Private Equity: Offshore Investments and Phantom Income
Private equity funds pool capital for investment in privately-held businesses. Increasingly, PE funds are looking to global investment markets and foreign opportunities.
Investors and fund managers generally share a number of common tax goals, including minimizing “phantom” income—that is, profit allocations that do not have a corresponding cash distribution.
In keeping with this goal, funds investing outside of the United States typically attempt to mitigate, if not avoid, U.S. anti-deferral regimes. Historically, the two most notable regimes in this respect are the Subpart F rules applicable to U.S. shareholders of “controlled foreign corporations” (CFCs) and the “passive foreign investment company” (PFIC) regime. In addition, the Tax Cuts & Jobs Act introduced another commonly encountered anti-deferral regime: global intangible low-taxed income (“GILTI”).
Controlled Foreign Corporations (“CFCs”)
A controlled foreign corporation (“CFC”) is a foreign corporation in which “U.S. Shareholders” have sufficient ownership. Under the current tax law, “U.S. shareholders” must, in the aggregate, own more than 50 percent of the total combined voting power or value of the foreign corporation’s stock. The ownership can be direct, indirect, or constructive.
A U.S. shareholder is a U.S. person who owns—again, directly, indirectly, or constructively—10 percent or more of the total combined voting power of voting stock or the total value of all classes of stock entitled to vote in a foreign corporation.
Of particular note, for tax years ending on or before December 31, 2017, section 958(b)(4) “turned off” “downward attribution”—that provision prevented a U.S. person from being treated as owning stock that owned by a non-U.S. person. The Tax Cuts & Jobs Act of 2017, however, repealed section 958(b)(4). As a result, for tax years beginning on or after January 1, 2018, “downward attribution” applies to treat U.S. persons as owning the stock of non-U.S. persons. This change had the effect of causing many taxpayers to fall under the definition of “U.S. shareholder,” which caused many foreign corporations to fall within the definition of a CFC, even though they had not in prior years.
Under the CFC rules, a U.S. partnership is treated as a U.S. person, even though subchapter K generally treats a partnership as a conduit that is not subject to an entity-level tax. Thus, a domestic partnership owning more than 50% of a foreign corporation will be treated as a U.S. shareholder of a CFC.
Subpart F Phantom Income
Subpart F rules treat a U.S. shareholder of a controlled foreign corporation (“CFC”) as though it received its pro-rata share of certain categories of the CFC’s current earnings and profits (“E&P”). That is, a U.S. shareholder is required to include in current income its pro-rata share of the CFC’s Subpart F income even if it is not distributed and received.
A fund investing outside the U.S. will generally seek to minimize its exposure to Subpart F’s CFC regime. Sponsors may employ a number of structures, such as organizing a primary fund as a foreign partnership or an offshore “alternative investment vehicle” (“AIV”) as a separate funding vehicle.
A foreign corporation falls under the definition of a passive foreign investment company (“PFIC”) if it satisfies either the income test or the asset test.
Income test. 75% or more of the corporation’s gross income for its tax year is passive income.
Asset test. At least 50% of the average percentage of assets held by the foreign corporation during the tax year are assets that produce passive income or that are held for the production of passive income.
PFIC Look-thru rule.
For purposes of determining whether a foreign corporation is a PFIC, the foreign corporation is treated as if it directly held its proportionate share of the assets, and directly received its proportionate share of the income, of any corporation in which it owns at least 25% of the stock (by value).
CFC overlap rule.
A 10%-or-more U.S. shareholder that includes in income its pro-rata share of subpart F income for the stock of a CFC that is also a PFIC is generally not subject to the PFIC provisions for the same stock during the qualified portion of the shareholder’s holding period of the stock in the PFIC. This exception, however, generally does not apply to option holders.
Tax Consequences for Shareholders of a Section 1291 Fund
Unless a taxpayer makes an election otherwise, a PFIC defaults into the status of a “section 1291” fund. Shareholders of a section 1291 fund are subject to a tax regime that imposes a tax on the receipt of an excess distribution and the recognition of gain on the sale or disposition of the stock of the section 1291 fund. The entire amount of gain from the disposition of a section 1291 fund is treated as an excess distribution.
An excess distribution is the portion of any distribution received from a section 1291 fund that is greater than 125% of the average distributions received by the shareholder with respect to such stock during the 3 preceding tax years (or, if shorter, the portion of the shareholder’s holding period before the current tax year). The law provides an exception, however, with respect to distributions received or deemed received during the first tax year of the shareholder’s holding period of the stock.
The excess distribution is generally determined on a per-share basis and is allocated to each day in the shareholder’s holding period of the stock.
The portion of the excess distribution that is allocated to the current tax year and the shareholder’s tax years in its holding period prior to the foreign corporation qualifying as a PFIC are taxed as ordinary income. The portion allocated to the taxpayer’s holding period during which the foreign corporation qualified as a PFIC are subject to the separate punitive tax and interest charge provisions in section 1291(c).
Qualified Electing Fund (QEF)
A PFIC is a QEF if a U.S. person who is a direct or indirect shareholder of the PFIC makes a proper and timely election to treat the PFIC as a QEF.
The Tax Consequences for Shareholders of a QEF
A shareholder of a QEF is required to include (i) its pro-rata share of the ordinary earnings of the QEF in gross income as ordinary income annually and (ii) its pro-rata share of the net capital gain of the QEF as long-term capital gain.
If the QEF election is not made for the first year of the shareholder’s holding period in the PFIC, the shareholder may be able to “purge” the “PFIC” taint through an election to trigger a deemed sale or deemed dividend where appropriate. In such case, the PFIC will become a pedigreed QEF pursuant to Treasury Regulation section 1.1291-9(j)(2)(ii).
