a provision had been included in the

House Bill (but not the Senate Bill)

* Tax Cuts and Jobs Act Bill as released on December 15, 2017


9


Hedge Funds

• US Tax-Exempt Investors are generally exempt from US

federal income tax, but subject to tax (the “unrelated

business income tax” or the UBIT) on “unrelated business

taxable income” (UBTI)

Tax rates that apply are regular graduated corporate or trust

rates depending on whether the US Tax-Exempt Investor is a

corporation or a trust

• UBTI includes “unrelated debt-financed income” (UDFI)

• Charitable remainder trusts (CRTs) instead subject to 100%

excise tax on any UBTI


10


Hedge Funds

• Required to file IRS Form 990-T (Exempt Organization

Business Income Tax Return) if $1,000 or more of gross

income from an unrelated business

• State and local taxes and tax filing obligations may also

apply

• UBTI is income “derived by any organization from any

unrelated trade or business…regularly carried on by it.”

§512*

* All § references are to the US Internal Revenue Code of 1986, as amended


11


Hedge Funds

• Definition of “unrelated trade or business” has 2 elements:

Trade or business (within the meaning of §162)

o Activity carried on for the production of income

Unrelated to the organization’s exempt purpose

o Not “substantially related” (aside from the production of funds) to the

performance of the charitable, educational or other activities that are

the basis of its exemption. §513

• “Regularly carried on” requirement

• Can arise from trade or business anywhere in world – not

required to be a US trade or business


12


Hedge Funds

• Most passive income generally is excluded from UBTI. §

512(b) generally excludes:

Capital gains

Dividends

Interest

Royalties

Loan commitment fees

But see next slide ….

Payments with respect to securities

loans

Annuity payments

Most rents from real property


13


Hedge Funds

• HOWEVER, if the passive income is UDFI, it will be

treated as UBTI

• UDFI is certain income from property with “acquisition

indebtedness.”

• “Acquisition indebtedness” is indebtedness incurred in the

acquisition or improvement of property; a “but for” and

“reasonably foreseeable” test casts a wider net. §514(c)


14


Hedge Funds

• UDFI includes:

Income from property subject to “acquisition indebtedness” at

any time during the taxable year

Gain from a disposition within 12 months after the “acquisition

indebtedness” was paid off

• Calculation of amount of UDFI is adjusted to take into

account percentage of leverage and length of time

outstanding

• Special exceptions may apply such as “fractions rule” in

certain real estate funds


15


Hedge Funds

• If fund is a partnership for US federal income tax purposes,

any UBTI/UDFI will flow through the fund to US Tax-Exempt

Investors

• This flow through treatment applies regardless of:

how many tiers of tax transparent entities for US tax purposes

whether entities are formed under US or non-US law


16

Tax Legend

Partnership for US tax purposes

Corporation for US tax purposes

Investor Grouping


17


Hedge Funds

• UBTI/UDFI Flows

Through Tiers of Tax

Transparent Entities

for US Tax Purposes

Fund

(US or Non-US)

Holding

Vehicle

UBTI UDFI

Operating

Restaurant LLC

Operating Business Acquisition Indebtedness

US Tax-Exempt

Investors


18


Hedge Funds

• Two common sources of UBTI in private equity or hedge

funds:

An equity investment in a partnership for US tax purposes that is

engaged in a trade or business (Operating Flow Through)

UDFI as a result of borrowing directly by the fund or through a

lower tier partnership for US tax purposes

• May also be other sources of UBTI (e.g., fees for services)

• Funds of funds – remember, UBTI/UDFI flows through tiers

of tax transparent entities for US tax purposes


19


Hedge Funds

• Fund agreement may or may not have an undertaking to

avoid or minimize UBTI/UDFI depending on fund strategy,

intended investments and whether the fund is offering a

blocker structuring option for US Tax-Exempt Investors

• If there is an undertaking, consider whether there are

carveouts


20


Hedge Funds

UBTI/UDFI Consequences in an Unblocked Structure

Fund

(US or Non-US)

US Tax-Exempt

Investors

Portfolio

Investment

Other

Investors Consider:

• Operating Income

• Treatment of sale of portfolio

investment by Fund

• Treatment of sale of interest in

Fund by US Tax-Exempt

Investor

- IRS TAM 9651001 Operating Flow

Through


Acquisition

indebtedness

21


Hedge Funds

• Net gains from one unrelated trade or business against

losses from another?

