Authored by: Gregory Kastner
Use of blockers
To avoid the often onerous income tax withholding requirements, hedge funds and private equity managers sometimes implement structures known as “blockers.” These so-called “blockers” are generally corporations that pay entity level tax themselves and do not pass through the attributes of income they receive to their owners as partnerships and S Corporations do.
U.S. income subject to taxation
An entity or individual that receives United States sourced income is required to pay U.S. income tax. An exception to this is if the entity does not pay tax itself, but rather, as a partnership or S corporation, passes its income through to its owners. However, being a pass-through entity does not automatically exclude it from the need to pay taxes. Some states have entity level taxes, such as California’s limited liability fee that is based on gross California-sourced income. Many jurisdictions, including the U.S. federal government, also may require a pass-through entity to withhold taxes on income that is sourced to that jurisdiction. Many states tweak that rule to require withholding on only distributions of income that is sourced to that state as opposed to when the income is earned. On U.S. federal sourced income, there may be a treaty in place between the country of residence of the individual or corporation and the United States government that may reduce the withholding rate of tax or, in some cases, eliminate it altogether. For so-called tax haven countries such as the Cayman Islands, generally no treaty rate is available. If the foreign individual or entity can show they have losses that would reduce or eliminate the U.S. tax, they can file a U.S. return to ask for a refund, but they must file which in turn requires informational and economic disclosures they are often reluctant to reveal.
Certain types of U.S. income relevant to investment vehicles such as hedge funds and private equity are excluded from federal withholding under Internal Revenue Code (IRC) §871. Capital gains paid to aliens in the United States 182 days or less and portfolio interest are both excluded. Portfolio interest is defined as that which is paid on an obligation that is in registered form and cannot be paid to a 10 percent or greater shareholder and cannot be contingent on profits or income. A misclassification to be wary of is money market funds that actually pay dividends and not interest. However, if the money market fund issues a statement disclosing those money fund dividends as interest-related, no withholding would be required.
U.S. Real Property Interests
Further complicating the need to withhold are the requirements imposed on sales of United States Real Property Interests (USRPIs). IRC §897 defines an USRPI as:
- An interest in real property (including one in a mine, well or other natural deposit) located in the U.S. or the Virgin Islands
- An interest (other than that of a creditor) in a United States real property holding corporation (USRPHC)
If the fair market value of a domestic corporation’s USRPIs is 50% or greater of 1) the fair market value of its USRPIs plus 2) other real property plus 3) other business assets, then that corporation is a USRPHC. However, if the USRPHC’s stock is traded on an established securities market, the rules don’t apply if the owner holds less than 5 percent of the stock. Constructive ownership rules apply here so trying to use layering or pass-through entities to circumvent these rules may not work.
Under IRC §1495, the withholding requirement imposed on these USRPI sales is 15 percent (10 percent before February 17, 2016) of the amount realized allocable to a foreign person. The amount realized is a gross number, not a net number and includes the cash received, any other property received and any liabilities assumed by the other party. Obviously this amount could be substantially higher than the tax ultimately imposed on any gain on the transaction and so the foreign person would have to file an U.S. tax return to apply for any refund.
ECI and FDAP withholding rates
Where do the U.S. income tax withholding obligations lie? Under IRC §1441 and §1442, all persons (including lessees or mortgagors of real or personal property, fiduciaries, employers and all officers and employees of the U.S.) having the control, receipt, custody, disposal or payment of any of the income discussed above to a foreign individual or entity would be required to withhold. On income classified as Fixed Determinable Annual Periodic (FDAP), the U.S. federal withholding rate is 30 percent (unless lowered by treaty). FDAP income includes non-portfolio interest, dividends, rents and royalties. On income classified as Effectively Connected Income (ECI) which is generally derived from a trade or business within the U.S., the U.S. federal withholding rate is the highest individual marginal tax rate, currently 35 percent (also subject to treaty). States generally impose their withholding requirements as well, though, as mentioned earlier, sometimes it is tied to distributions of income rather than when it is actually earned.
To relieve the burden of having to do withholding itself, a payee/investor must properly disclose to a payor/pass-through entity its structure if requested. Generally, the payor/pass-through entity requests a Form W-9 or W-8 to determine what its withholding requirements may be.
- An U.S. person or entity (or an U.S. “blocker” corporation) completes a Form W-9
- A foreign pass-through entity (such as a typical Cayman Islands Master fund) completes a Form W-8IMY
- A foreign individual or corporation not electing to be treated as a U.S. pass-through entity completes a Form W-8BEN (such as a typical Cayman Islands feeder fund or Cayman Islands “blocker” corporation)
Inadvertent U.S. sourced income
Especially since the banking crisis and tightening of lending restrictions, hedge funds and private equity entities often have stepped in to loan money to companies and, in some cases, individuals for both business and real estate purchases. These entities may not realize these transactions may generate ECI and state-sourced income that must be withheld on. Loan origination fees in the guise of cash or, in some cases, securities or other types of property are considered generated from the trade or business of loaning money. If any of these loans are foreclosed on, the investment vehicle may also become the owner of an USRPI which, when sold, may need to have the proceeds attributable to foreign investors withheld on.
