The United States is no stranger to capital from foreign
investors. Perhaps in South Florida especially, this is no more
evident than in the real estate market, particularly when it comes
to investors from Latin America. Over the years, however, foreign
clients have diversified their tastes, as we have seen more and
more money flow into U.S. capital markets. More recently, we've
also seen foreign investors diversify their holdings even further,
dipping into the U.S. private equity market. This post quickly
highlights some of the U.S. tax considerations that are relevant
for foreign clients making U.S. private equity investments, which
at the root will typically be structured through some type of U.S.
company (commonly referred to as a "fund" in the private
equity setting).
For most foreign clients, the most pressing question is likely to
be: "How will the income or gain from my investment be taxed
in the U.S.?" This is an income tax consideration. With
respect to the income generated by an investment, the answer lies
in the type of income that the investment is producing. Foreign
investors are only subject to U.S. income tax on their U.S. source
income, and that income can be divided into two main categories:
(i) passive income (things like interest and dividends from passive
investments); and (ii) active income (income that is related to, or
connected with, an active trade or business in the United States).
In tax terms, these types of income are respectively referred to by
the acronyms "FDAP" or "FDAPI" (which stands
for fixed, determinable, annual, or periodical income) and
"ECI" (which stands for effectively connected
income).
In the case of FDAPI, foreigners are generally subject to U.S.
income tax under a withholding regime in which a 30% withholding
tax is imposed on the income at source.1 Importantly,
this withholding tax applies on a gross basis, meaning that
deductions cannot be taken to offset the
income.2 ECI, on the other hand, is subject to tax
at the same rates that apply to U.S. taxpayers and is taxable on a
net basis, meaning that deductions can be taken in
arriving at the amount of taxable income for U.S. tax
purposes.3
With respect to gain from an investment, here again, the type of
asset generating the gain will ultimately determine how a foreign
investor is taxed. While a full discussion of the topic is beyond
the scope of this article, the following are some general guiding
principles:
- Gains from portfolio investments in non-real estate related U.S. corporations and most publicly traded securities are not subject to U.S. income tax (e.g., a foreign person sells shares of Apple at a gain).
- Gains derived in the active conduct of a U.S. trade or business (whether conducted directly by a foreign investor or indirectly by being a partner in a partnership that is engaged in a U.S. trade or business) are generally treated as ECI and taxed accordingly.
- Gains from the sale of U.S. real estate or investments in U.S.
corporations that own mostly U.S. real estate are automatically
treated as ECI under the Foreign Investment in Real Property Tax
Act of 1980 (commonly referred to as "FIRPTA") and taxed
accordingly.
In addition to these substantive tax aspects, the U.S. income tax return filing requirements are likely to be of interest to a foreign investor. In the case of FDAPI, provided the U.S. tax obligation is fully satisfied by withholding (meaning, the payor of the income does its job and remits the full withholding amount to the IRS), the foreign investor is not required to file an income tax return to report the income. In the case of ECI, however, a foreign investor must file an income tax return to report the amount of income and pay the U.S. tax owed. This filing obligation takes on added significance, because available deductions cannot be claimed unless an income tax return is timely filed.
With this backdrop in mind, foreign investors should understand
what type of investment they are making and what the anticipated
returns consist of. For example, is the investment a debt
investment that is just producing interest? Is the investment a
passive portfolio investment where the return will consist largely
of gain upon a sale? Or is the investment into an actively managed
and operated business (which might typically be seen in the case of
a commercial real estate investment)? To get these answers, foreign
investors can look to the private equity fund's offering
materials, which should contain a general discussion providing a
broad overview of the nature of the investment. The U.S. tax
ramifications and considerations can often be found in a fund's
Offering Memorandum (or Private Placement Memorandum), which
typically contains a section discussing the "Tax Risks"
or "Tax Considerations" related to the
investment.4
For those funds that are larger in scale or are professionally
managed, the fund sponsor or manager may already have structures in
place that are suitable for foreign investors from a U.S. tax
perspective in order to maximize tax efficiencies (e.g., use of a
U.S. "blocker" corporation for certain types of
investments). Like most things when it comes to U.S. tax planning,
however, every foreign investor's case may be different, and
what makes sense for one foreign investor may not be ideal for
another.