Conference Committee Bill:

o UBTI determined on a business-by-business basis; cannot

use losses from one business to offset gains from another

o Effective for taxable years beginning after December 31, 2017

o Special transition rule for net operating losses arising in a

taxable year beginning before January 1, 2018


Blocker Corporations – Foreign

24


• Foreign Blocker Corporations typically used:

Where fund expects to use leverage as part of its investment

strategy and expects to give rise to UDFI

Material US taxes are not expected on the Foreign Blocker

Corporation

Common in hedge funds

Also see in private equity funds


25


• Legal form of Foreign Blocker Corporation may or may not

be a corporation, but it is a corporation for US tax purposes

IRS Form 8832 “check the box” elections

• Blocker Corporations can be structured different ways, but it

is common for a Foreign Blocker Corporation implemented to

block UDFI to be either a feeder fund or a parallel fund

• US Tax-Exempt Investor might form its own Foreign Blocker

Corporation


26


• US Tax-Exempt Investors typically own equity interests in the

Foreign Blocker Corporation

Leverage capitalization generally not used

• Non-US Investors often participate in structure with US Tax-

Exempt Investors


27


Foreign Blocker Corporation – Feeder Fund

Fund

Feeder Fund

Foreign Blocker

Corporation

Acquisition

Indebtedness

Other

Investors

US Tax-Exempt

Investors


28


Foreign Blocker Corporation – Parallel Funds

Fund - A

Fund -B

Foreign Blocker

Corporation

Acquisition Indebtedness

Other

Investors US Tax-Exempt

Investors

Acquisition Indebtedness


29


US Federal Income Tax Consequences to US Tax-Exempt

Investor of Investing in Foreign Blocker Corporation*

• Blocked from receiving UBTI/UDFI

• Dividends paid by the Foreign Blocker Corporation not

treated as UBTI/UDFI

• Gain on sale of Foreign Blocker Corporation shares/upon

liquidation of shares not treated as UBTI/UDFI

* Assumes US Tax-Exempt Investor did not borrow to acquire its interest in the

Foreign Blocker Corporation/interest is not debt-financed


30



Investor of Investing in Foreign Blocker Corporation*

• No UBTI under “passive foreign investment company” (PFIC)

rules

• No UBTI under “controlled foreign corporation” (CFC) rules

Exception for insurance income

Expansion of CFC rules under Conference Committee Bill


Foreign Blocker Corporation/interest is not debt-financed


31


US Federal Income Tax Consequences to Foreign Blocker

Corporation

• Assuming the Foreign Blocker Corporation is not treated as

engaged in a US trade or business:

Capital Gains: Not subject to US tax

US Source Dividends: 30% US withholding tax

US Source Interest: 30% US withholding tax

Other US Source Fixed Determinable Annual or Periodical

Income (FDAP): 30% US withholding tax


32



Corporation



Foreign Blocker Corporation may be eligible for “portfolio

interest exemption” which provides for a 0% rate of withholding

on interest if certain requirements are met, including that the

Foreign Blocker Corporation owns (i) in the case of an obligor

that is a corporation, less than 10% of the total combined voting

power of all classes of stock of such corporation entitled to vote

or (ii) in the case of obligor that is partnership, less than 10% of

the capital and profits in the partnership


33



Corporation



Unlikely that the Foreign Blocker Corporation is eligible for a

reduction or exemption from US withholding tax under a US tax

treaty since the Foreign Blocker Corporation is typically formed

in a jurisdiction that does not have an income tax treaty with

the US


34



Corporation

• If the Foreign Blocker Corporation is engaged in a US trade

or business/receives income treated as “effectively

connected income” (ECI):

Gain from the disposition of a “United States real property

holding corporation” (USRPHC) or other “United States real

property interest” (USRPI) under Code Section 897: subject to

tax at regular graduated US corporate rates

Operating Income: subject to tax at regular graduated US

corporate rates

Additional 30% “branch profits tax” may apply


35


If the Foreign Blocker Corporation is engaged in a US trade

or business/receives income treated as “effectively

connected income” (ECI):

• Gain from the disposition of an interest in a US Operating

Flow Through - Conference Committee Bill:

Codifies Rev. Rul. 91-32, thereby reversing the recent Tax Court

decision in Grecian Magnesite;* gain on sale of a US Operating

Flow Through treated as ECI; applies to sales, exchanges and

dispositions on or after November 27, 2017

10% buyer withholding tax obligation unless buyer receives

affidavit from seller that it is not a foreign person; applies to

sales, exchanges and dispositions after December 31, 2017

*Grecian Magnesite Mining, Industrial & Shipping Co., S.A., v. Commissioner, 149 T.C. No. 3


36


• Will the Foreign Blocker Corporation be subject to non-US

tax?