Why blockers are used
“Blocker” corporations are utilized by hedge fund or private equity managers to aid with all these forgoing rules. They also help simplify withholding calculations when pooling both offshore and onshore investors’ money. Structuring the “blocker” as an U.S. corporation versus a foreign domiciled corporation has both advantages and disadvantages.
U.S. blocker advantages
If the “blocker” is structured as an U.S. corporation, the 15 percent rate of withholding on sales of USRPI would not apply. This could be a distinct advantage in terms of cash flow for entities receiving US real estate sales proceeds, as a foreign “blocker” would have to wait possibly for months to file a tax return to receive any over withheld taxes.
Reporting requirements imposed by the Foreign Account Tax Compliance Act (FATCA) should also be considered when choosing a domicile for the “blocker.” A foreign “blocker” would probably have to incur additional costs to comply with registration and annual compliance requirements, whereas a domestic corporation would not have that particular burden.
Trump Administration note: If the new Trump administration were to repeal FATCA as has been suggested, this distinction would disappear.
A third advantage of using an U.S. corporate “blocker” would be the option to dissolve the entity. U.S. corporations are taxed first on their overall profit and then their shareholders are taxed when they take a distribution of accumulated earnings and profits in the form of a dividend. If the stock is sold at a profit, the shareholder pays tax as a capital gain. However, if a domestic corporation dissolves before distributing the accumulated earnings and profits in the form of a dividend, those earnings are never subjected to the second level of dividend tax and only to the corporate level of income tax. Those undistributed profits are essentially converted to capital gains by the shareholders. There are obvious limitations to this strategy: can the entity dissolve without disrupting an ongoing business? That is, contracts, branding and customer relations must be considered. Will the cost of organizing a new entity or maintaining multiple U.S. entities be prohibitive? However, for a private equity entity doing one deal, this might be the ideal strategy to mitigate the double taxation of the U.S.
U.S. “blockers,” however, must pay U.S. tax on their worldwide income and not just on their U.S. sourced income. They also have more reporting requirements in terms of Forms 1099 and Forms W-2 than a foreign corporation. So there are some distinct advantages of domiciling a “blocker” offshore.
Foreign domiciled blocker advantages
Foreign corporations are subject to the branch profits tax which attempts to level the playing field between onshore and offshore corporations in that both entities pay a double level of taxation on their profits. First, foreign corporations are subject to a corporate income tax on their U.S. based profits. Then, they are subject to the branch profits tax when those U.S. based earnings and profits are distributed to the shareholders. Combined, this imposes a 54 percent federal tax rate on U.S. based profits earned by a foreign corporation. These profits could also be subject to state income tax. (If this foreign corporation were owned by U.S. persons, the tax rate could climb to almost 70 percent when the individual tax rate is included. The Controlled Foreign Corporation (CFC) and Passive Foreign Investment Company rules must also be considered in this case. Learn more about those rules.) However, unlike domestic corporations, foreign corporations would only pay U.S. taxes on the U.S. based profits – quite an advantage if the entity has multiple sources of income and especially true if the offshore operations are profitable and the cost to set up and maintain several “blockers” is prohibitive to the economics of the business.
Similar to their domestic counterparts, foreign corporations can exclude U.S. based earnings and profits from the branch profits tax by dissolving. However, the foreign option is much more restrictive. To terminate a U.S. business completely, the foreign “blocker” must do all of the below (without exception):
- Have no U.S. assets at year end or have an irrevocable resolution in place to liquidate completely
- Not use directly, indirectly or through an affiliate the assets or earnings of the terminated U.S. business in any other U.S. business for 3 years
- Derive no ECI for 3 years
- Waive the statute of limitations for assessment of the branch profits tax
The assets and earnings referenced in 2) are money, any other assets into which the U.S. assets were converted for up to 3 years and the proceeds of sales of its stock by its shareholders at any time. Loans or pledges of any of the enumerated assets to a related corporation (if one is a 10% shareholder of the other) are treated as being used. Having to dissolve all of the U.S. operations to take advantage of this exclusion is a distinct disadvantage of the foreign “blocker.”
There are obviously multiple considerations to factor into making a domicile choice for your blocker. Timing, type, frequency and location all play a role. It is advisable to speak with your financial and legal advisors prior to making a decision.
For more information on this topic, or to learn how Baker Tilly asset management industry specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.