Why Do U.S. Investment Funds Operate in Tax Havens?

By :: January 20th, 2012

Mitt Romney’s holdings in the Cayman Islands have generated lots of interest in investment funds that are managed from the U.S. but incorporated in foreign jurisdictions.   But taxable U.S. investors like Romney don’t get much benefit from such funds.  The real winners are U.S. tax-exempt entities, such as charities, pension funds, university endowments, and IRAs, as well as foreign investors.   And investment fund managers can benefit too.

Here’s why:  When tax-exempt investors make money that is separate from their tax-exempt purpose, they are subject to a special tax, known as the “UBIT” or the unrelated business income tax.  A special rule also deems all debt-financed income to be unrelated business income.  Because deals put together by private equity firms are often heavily leveraged (as are investments by hedge funds), debt-financed income often is generated.

If a tax-exempt entity were a partner in one of these deals, it would be taxed as if it earned the income that was earned by the partnership and, thus, be subject to the UBIT. 

But tax-exempts (including individuals who invest through their IRAs) can avoid this tax by investing in a corporation which, in turn, invests in the partnership (or invests directly in the deal).  The tax-exempt’s income from its investment then comes either as dividends or capital gains, neither of which is subject to the UBIT.  But there is a problem:  If the corporation were based in the U.S., it would have to pay corporate-level tax on the earnings from the partnership, thus lowering returns to the tax-exempt.  But, if the corporation located in a tax haven, it would owe no tax (U.S. or foreign) on the earnings.

Similarly, foreign investors could use a corporation to block tainted income from a partnership.  Normally, foreign investors would be subject to tax on U.S. income that is effectively connected to a U.S. trade or business.  But a foreign investor who received distributions from another foreign corporation or realized gains from the sale of its stock could avoid any direct U.S. tax and would not have to file any U.S. returns.

Setting up as a foreign corporation may also benefit the investment fund managers by allowing them to defer compensation.   By now, most readers of Tax Vox know that these managers often are paid for their services with profits of a partnership (“carried interest”).  But they can also be compensated with a contractual right to payment from a foreign corporation which, like carried interest, can be based on an investment fund’s performance. 

Income from a carried interest often is taxed as capital gains rather than as ordinary income, and thus enjoys a lower rate (15 percent v. 35 percent).  But the tax is owed right away.  The contractual right is taxed as ordinary income, but generally is deferred until the manager is actually paid.  If the investments are throwing off long-term capital gains, the manager may prefer to be paid through carried interest.  But if the fund is turning over frequently and thus generating lots of short-term gains (which are taxed at ordinary rates anyway), the manager may prefer a contract payment that is deferred—and taxed later.

These arrangements don’t entirely wipe out every investor’s tax liability. U.S. taxpayers, such as Romney, pay tax on their income regardless of where they earn it, so they can’t avoid U.S. tax by investing in Cayman entities.  In addition, although U.S. taxpayers generally are not taxed on income derived through a foreign corporation until the income is distributed as a dividend, U.S. investors often must accrue income currently if the foreign corporation primarily has passive income or assets or U.S. owners.   

Of course, investment funds may want to incorporate abroad for non-tax reasons, such as fewer regulations and less disclosures.  But tax advantages are a major factor.  Despite the headlines, tax-exempt investors, and fund managers, and not U.S. taxable investors often benefit most from these arrangements.

15Comments

  1. Ali Naqvi  ::  3:47 pm on January 20th, 2012:

    Steven,
    Thanks for writing on this important subject and shedding some sunlight on this little understood benefit accruing to hedge fund managers and the tax-exempt investors. It is interesting thatin a relative sense the benefit is hugely valuable to the managers of the off-shore funds as thy can defer taxes on their performance fees…which are the largest component of their income. Additionally they can then compund the earnings on these defered amounts in a tax sheltered off-shore account. The savings for the tax-exempt investors only amount to small number of basis-points of return on their sizable portfolios.
    We manage two hedge funds in our firm, both are US domiciled partnerships. Unfortunatelty, as we also seek to become larger and have large US tax-exempts as investors in our funds, we will also be faced with the issues of starting an off-shore fund, and incur additional legal and administrative costs.
    A simple solution to deal with this tax loophole would be to allow tax-exempts an exemption from the UBIT within certain constraints. This would allow them to invest in US based funds such as ours without incurring a tax penalty.
    I would not be surprised if this type of change also ended up creating a fair amount of new jobs in the fund-administration area within the US.
    Thank you,

