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.
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.