Who’s afraid of the US tax system?
The complexities of US taxation, particularly Unrelated Business Taxable Income (UBTI), can deter European private equity firms looking to unlock the lucrative US pension funds market, but learning how to navigate them really is worth the effort.
European PE is driven by a fiercely competitive marketplace and the US, home to about half of the world’s largest pension funds, is an enticing potential investment source for companies. Pension funds have moved on from investing solely in publicly listed assets to broadening their portfolios across investment classes, such as PE and venture capital, and across geographical regions further afield. For US pension funds, the European PE market remains a solid option.
For the PE firm, however, diving into the US market with its notoriously complex tax system can be daunting. US pension funds, keen to avoid nasty surprises with taxable debt-financed investments, must have confidence in the K-1 and K-3 forms coming back from their PE investors. Attractive private equity firms prequalify by having the appropriate structure in place, meeting due diligence and being watertight in the information they share with their pension fund investors for reporting.
What are the key tax considerations, then, for the European PE firm preparing to dive into the US pension fund market? First things first, it is imperative that we have a strong understanding of how US investors are taxed.
Tax exposure for investors
For funds structured as a partnership, investors are taxable on their share of the fund’s income each year, regardless of whether any cash or distribution is actually paid.
For foreign entities, the tax treatment of a structure follows the IRS default classification rules. Entities that have multiple members, at least one of whom has unlimited liability, are treated as equivalent to a partnership. Entities where liability of all members is limited are treated as a corporation.
Limited liability companies (LLCs) with multiple members are generally taxed as a partnership, in the absence of their making a formal IRS election to adopt a different tax classification. The IRS will use a default entity classification – corporation, partnership or disregarded entity (the foreign business has one owner, with unlimited liability) – depending on the number of owners and whether the owners have limited or unlimited liability.
Required tax information
Funds structured as a partnership need to provide forms K-1 and K-3 to US investors to provide them with a summary of their income share. The K-1 will supply investors with their allocated share of the partnership’s total income and expenses, and typically provides additional supplementary detail to assist with the preparation of the investor’s tax filings.
US investors are taxable on their worldwide income and will always require a K-1, even where the fund has no US income or US investments. Introduced by the IRS to give more transparency and clarity for the owners of so-called ‘pass-through vehicles’, such as PE firms, the K-3 form provides more specific detail, primarily with respect to foreign transactions and credits.
Tax-exempt investors and UBTI
Qualified US pension funds are one of a number of sources of capital for venture capital and other private equity funds that are tax exempt under the Internal Revenue Code. Tax exempt investors also include individual retirement accounts, foundations, endowments and state or municipal colleges and universities. But these investors may still be taxable on income that meets the definition of UBTI.
UBTI includes income from trade or business activities that are not related to the investor’s tax-exempt purpose, for example a university that operates a bookstore that sells to the general public. So, what is and isn’t UBTI?
It generally does not include:
- Passive income (interest, capital gains, dividends) from investment assets, but these can be UBTI if the asset was acquired with third-party debt, such as a bank facility.
- Debt taken directly by the portfolio company, or debt financing raised by the fund from the investors.
It does include:
- Interest or dividend income that arises from an investment subject to acquisition indebtedness while that debt is outstanding. Upon repayment of that debt, any subsequent interest may not be UBTI.
- Disposals of assets subject to acquisition indebtedness. These may result in UBTI capital gains, even after the debt has been repaid, if disposal took place less than a year later. Funds need to be able to identify any UBTI income or assets that may be considered subject to acquisition indebtedness, and provide that information to tax-exempt investors as part of the K-1 reporting.
- Underlying investments. Even if the fund has no UBTI, UBTI can flow up if the fund invests in another fund, partnership, or a US LLC.
Strategies to mitigate UBTI risks
So, if you’re a venture capital or PE firm, much of your income will come from the sale of portfolio companies and from dividends and interest. As long as money isn’t borrowed to acquire the portfolio companies in the first place, investment activities do not generally lead to UBTI. The IRS does get interested, however, if you owe money from your investments.
How do you avoid UBTI? Mitigation strategies may include:
- Changes to how the fund uses debt financing, such as taking draws that are shorter in duration and repaid sooner.
- Structuring, for example setting up a blocker holding company above a UBTI-producing investment to prevent the UBTI from flowing to the investor.
- Creating a corporate feeder vehicle for tax-exempt investors – the master-feeder structure enables funds to take advantage of beneficial pass-through tax treatment.
- And yes, consulting a tax adviser who understands US taxation is a wise move because it will help you take tax out of the equation as a barrier to attracting investment.
In summary, by being sharp with your information for reporting, and smart with how you manage exposure to unrelated business tax income, your PE firm can score big with US pension funds. Contact us with any queries.
This article was previously published in The Drawdown.