    Ali Naqvi
    Naqvi-Van Ness Asset Management, LLC
    28 West 44th Street, 16th Floor
    NY, NY, 10036
    Tel #1 212-899-5477

  2. Vivian Darkbloom  ::  3:52 pm on January 20th, 2012:

    Well, on the one hand I should commend the TPC for finally trying to address the role of tax exempt entities in the private equity business.

    I sense, however, from this post that the author likely knows more than he is able to express in the English language. The story is a bit garbled. Part of that may have to do with the complexity of the subject, but it reminds me of the following remark made with respect to an entirely different, but equally difficult subject:

    “I know more than I can express in words, and the little I can express would not have been expressed, had I not known more”.

  3. Vivian Darkbloom  ::  4:00 pm on January 20th, 2012:

    Ali,

    If Steven were to shed even more light, he would reveal how tax exempt entities share their tax exempt status with general partners of private equity funds for the mutual benefit of both and that this arbitrage is really what is depriving the US Treasury of tax dollars they would otherwise be entitled to.

    May I suggest that an even better suggestion would be to start taxing tax exempt funds on their investment income which certinaly eliminates the UBIT “problem” or, at the least, preventing them from sharing their tax exempt status with taxable persons in a manner never intended by Congress. At the very least, these funds would not have any problem investing with you if you were to use solely equity and no leverage. That is something completely within your control.

  4. Michael Bindner  ::  1:10 am on January 21st, 2012:

    The salient point, which no one else seems to be making, is that the low capital gains and dividend rates were created to lessen the impact of double taxation of income. If the taxes for the firm are parked off shore, however, it sets the whole justification for a lower rate on its head. This is likely what Governor Romney is afraid of us finding out.

  5. Ben  ::  10:42 am on January 21st, 2012:

    Steven – I’m a bit confused by your post. You don’t mention that US source dividends and interest paid to a Cayman corp would be subject to 30% withholding, absent an applicable exemption. Presumably the portfolio interest exception doesn’t apply to an internally leveraged investment. Accordingly, this structure would simply reduce taxes on UBIT, but not avoid taxation on UBIT.

    With regard to foreign investors investing in a US partnership that is engaged in a US trade or business, if they were to do so through a foreign corp, that foreign corp would be subject to net basis taxation on its effectively connected income, as well as subject to the branch profits tax. So rarely would a foreign investor use a cayman corporate blocker for this purpose. It may, alternatively, invest through a US corporate blocker so as to avoid having to file US tax returns and instead have the shell corporate blocker file returns, but that doesn’t all it to avoid US tax.

  6. Stuart Levine  ::  11:26 pm on January 21st, 2012:

    You say “U.S. investors often must accrue income currently if the foreign corporation primarily has passive income or assets or U.S. owners.” Am I correct that this would apply only if the foreign corporation were a controlled foreign corporation (CFC) or a foreign personal holding company. If either of those classifications are what you are referring to, it would seem to be fairly easy to avoid either adverse classification.

  7. Vivian Darkbloom  ::  12:34 pm on January 22nd, 2012:

    “A simple solution to deal with this tax loophole would be to allow tax-exempts an exemption from the UBIT within certain constraints. This would allow them to invest in US based funds such as ours without incurring a tax penalty.”

    This begs further clarification. Not only are contributions to such funds tax deductible, but tax exempt entities (pension funds, endowment funds, etc) are generally exempt from US tax on their investment income. So far, that is a double tax benefit. The tax code, however, generally prohibits these exempt entities from claiming a tax exemption for income that is considered “unrelated business taxable income” (UBTI for which they pay “UBIT”). The general thought here is that these exempt entities should not be able to compete with taxable entities on matters unrelated to their “charitable” or “exempt” purposes. Another subset of UBTI is income that is “debt financed”. Congress felt that the benefits given to exempt organizations from investing *their own* funds in portfolio investments was quite generous enough. They therefore wanted to limit the ability to use *borrowed funds* to further leverage those exempt investments (there was also the general idea that such publicly subsidized organizations should be very prudent with their funds and that is incompatible with adding investment risk through leverage).

