Tax Planning Considerations for Foreign Clients Making Private Equity Investments in the United States – Tax Withholding

To print this article, all you need to do is be registered or log in to Mondaq.com.

The United States is no stranger to capital from foreign investors. Perhaps in South Florida in particular, this is no more evident than in the real estate market, especially when it comes to investors from Latin America. Over the years, however, foreign customers have diversified their tastes as we have seen more and more money flow into US financial markets. More recently, we have also seen foreign investors further diversify their holdings, tapping into the US private equity market. This article quickly highlights some of the U.S. tax considerations that are relevant to foreign clients making private equity investments in the United States, which at their core will typically be structured through some type of U.S. corporation ( commonly referred to as a “fund” in the context of private equity).

For most foreign clients, the most pressing question is probably: “How will the income or gain from my investment be taxed in the United States?” This is a tax consideration. When it comes to the income generated by an investment, the answer lies in the type of income that the investment produces. 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 related to, or related to, a trade or business carried on in the United States). For tax purposes, these types of income are referred to by the acronyms “FDA” or “FDAPI” (which stands for Fixed, Determinable, Annual, or Periodic Income) and “ECI” (which stands for Effectively Connected Income), respectively.

In the case of the FDAPI, aliens are generally subject to US income tax under a withholding tax regime in which a 30% withholding tax is imposed on withholding income.1 It is important to note that this withholding tax applies on a gross basis, which means that the deductions can not be taken to offset 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 to be taken into account in determining the amount of taxable income for US tax purposes.3

With regard to the gain from an investment, again, the type of asset generating the gain will ultimately determine how a foreign investor is taxed. Although a full discussion of the subject is beyond the scope of this article, here are some general guiding principles:

  • Gains from portfolio investments in U.S. corporations not related to real estate and most publicly traded securities are not subject to U.S. income tax (for example, a foreign person sells shares of Apple with a gain).

  • Earnings from the active conduct of a trade or business in the United States (whether conducted directly by a foreign investor or indirectly as a partner in a partnership engaged in a trade or business in the United States United States) are generally treated as ECIs and taxed accordingly.

  • Gains from the sale of U.S. real estate or investments in U.S. corporations that primarily own U.S. real estate are automatically treated as ECIs under the Overseas Real Estate Investment Tax Act of 1980 (commonly referred to as “FIRPTA”) and taxed accordingly.

In addition to these substantive tax aspects, US tax filing requirements may be of interest to a foreign investor. In the case of the FDAPI, provided that the U.S. tax liability is fully satisfied by the withholding (meaning that the payer of the income does its job and pays the full amount of the withholding to the IRS), the foreign investor is not required to file a tax return. to report income. In the case of ECI, however, a foreign investor must file a tax return to report the amount of income and pay any US tax owing. This filing requirement takes on added importance, as available deductions can only be claimed if a tax return is filed in a timely manner.

In this context, foreign investors need to understand what type of investment they are making and what the expected returns are. For example, is the investment a debt investment that only earns interest? Is the investment a passive portfolio investment whose return will consist largely of a gain on a sale? Or is the investment in an actively managed and operated business (which can generally be the case with a commercial real estate investment)? For these answers, foreign investors can consult the private equity fund’s offering documents, which should contain a general discussion giving a broad overview of the nature of the investment. 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 “tax risks” or “tax considerations” related to investment.4

For larger or professionally managed funds, the fund sponsor or manager may already have structures in place that are suitable for foreign investors from a U.S. tax perspective to maximize tax efficiency (e.g. “ corporation for certain types of investments).However, like most things in tax planning in the United States, every foreign investor’s case may be different, and what makes sense to a foreign investor may not be ideal for another.

In addition to the foregoing considerations, which focus on US tax consequences, a foreign investor should also keep in mind US estate tax consequences with respect to the investment. Similar to income tax, foreign investors are only subject to US estate tax with respect to assets located in the United States at the time of death (or, to put it in tax terms, assets that have a US situs). For an investment in a US fund structure made directly by a foreign investor, there may well be exposure to US estate tax, while an investment made through an appropriate non-US holding vehicle and properly administered can provide US estate tax protection. Although not intended for this purpose, in the context of private equity, an entity called a “foreign feeder fund” may be an appropriate vehicle from a US estate tax planning perspective.

Going further, a foreign investor should also consider their estate or estate planning as it relates to the investment. For example, who will inherit the investment on the death of the foreigner? Foreign beneficiaries? US beneficiaries? A mix of both? Does the foreign investor have an estate plan in place, either by will or by trust? Consideration will also likely be given to US tax implications for beneficiaries who inherit the investment, particularly US beneficiaries.

While it is impossible in a single article to address all of the US tax planning considerations that will be important to a foreign client making a private equity investment in the United States, below is a list of some of the most 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 this is a leveraged investment, will the interest be subject to US income tax or qualify for an exception?5

  • If it is a stock investment, does the investment relate to a passive interest in a holding company or an actively managed business or business in the United States?

  • How does the fund generally structure entry for its foreign investors, and in particular, does the fund implement alternative vehicles or structures with respect to such investments in an active US trade or business?6

  • Does the fund use a foreign feeder fund and, if so, how is this foreign feeder fund classified for US tax purposes?

  • Are there any holding period requirements (i.e. must an investor remain invested in the fund for a certain period of time) and what is the expected exit strategy for the investment?

  • What is the process (or does the fund even allow) to switch from the “foreign” or “offshore” side of the fund to the “domestic” or “onshore” side of the fund (for example, if a foreign investor switches to US while holding the investment or if a US beneficiary inherits the investment).

Although private equity offerings may present attractive investment opportunities for foreign investors (which each investor should evaluate independently), the related US tax implications should be considered well in advance before making a investment.

Footnotes

1 The 30% withholding tax may be reduced or eliminated under certain tax treaties with other countries, but with respect to Latin America, practitioners should keep in mind that the United States does not only have tax treaties in force with Mexico and Venezuela (with the fate of the tax treaty between the US and Chile remaining uncertain at this time).
2 For example, a foreigner receives a $100 dividend from Microsoft. 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 typically include items such as 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 at times there may be a tax position taken by the fund on which differing opinions may exist among practitioners. Foreign investors should therefore seek their own US tax advice before making the investment.
5 The most relevant exception in this area is interest that qualifies for “portfolio interest exemption”, but that’s a discussion for another post.
6 The answer to this question is relevant to both substantial US income tax outcomes for a foreign investor and US tax filing requirements.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

Comments are closed.