A shareholder who receives a distribution from an unpedigreed QEF will also be subject to the Section 1291 rules.
A U.S. shareholder of a PFIC may elect into the mark-to-market regime if the stock is “marketable stock.”
Marketable stock is defined as PFIC stock that is regularly traded on:
- A national securities exchange that is registered with the Securities and Exchange Commission (SEC),
- The national market system established under section 11A of the Securities Exchange Act of 1934, or
- A foreign securities exchange that is regulated or supervised by a governmental authority of the country in which the market is located and has the characteristics described in Regulations section 1.1296-2(c)(1)(ii).
- Stock in certain PFICs described in Regulations section 1.1296-2(d).
Special rules apply with respect to regulated investment companies (RICs) that own PFIC stock.
After a PFIC shareholder elects to mark the stock to market under section 1296, the shareholder either:
- Includes in income each year an amount equal to the excess, if any, of the fair market value of the PFIC stock as of the close of the tax year over the shareholder’s adjusted basis in such stock; or
- Is allowed a deduction equal to the lesser of:
- The excess, if any, of the adjusted basis of the PFIC stock over its fair market value as of the close of the tax year; or
- The excess, if any, of the amount of mark-to-market gain included in the gross income of the PFIC shareholder for prior tax years over the amount allowed such PFIC shareholder as a deduction for a loss with respect to such stock for prior tax years.
Global Intangible Low-Taxed Income (“GILTI”)
The TCJA enacted the GILTI rules, which require U.S. shareholders of controlled foreign corporations (“CFCs”) to include GILTI in gross income each year (the “GILTI inclusion”). PE funds that are structured as domestic partnerships and that own foreign portfolio company investments may see a degree of tax relief through the GILTI regime (in the form of lower effective tax rates), though may be subject to phantom income without proper planning.
GILTI, working in tandem with Subpart F, closed substantial pre-TCJA anti-deferral gaps, and resulted in the inclusion of a large swath of offshore earnings in US taxable income on a current basis. 10% US shareholders/investors who are not corporations may, however, see detrimental tax impact–though certain planning mechanisms may be available, such as a section 962 election to realize foreign tax credits.
The GILTI provisions under section 951A in effect approximate the intangible income of a CFC by assuming a 10% rate of return on the tangible assets of the CFC. Any income in excess of that “normal return” on assets is effectively treated as intangible income.
A U.S. shareholder’s GILTI inclusion is the excess of the U.S. shareholder’s pro-rata share of net CFC tested income over its net deemed tangible income return (“net DTIR”).. And tested income is gross income without regard to certain exceptions:
- Subpart F
- High-Tax Income
- Certain FOGEI
- Certain related-party dividend
Offshore Parallel Vehicles
A parallel fund invests alongside—that is, in parallel to—another “master” or main fund. Often, the parallel fund may be formed offshore in another jurisdiction. For instance, a Delaware-based fund may operate a Cayman Islands-based fund (the parallel fund) to accommodate non-US investors by allowing them to avoid US reporting obligations.
Domestic fund managers may choose to fund foreign portfolio company investments through an offshore alternative investment vehicle. Generally, the domicile of the AIV will determine whether the foreign corporation is a CFC. There is, however, often a potential risk that the Service could view the fund, rather than the AIV, as the relevant shareholder for CFC-characterization purposes—a risk that is presented when, as is often the case, the funds’ returns are aggregated for purposes of determining whether the general partner has a right to a carry distribution.
Use of hybrid entities provides another potential mechanism to mitigate exposure to the subpart F regime. Funds may utilize a combination of an interposed Luxembourg or Dutch holding company between the fund level and operating subsidiaries, intercompany debt, and earnings stripping arrangements to lower the overall effective tax rate. Structures such as this, however, require ensuring that no significant part of the holding company’s offshore earnings are subject to tax (on any U.S. shareholders) under the CFC regime. Use of hybrid arrangements may allow the taxpayer to avoid recognizing payments made by the holding company’s subsidiaries (e.g., dividends and interest paid to the holding company) for U.S. tax purposes, thereby avoiding payments to holding company that would otherwise be characterized as subpart F income.
 The Subpart F rules were first enacted in 1962 as part of the Revenue Act of 1962 (the ‘‘1962 Act’’), Pub. L. 87–834. Subpart F was specifically intended to curtail the use of low-tax jurisdictions for indefinite deferral of U.S. tax on certain earnings that would otherwise be subject to U.S. federal income tax. H.R. Rep. No. 1447 at 57 (1962). Congress expressly sought to target taxpayers who had ‘‘taken advantage of the multiplicity of foreign tax systems to avoid taxation by the United States on what could ordinarily be expected to be U.S. source income.’’ Id. at 58.
Before the 1962 Act, United States shareholders of CFCs were not subject to U.S. tax on the earnings of foreign subsidiaries unless and until earnings of the foreign corporations were distributed to the shareholders as a dividend. S. Rep. No. 1881 at 78 (1962). The subpart F regime eliminated deferral for certain earnings of CFCs—subjecting those earnings to immediate U.S. taxation regardless of whether there was an actual distribution.
 A U.S. shareholder’s net CFC tested income is the aggregate pro-rata share of tested income from each of its CFCs minus the aggregate pro-rata share of tested loss from each of its CFCs (but not less than zero). Net DTIR is defined as 10% of the U.S. shareholders pro-rata share of aggregate qualified business asset investment (“QBAI”) of its CFCs less specified interest expense. A CFC’s QBAI is its average quarterly basis in depreciable tangible property used in a trade or business for the production of tested income.
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