    As interpreted heretofore, such funds cannot *directly* incur debt (or guarantee debt) to finance their investments and as partners in a partnership that itself borrows or guarantees debt they would be considered to borrow a pro rata share of the partnership debt. So, the workaround for this has been for the exempts to set up “blocker” corporations between themselves and their leveraged investments such as those described above. This has satisfied the letter of the law, but is this form actually consistent with its substance? Is this appropriate conduct for “civic” organizations?

    Apparently, Mr. Naqvi’s answer to what he calls a “loophole” is to open that hole even wider. Why? Because hedge funds traditionally have much higher levels of leverage than their private equity fund counterparts (blockers or not). That demonstrates quite a bit of cheek, because this answer would make it easier for hedge fund managers to enter into “carried interest” arrangements with those exempt investors. The essence of those arrangements, as I’ve commented in an earlier post, is to allow tax exempt investors, who are indifferent to whether they get a deduction for manager compensation or whether the character of their portfolio income is “ordinary” or “capital gain” , to basically “share” that exempt status by granting “carried interests” to the fund managers.

    I agree that Congress should focus more on the “loophole” Mr. Naqvi has so kindly identified for the readers here. But, I would suggest a much different set of possible solutions. These alternatives could include:

    1) Eliminating that exempt status completely;
    2) Prohibiting the sharing of tax attributes from exempt organizations with taxable persons through partnerships and other techniques (the *real” problem with “carried interest”); and/or
    3) Adopting “look-thru” rules that prohibit these exempt organizations from acheiving indirectly that which they are prohibited from doing directly.

  8. Ali Naqvi  ::  5:13 pm on January 22nd, 2012:

    Vivian,
    Your criticisms are quite correct. My suggested solution was very flawed and based on my extremely incomplete understanding of UBIT and the intent of the laws with respect to tax-exempts. I do now understand this issue much better thanks to your clarifications. Your recommendations are on the mark especially the concept of “look through” for the tax exempts. My desire was to simply have some method of leveling the field when it comes to the tax profile of US based funds versus Offshore funds for US tax exempt investors.
    Thank you,
    Ali Naqvi

  9. Ali Naqvi  ::  1:11 pm on January 23rd, 2012:

    Vivian,
    Your criticisms are quite correct. My suggested solution was very flawed and based on my extremely incomplete understanding of UBIT and the intent of the laws with respect to tax-exempts. I do now understand this issue much better thanks to your clarifications. Your recommendations are on the mark especially the concept of “look through” for the tax exempts. My desire was to simply have some method of leveling the field when it comes to the tax profile of US based funds versus Offshore funds for US tax exempt investors.
    Thank you,
    Ali Naqvi

  10. Jason  ::  2:51 pm on January 25th, 2012:

    Mostly accurate, but most fee deferral has been ended thanks to 457A.

    As for Ben’s comments, there are many techniques to reduce effective taxes to zero in all the situations he raises, including in the case of ECI investments, leveraging up your US blocker at very high debt-equity ratios.

  11. Reid1  ::  2:45 am on August 9th, 2012:

    It is my understanding that you cannot use a foreign blocker corporation that you personally created or have a voice in the management. My understanding is that Congress went out of their way to close this loophole as much as possible. The foreign blocker had to have an independent economic purpose other than to block UBIT taxes. Consequently, a hedge fund client’s non-profit or IRA could block UBIT but the manager could not set up an IRA and use his own blocker to shield his personal assets from the UBIT taxes. Similarly, the Red Cross USA, for instance cannot start Red Cross Cayman Islands Lim. To block UBIT taxes. What do you know about these nuances?

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  14. new providence  ::  12:36 pm on March 30th, 2014:

    Bain Capital ($70 B AUM) have 138 PFIC funds in the Cayman Islands to avoid Capital Gains taxes.

    http://tomazz1.wordpress.com/2014/03/08/tax-planning-for-pfics-and-cfcs-and-fatca/

    PFICs and QEFs don’t have to file tax returns.. Says tax code… MittRomney filed 10 QEFs in 2010

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