Taxation of Private Equity and Hedge Funds - "Blocker" Corporations

"Blocker" Corporations

Although a partnership structure is advantageous for most investors due to the elimination of an entity-level tax, it is not the desired form for all investors. In particular, foreign investors and domestic tax-exempt organizations both have reasons to prefer to interpose a corporation in the private equity or hedge fund structure.

Foreign investors are generally not required to file tax returns unless they have “effectively connected income,” derived from the active conduct of a U.S. trade or business. Passive investment in a corporation does not give rise to a U.S. trade or business. However, active investment management of the type performed by private equity funds or hedge funds typically does. Because partners in a partnership are treated as engaged in whatever business the partnership itself is engaged in, this means that if a foreign investor invests in a hedge fund or private equity fund, it will generally be forced to file a U.S. tax return. To avoid this requirement, a foreign investor will often invest through a blocker corporation (usually located in the Cayman Islands or another offshore jurisdiction). The corporation itself will be required to file U.S. tax returns, and will pay taxes at the normal U.S. corporate tax rate, but the foreign investor will receive only dividends or capital gains from the blocker, and will therefore not be required to file a U.S. return. As an alternative to the “blocker” structure, hedge funds seeking to attract foreign investors can also structure as partnerships, but simply restrict themselves to activities that are not treated as a U.S. trade or business. For example, U.S. tax law provides that trading in securities for the taxpayer’s own account will not constitute a U.S. trade or business. Thus foreign hedge funds formed as corporations do not generally pay corporate income tax.

Domestic tax-exempt entities face similar concerns when investing in funds structured as partnerships. While tax-exempt on income related to their tax-exempt purpose, tax exempt entities are required to file tax returns and pay income tax on “unrelated business taxable income,” commonly referred to as UBTI. Because the activities of an entity structured as a partnership flow through to its investors, if the partnership receives income that would be UBTI in the hands of the tax-exempt investor, the investor is forced to file an income-tax return and pay unrelated business income tax. To avoid this requirement, tax exempt entities use offshore blocker corporations in much the same way foreign investors do. To date, no bill has been introduced to change this treatment, although concerns over the tax gap have led to increased scrutiny of business structures involving offshore corporations in general. For example, in May 2007, the Senate Finance Committee held a hearing about offshore structures used for tax evasion .