Foreign Blocker Corporation typically is organized in a

low/no tax jurisdiction

If non-US investments will be made, consider whether Foreign

Blocker Corporation may be subject to any non-US withholding,

capital gains or other taxes

• Foreign Blocker Corporation might be subject to tax on

income that US Tax-Exempt Investor would not have been

subject to if invested directly (not through the Foreign Blocker

Corporation)


37


• Also consider:

FATCA Compliance

CRS Compliance


Blocker Corporations – Domestic

40


• Domestic Blocker Corporations are typically used to block

UBTI from operating income, such as an investment in a US

Operating Flow Through

• Domestic Blocker Corporations can be structured in many

different ways including:

Above the Fund

Below the Fund

Outside the Fund through Alternative Investment Vehicle

Structures


41



Investor of Investing in Domestic Blocker Corporation*

• Blocked from receiving UBTI/UDFI

• Dividends paid by the Domestic Blocker Corporation not

treated as UBTI/UDFI

• Gain on sale of Domestic Blocker Corporation shares/upon

liquidation of shares not treated as UBTI/UDFI


Domestic Blocker Corporation/interest is not debt-financed


42


US Federal Income Tax Consequences to Domestic

Blocker Corporation

• Subject to tax at regular graduated US corporate rates

• If Domestic Blocker Corporation sells portfolio investment,

any gain on sale will be subject to blocker level tax

• If exit is through sale of Domestic Blocker Corporation stock,

then capital gain is exempt from UBTI (assuming not UDFI)


43


US Federal Income Tax Consequences to Domestic

Blocker Corporation

• Domestic Blocker Corporation may be capitalized with both

debt and equity

Interest deductions related to debt reduce taxable income of

Domestic Blocker Corporation, subject to applicable limitations

on interest deductions

Interest payments on shareholder debt to US Tax-Exempt

Investor generally exempt from UBTI, unless Blocker

Corporation is a “controlled entity” under § 512(b)(13)


44


US Tax-Exempt Investor is a Controlling Entity

AIV

Domestic

Blocker

Corporation

Controlled

Entity

Controlling US Tax Exempt Investor

Owns more than 50% of vote or value

Other Investors

US Operating Flow Through

Capitalized with

Shareholder loans and Equity

Interest received or accrued by

controlling US Tax-Exempt Investor

from Controlled Entity treated as UBTI

to the extent it reduces the net

unrelated income, or increases the net

loss, of the Controlled Entity.


Required US Federal Income

Tax Filings for US-Tax Exempt

Investors Related to Foreign

Blocker Corporations

46

Foreign blocker corporation – US Federal

Income Tax Filings Requirements of US

Tax-Exempt Investors

• Circumstances in which an IRS Form 926 (Return by a US

Transferor of Property to a Foreign Corporation) must be

filed include:*

A US person who transfers cash to a foreign corporation must

report the transfer if:

o immediately after the transfer the person holds directly or

indirectly at least 10% of the total voting power or the total

value of the foreign corporation or

o the amount of cash transferred by the person to the foreign

corporation during the 12-month period ending on the date

of the transfer exceeds $100,000

*Does not describe all circumstances in which an IRS Form 926 must be filed


47




• Circumstances in which an IRS Form 5471 (Information

Return of US Persons With Respect to Certain Foreign

Corporations) must be filed include:*

A US person who acquires stock in a foreign corporation which

either by itself, or when added to any stock owned on the date of

acquisition, equals:

o 10% or more of the total value of the foreign corporation’s

stock or

o 10% or more of the total combined voting power of all

classes of stock with voting rights

*Does not describe all circumstances in which an IRS Form 5471 must be filed


48


Income Tax Filings Requirements of US Tax-

Exempt Investors

• IRS Form 8621 (Information Return by a Shareholder of a

Passive Foreign Investment Company or Qualified Electing

Fund) generally should not be required to be filed by a US

Tax-Exempt Investor unless US Tax-Exempt Investor

borrows to acquire its interest in the Foreign Blocker

Corporation/interest is debt financed

• IRS Form 8938 (Statement of Specified Foreign Financial

Assets) generally should not be required to be filed by a US

Tax-Exempt Investor


49




• Circumstances in which a FinCEN Form 114 (Report of

Foreign Bank and Financial Accounts – “FBAR”) must be

filed include:*

The Foreign Blocker Corporation has a financial account

(including a securities, brokerage or checking accounting)

located outside of the United States and the US person owns,

directly or indirectly:

o more than 50% of the total value of shares of stock or

o more than 50% of the voting power of all shares of stock

Aggregate value of the US person’s applicable foreign financial

accounts exceeds $10,000 at any time during the calendar year


*Does not describe all circumstances in which an FBAR must be filed

Certain Tax

and Operational

Risks/Considerations

51

Certain Tax and Operational


• Is filing US tax returns, including state tax returns, with

respect to UBTI a problem for the US Tax-Exempt Investor?

If yes, then US Tax-Exempt Investor has less flexibility

• If US Tax-Exempt Investor can choose between investing

through a Blocker Corporation vs. investing unblocked, then

generally an economic decision


52

Certain Tax and Operational


• Blocker Structures can be complex – internal resources

required to review structures

• Consider Blocker Corporation costs in addition to any tax

leakage

• Will the Blocker Corporation be respected?

IRS Private Letter Rulings with respect to Foreign Blocker

Corporations

• Risks related tax treatment of debt capitalization

• Uncertainty in tax laws


Thank You

Brian Huber Senior Counsel, Proskauer Rose LLP

617-526-9675

[email protected]

Marguerite Lombardo Senior Counsel, Proskauer Rose LLP

617-526-9472

[email protected]

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