In addition to the foregoing considerations, which focus on U.S.
income tax considerations, a foreign investor should also keep in
mind U.S. estate tax considerations with respect to the investment.
Similar to the income tax, foreign investors are only subject to
U.S. estate tax with respect to those assets located in the U.S. at
the time of death (or to put it in tax terms, those assets that
have a U.S. "situs"). For an investment into a U.S. fund
structure made directly by a foreign investor, there may very well
be U.S. estate tax exposure, whereas an investment made through an
appropriate and properly administered non-U.S. holding vehicle can
provide U.S. estate tax protection. Although it may not be intended
for this purpose, in the private equity context, an entity referred
to as a "foreign feeder fund" may serve as a suitable
vehicle from a U.S. estate tax planning perspective.
Taking it one step further, a foreign investor should also consider
his or her estate or succession planning with respect to the
investment. For example, who will inherit the investment upon the
foreigner's death? Foreign beneficiaries? U.S. beneficiaries? A
mix of both? Does the foreign investor have a succession plan in
place, either via a will or a trust? Consideration will also likely
need to be given to the U.S. tax implications for the beneficiaries
who inherit the investment, particularly any U.S.
beneficiaries.
While it would be impossible in one article to touch on every U.S.
tax planning consideration that will be of importance to a foreign
client making a U.S. private equity investment, below is a list of
some of the more common questions and considerations that are
likely to be of interest to foreign investors based on our past
experience (in no particular order of importance):
- Is the investment a debt investment or an equity investment?
- If a debt investment, will the interest be subject to U.S. income tax, or does it qualify for an exception?5
- If an equity investment, does the investment relate to a passive holding in a portfolio company or an actively managed trade or business in the United States?
- How is the fund generally structuring entry for its foreign investors, and in particular, is the fund implementing any alternative vehicles or structures with respect to those investments in an active U.S. trade or business?6
- Is the fund utilizing a foreign feeder fund, and, if so, how is that foreign feeder fund classified for U.S. tax purposes?
- Are there any holding period requirements (i.e., must an investor stay invested in the fund for a certain period of time), and what is the anticipated exit strategy for the investment?
- What is the process (or does the fund even allow) for switching
from the "foreign" or "offshore" side of the
fund to the "domestic" or "onshore" side of the
fund (e.g., if a foreign investor moves to the U.S. while still
holding the investment or if a U.S. beneficiary inherits the
investment).
While private equity offerings may present attractive investment opportunities for foreign investors (which is something for each investor to evaluate independently), the related U.S. tax implications should be considered well in advance before making an investment.
Footnotes
1 The 30% withholding tax can be reduced or eliminated
under certain income tax treaties with other countries, but in
terms of Latin America, practitioners should keep in mind that the
U.S. has income tax treaties in force only with Mexico and
Venezuela (with the fate of the U.S.-Chile income tax treaty
remaining uncertain for the time being).
2 For example, a foreigner receives a $100 dividend from Microsoft.
Out of that $100, a $30 withholding tax will be remitted to the
IRS, leaving the foreign investor with $70 of after-tax
income.
3 In the case of a real estate business, for example, this would
generally include things like depreciation, insurance, property
taxes, mortgage interest, maintenance and repairs, etc.
4 Such fund documentation does not constitute legal advice to the
foreign investor, however, and sometimes there could be a tax
position that is being taken by the fund on which different
opinions could exist amongst practitioners. Foreign investors
should therefore seek their own U.S. tax advice prior to making the
investment.
5 The most relevant exception in this arena is interest which
qualifies for the "portfolio interest exemption," but
that is a discussion for another post.
6 The answer to this question has relevance both for the
substantive U.S. income tax outcomes for a foreign investor as well
as the related U.S. tax filing requirements.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
