In March 2009, Sen. Carl Levin (D-Mich.) introduced the Stop Tax Haven Abuse Act (S. 506) (the 2009 Act) to "stop tax cheats" and target "off-shore tax abuses that rob the U.S. Treasury."1 Although most of its provisions never were enacted, it did lead to the passage of sweeping withholding and information-gathering rules contained in the Foreign Account Tax Compliance Act (FATCA). Sen. Levin, through his Cut Unjustified Tax Loopholes Act (S. 2075) (the Act), is taking another shot at so-called "loopholes." The "domestication" provisions of the Act (substantially similar to those in the 2009 Act) would inappropriately tax foreign corporations where no abuse exists, and could discourage investment through U.S-based investment funds. Perhaps most ironic and disappointing is that these provisions may force investors to invest in the United States through foreign investment managers, which would only serve to reduce U.S. tax revenues.
Domestication of Foreign Corporations
The Act would amend the Internal Revenue Code’s definition of a "domestic corporation" to include a foreign corporation if (1) the management and control of the corporation occurs, directly or indirectly, primarily within the United States and (2) either (A) the stock of such corporation is regularly traded on an established securities market or (B) the aggregate gross assets of such corporation, including assets under management for investors, whether held directly or indirectly, for the current year or any preceding year equals or exceeds $50 million.2 Generally, management and control will be treated as occurring primarily in the United States if substantially all of the executive officers and senior management of the corporation who exercise day-to-day responsibility for making decisions involving strategic, financial, and operational policies of the corporation are located in the United States. For this purpose, individuals who are not executive officers and senior management, such as officers or employees in the same chain of corporations as the foreign corporation, will be treated as executive officers and senior management if they exercise the day-to-day responsibilities described in the preceding sentence. The Act directs Treasury to issue regulations addressing their posts.
The Act imposes a lower threshold on foreign corporations connected to investment funds. If the assets of a foreign corporation consist primarily of assets being managed on behalf of investors, management and control of the foreign corporation will be treated as occurring primarily in the United States if decisions about how to invest the assets are made in the United States. This stems from Sen. Levin’s belief that foreign corporations established in a foreign jurisdiction but that have little or no activities in that jurisdiction are created to enable owners to "take advantage of all of the benefits provided by U.S. legal, educational, financial, and commercial systems, and at the same time avoid paying U.S. taxes."3
Impact on Hedge and Private Equity Funds
Many hedge and private equity funds establish non-U.S. corporations as "blockers" on behalf of investors to invest in the fund, as a separate offshore component of a single fund, or by the fund to make certain investments in portfolio companies. These so-called "blockers" are formed to: (A) prevent U.S. tax-exempt investors from recognizing unrelated business taxable income (UBTI); and/or (B) prevent foreign investors from recognizing income that is "effectively connected to a U.S. trade or business" (ECI).4 Some background about blockers is necessary to understand why the domestication provisions are inappropriate.
Tax-exempt investors, such as pension funds, charities and educational organizations, generally do not pay tax on their investment income. They do, however, pay tax on UBTI, which includes income that is debt-financed or from an unrelated trade or business. Where a partnership, including an investment fund formed as a partnership, is engaged in a trade or business or incurs indebtedness, a tax-exempt investor in such partnership is required to pay tax on the UBTI flowing through from the partnership as though it derived the income directly.
Because hedge funds and private equity funds typically employ leverage in their investment strategy, they often use blockers to avoid this flow-through of UBTI to tax-exempt investors. Additionally, funds that invest in operating companies formed as partnerships also often use blockers to avoid the flow-through of this business income, which would be UBTI, to tax-exempt investors.
It should be noted that the pass-through of UBTI resulting from leverage was considered by many to be so inappropriate that the House passed proposed legislation as part of the carried interest legislation to avoid this result (see Pepper Hamilton’s Tax Update regarding UBTI blockers. "Does H.R. 3501 Signal the End of UBTI Blockers?" for a discussion of this proposed legislation). Additionally, a myth must be dispelled: Fully taxable U.S. corporations typically are used to block UBTI from U.S. businesses (as opposed to merely debt-financed income), and any foreign blocker of such U.S. business income would be fully subject to tax in the United States and also subjected to a branch profits tax, as discussed below under "ECI Blockers."
Foreign investors are subject to tax in the United States under one of two systems, depending upon the type of U.S. income earned. The investment income of foreign investors, such as dividends and interest (but not capital gains or "portfolio interest") is subject to U.S. tax only if it is sourced to the United States (e.g., dividends from U.S. companies). The tax on investment income is collected by means of withholding at the source of payment, at the flat rate of 30 percent (or lower treaty rate), with no deductions available to offset the gross income.
