Insight Center: Publications

Does H.R. 3501 Signal the End of UBTI Blockers?

Tax Update

Author: Steven D. Bortnick


The taxation of private equity funds and their managers has become the object of much publicity and scrutiny in the popular and tax press lately. Information gathered at the September Congressional hearings relating to the taxation of carried interests (the managers’ interest in profits of a private equity or hedge fund with respect to investors’ capital), spurred another bill designed to alleviate the risk of generating unrelated business taxable income (UBTI) with respect to partnership borrowings.


Tax-exempt organizations, such as charities and pension plans, are subject to income tax on their UBTI. This includes their share of UBTI generated by a partnership in which they invest. UBTI includes income from a business regularly carried on which unrelated to the exempt purpose of the organization. It also includes income and gain from debt financed investments. Case law further provides that if a partnership in which an exempt organization invests incurs indebtedness, the tax-exempt partner can recognize UBTI from debt financed property of the partnership, even if the tax-exempt organization, as a limited partner, never would be liable for the indebtedness. Accordingly, if a tax-exempt organization is a partner in a hedge fund or private equity fund that borrows to make investments, the organization may recognize UBTI.

Investors’ tolerance for UBTI varies significantly, as do the level of commitments of investment funds to avoid or minimize the recognition of UBTI. Those funds that commit to avoid or minimize UBTI may form blocker entities through which to make leveraged investments or investments in portfolio companies formed as partnerships or limited liability corporations. Generally, these are offshore vehicles formed as corporations (or partnerships which elect to be treated as corporations for US tax purposes). Indebtedness incurred by a corporation would not be treated as indebtedness of the fund or its partners. Alternatively, where the fund is not required to avoid UBTI, tax-exempt limited partners may form their own UBTI offshore blocker corporations. It also is common practice for hedge funds that use leverage to form a company in a tax haven jurisdiction through which tax-exempt and foreign investors invest.

Proposed Legislative Changes

H.R. 3501 (the Proposed Legislation) was introduced on September 7, 2007 to attempt to alleviate the need to use such offshore blocker corporations. Generally, it provides that “acquisition indebtedness” does not include indebtedness incurred or continued by a partnership in purchasing or carrying any qualified security or commodity. Property is only considered debt financed if there is acquisition indebtedness with respect to such investment. Accordingly, the intent here is that income or gain with respect to debt-financed qualified securities not be treated as UBTI. For this purpose, a “qualified security” includes stock in a corporation, partnership or beneficial interests in widely-held or publicly-traded partnerships or trusts, notes, bonds, indentures or other evidences of indebtedness, certain notional principal contracts, evidences of interests in, or derivative financial instruments in, the above securities or any currency, including any option, forward contract, short position and similar financial instruments, and certain identified hedges. A “qualified commodity” includes any actively traded commodity, notional principal contracts with respect thereto and certain identified hedges thereto. Options and derivative contracts with respect to such securities and commodities also are qualified securities or commodities.

Even under H.R. 3501, debt financed property of a partnership may give rise to UBTI unless the partnership incurring the indebtedness satisfies certain requirements. The Proposed Legislation makes reference to existing UBTI provisions dealing with indebtedness incurred by a partnership to acquire or improve real property. In order to fall within the exception of the proposed legislation, (i) all allocations to tax-exempt entities must have “substantial economic effect,” and (ii) either (A) each allocation to a tax-exempt organization must be a “qualified allocation” or (B) partnership allocations must satisfy the so-called “fractions rule.”

Generally, in order for an allocation to be a “qualified allocation,” it must be consistent with the tax-exempt organization’s being allocated the same share of each item of income, gain, loss, deduction, credit and basis. Additionally, this share must remain the same during the entire period the entity is a partner in the partnership. The fractions rule generally requires that a tax-exempt organization not have a share of overall partnership income for any taxable year greater than the partner’s share of the overall partnership loss for the taxable year for which the partner’s loss share will be the smallest. A complete discussion of the qualified allocation and fractions rules is beyond the scope of this update. However, it is important to note that there will be technical requirements that must be complied with in order for a fund to avail itself of the proposed UBTI exception.

The Proposed Legislation also provides that rules similar to those discussed herein shall apply in the case of tiered partnerships and other pass-through entities.

Pepper Perspective

The Proposed Legislation, if enacted, would be a welcome change for private equity and hedge funds and their investors. However, it cannot be viewed as a cure-all. Though many investments held by such partnerships could be debt financed without giving rise to UBTI, this exception would not apply to all investments. Additionally, qualification for the exception requires that the partnership’s allocations meet certain technical requirements. For some partnerships, this may require amending partnership allocations in order to fit within these requirements. Blockers still will be necessary to avoid UBTI from the investment in operating companies formed as flow-through vehicles, such as partnerships or LLCs. Finally, it should be noted that the exception only applies to indebtedness incurred by a partnership that has tax-exempt investors. Indebtedness incurred directly by tax-exempt investors in order to make investments still may give rise to UBTI.

Steven D. Bortnick

This article is informational only and should not be construed as legal advice or legal opinion on specific facts.