Private Equity (PE) and Venture Capital (VC) funds often attract significant investment from US tax-exempt entities. In doing so, these funds may need to avoid having Unrelated Business Taxable Income (UBTI). This article will address some of the scenarios that can cause a fund to generate UBTI.
US tax-exempt entities such as qualified pension funds, individual retirement plans (IRAs), Roth IRAs, foundations, endowments and state or municipal colleges and universities can qualify to be exempt from US tax. That said, these entities are subject to full US taxation on income they derivefrom the conduct of a trade or business that is unrelated to their tax-exempt purpose – this income is known as UBTI and is subject to US taxation at regular graduated rates. The UBTI rules attribute the unrelated trade or business activities of a partnership to its tax-exempt partners. Therefore, a tax-exempt partner of a partnership (including any fund structured as a partnership or treated as a partnership for US tax purposes) must report its distributive share of partnership income attributable to any unrelated trade or business activities of the partnership as UBTI (and the partnership must provide this detail to the tax-exempt partners).
Tax-exempt investors are allowed to exclude from US taxation most categories of investment income such as interest, dividends and capital gains – typically, these are the main sources of income for a Private Equity/Venture Capital (PE/VC) fund as these funds invest in operating companies which are most likely corporations for US tax purposes. However, it is possible that the fund may invest in an entity that is treated as tax-transparent for US tax purposes (i.e., a US LLC). If this occurs, the US tax-exempt investor will be treated as indirectly deriving income from the conduct of a trade or business (i.e., the trade or business of the investment itself) that is unrelated to their tax-exempt purpose and any income generated from this investment will be UBTI.
Therefore, what can a PE/VC fund do if it identifies an investment opportunity in a tax-transparent entity but needs to avoid UBTI? It can make the investment using a “blocker corporation” – this can either be a corporate entity that “sits” on top of the flow-through entity or it can be the flow-through entity itself if it elects to be treated as a corporation for US tax purposes.
In addition to the aforementioned rules, a US tax-exempt organization will have to recognize unrelated debt-financed income (a subset of UBTI) on any “debt-financed property”. The term “debt-financed property” means any property which is held to produce income and with respect to which there is an acquisition indebtedness. For purposes of these rules, the term “acquisition indebtedness” means, with respect to any debt-financed property, the unpaid amount of:
- The indebtedness incurred by the US tax-exempt organization in acquiring or improving such property;
- The indebtedness incurred before the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement; and
- The indebtedness incurred after the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement and the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition or improvement.
Read together, these provisions indicate that the UBTI issue is rather limited – the focus is on the indebtedness incurred by a US tax-exempt organization in acquiring an interest in the portfolio company through the use of debt (either directly or indirectly through the fund). Therefore, there is no UBTI issue if the portfolio company borrows money directly from a third party. Furthermore, the PE/VC fund can raise funds from its investors and then use these amounts to make a loan to any prospective or ongoing investment (rather than, or in combination, with an equity investment).
However, if the PE/VC fund borrows money from a third party (including any bridge financing) and uses these funds to make an investment in a portfolio company, then some (or all) of the income (including interest and dividends) distributed income up to the fund when such indebtedness was still outstanding will be unrelated debt-financed income. Furthermore, if the fund sells the portfolio company within 12 months of the indebtedness being paid off, some (or all) of any capital gain on the sale will also be considered unrelated debt-financed income.
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