Unlike the treatment of investment income, foreign persons are taxed like U.S. persons (i.e., at graduated rates up to 35 percent on a net basis) on ECI, and they must file a tax return if they are engaged in a trade or business in the United States, regardless of the extent of any income earned therefrom. In addition, foreign corporations also are subject to the "branch profits tax" on ECI. The branch profits tax is imposed upon deemed repatriations of ECI at a 30 percent rate (or lower treaty rate). The purpose of the branch profits tax is to replace the withholding tax that would be imposed on distributions from a U.S. subsidiary of the foreign corporation. If a foreign person invests in a partnership (including a fund) that is engaged in a trade or business in the United States, the foreign person will be deemed to be engaged in that trade or business, and will be required to file U.S. income tax returns and pay tax, as described above. It should be noted that investing/trading for one’s own account (even through a partnership or a fund) has long been excluded by statute from the definition of a U.S. trade or business.
Funds that invest in operating businesses through partnerships may employ the use of blockers to avoid the pass-through of ECI to foreign investors. Some foreign investors are so concerned about being "in the U.S. tax system" (a concern the proposed legislation certainly would not alleviate) that they insist on investing through blockers even if there is little likelihood of generating ECI. Again, a myth must be dispelled: Any blocker, U.S. or foreign, would be subject to tax in the United States on the ECI. In fact, because of the application of the income tax and branch profits tax, blockers used solely to block ECI typically are formed as U.S. corporations. Thus, no tax is avoided through the use of a blocker. Rather, the blockers prevent foreign persons from having to file U.S. tax returns.
Impact on the Use of Blockers
Under the Act’s domestication provisions, foreign blocker corporations of the type discussed above would be treated as U.S. corporations if investment decisions are made within the United States. The blockers would be subject to corporate tax at rates up to 35 percent, regardless of the source (U.S. or foreign), character (ordinary or capital gain) or nature (related to a business or mere investment) of the income they generate. Moreover, dividends paid to foreign persons would be subject to withholding tax at 30 percent (or lower treaty rate).
The consequences of this proposal would be catastrophic without further planning. Investment funds with foreign operations potentially could avoid these provisions by ensuring that investment decisions are made outside the United States. This could put U.S.-based investment managers at a competitive disadvantage to their foreign counterparts. Alternatively, funds could discontinue the use of blockers. Without UBTI blockers, hedge funds may look to leveraged exchange-traded funds to make leveraged investments. Additionally, tax-exempts may look to offshore managers or avoid funds that use leverage. Without ECI blockers, more foreign investors (who are willing to invest through U.S. managed funds) would be subject to obligations to file U.S. tax returns, but, as the blockers paid tax at the highest rates, it seems unlikely that the U.S. Treasury will receive more tax revenue.
Private Equity Holding Vehicles
The Act’s domestication provisions could significantly impact private equity funds’ ability to structure acquisitions to efficiently manage worldwide tax obligations. For example, because certain foreign countries tax gains on the sale of companies resident in their jurisdictions, a holding company could be formed in a treaty country to avoid that tax (or just make it easier to prove the existence of a tax exception rather than obtaining residence certificates from all investors). An issue raised by the Act and left to the Treasury to resolve in future regulations is the extent to which "investment decisions" of a foreign holding company, with a board independent from the fund, will be considered to be made in the United States where the sole shareholder of the holding company is a U.S.-based fund. Moreover, the controlled foreign corporation and passive foreign investment company rules currently exist to prevent the deferral of income offshore by U.S. investors participating in these structures. However, by domesticating these foreign holding companies, the Act would inappropriately tax all of the income from wholly-foreign operations.
Rather than increasing the tax paid to the U.S. Treasury, the domestication provisions of the Act, if enacted, could significantly reduce investment in U.S. hedge and private equity funds. The provision would tax income that simply should not be taxed in the United States (i.e., foreign source income) or tax it at inappropriate rates. This likely would force these funds to restructure in a manner that nevertheless would alienate tax-exempt and foreign investors. These provisions establish an unnecessary impediment to investment in U.S. investment funds. Whether this provision will be enacted is unclear.
1 Statement of Sen. Carl Levin on Introducing the Stop Tax Haven Abuse Act, available at 2009 TNT 45-32.
2 This rule will not apply if the corporation is subject to the rules for "controlled foreign corporations" (which require certain U.S. shareholders to currently include in income certain income of the corporation) and is a member of a group of corporations connected through 80 percent stock ownership to a parent corporation that is organized under U.S. law and that has substantial assets (other than cash, cash equivalents, and stock of foreign subsidiaries) held for the use of the active conduct of a trade or business.
3 Statement of Sen. Carl Levin on Introducing the Stop Tax Haven Abuse Act, available at 2009 TNT 45-32. See also Statement of Sen. Carl Levin on Introducing the CUT Loopholes Act, available at 2012 TNT 26-27.
4 For the reason described below, U.S. corporations typically are used as blockers where ECI is the sole concern.
Steven D. Bortnick and Timothy J. Leska
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.