‘Blocker’ corporations: Considerations for investment fund managers

Editor: Christine M. Turgeon, CPA

Fund managers should consider how any new fund should be structured for U.S. federal income tax purposes because certain types of investors may be sensitive to holding an investment in flowthrough form (e.g., directly into a fund) and need to use a corporate blocker to facilitate their investments. This item outlines several issues for fund managers to consider as they analyze how to use blocker corporations in their fund structures.

Background

“Blocker” is a colloquial industry term referring to an investment vehicle that is treated as a corporation for U.S. federal income tax purposes (e.g., a U.S. C corporation, a U.S. limited liability company that has elected to be treated as a corporation for such purposes, or a foreign entity that is treated as a corporation for such purposes). Due to the corporate status of the blocker, all items of income, gain, deduction, and loss of an underlying investment portfolio generally are taxed at the corporate level and not at the ultimate investor level until the time a distribution is made from the corporate blocker to the relevant investor. Thus, the corporation “blocks” the ultimate investor from earning the income directly.

Different reasons can exist for certain types of investors to want to invest through a blocker. For example, tax-exempt investors generally invest through blockers in seeking to mitigate potentially adverse tax consequences of earning unrelated business taxable income (UBTI). Foreign government investors (i.e., Sec. 892 investors) use blockers in seeking to mitigate potentially adverse tax consequences of earning commercial activity income (CAI), including possible loss of their tax exemption in certain circumstances. Other non-U.S. investors may be sensitive to earning effectively connected income with a U.S. trade or business (ECI).

A detailed explanation of the relevant tax sensitivities for investors that use blocker corporations is beyond the scope of this discussion; however, fund managers generally should consider several threshold questions in analyzing whether their blocker structures are both efficient and marketable.

Consideration 1: Blocker jurisdiction

Assuming that an investment manager concludes that a blocker should be offered as part of the overall fund structure based on the profile of expected investors, consideration should be given to choosing the jurisdiction of the corporate blocker because the jurisdiction can significantly affect overall investment returns.

U.S. blockers are subject to U.S. federal income tax at a rate of 21% on their worldwide income (including gains on exit), whether such income is U.S.- or foreign-source. State tax also may apply in addition to non-U.S. taxes (e.g., withholding taxes) to the extent applicable.

Non-U.S. or “foreign” blockers are not subject to U.S. federal income tax on their worldwide income. Instead, they generally would be subject to U.S. federal income tax on their U.S.-source income at a rate of either 30% on relevant gross income (passive-type income such as dividends, interest, and royalties) or 21% on ECI. Income earned related to a U.S. trade or business also generally is subject to an additional amount of U.S. tax (the branch profits tax), which increases the effective tax rate on income associated with a U.S. trade or business earned by a non-U.S. corporation to 44.7% unless it is mitigated under an applicable income tax treaty. Local jurisdiction tax also should be considered.

Fund-managed blockers (i.e., blocker vehicles organized by an investment manager, as opposed to an investor) often have been organized in the Cayman Islands. While it is effective for certain types of investments (due to the relatively inexpensive operation costs and the lack of a corporate income tax), this structure may increase the overall tax liability associated with certain investments, given that the United States and the Cayman Islands do not have an income tax treaty. Therefore, passive U.S.-source income earned by a Cayman Islands blocker may be subject to a 30% U.S. withholding tax, which otherwise could have been reduced had the blocker been organized in a different jurisdiction or as a local partnership that made an election to be treated as a corporation for U.S. federal income tax purposes.

The following high-level general guiding principles should be considered as part of a detailed investment strategy review, taking into account the particular facts and circumstances involved:

• U.S. blockers generally may be preferable for holding exclusively U.S. investments that generate taxable income that would be considered UBTI, CAI, or ECI. Note that in certain circumstances — e.g., to mitigate potential U.S. withholding taxes being triggered on the sale of a U.S. blocker that is considered a U.S. real property holding corporation (USRPHC) — a double blocker structure may be used (e.g., where a non-U.S. blocker holds the shares of the USRPHC).
• In general, U.S. blockers can be inefficient when they hold non-U.S. income-producing assets that make up a material part of the investment returns.
• Foreign blockers generally may be preferable for holding exclusively or primarily non-U.S. investments that generate taxable income that would be considered UBTI or CAI.
• In general, foreign blockers (depending on the country of organization) can be inefficient for holding U.S.- source income-yielding investments subject to several exceptions (e.g., the portfolio-interest exemption).
• The treaty network of any foreign blocker should be considered (or the treaty network of relevant investors, in the case of a reverse hybrid foreign blocker).
• Many funds contemplate both U.S. and non-U.S. investments. In such cases, a detailed tax-modeling exercise may be necessary in analyzing the preferred investment structure.

Consideration 2: Single or multiple blockers

Whether a fund manager uses a single blocker or multiple blockers for any particular fund structure depends on a number of tax- and non–tax-related factors. Managers may wish to consider the following as they determine their fund structures:

• Overall manager sophistication;
• Overall fund marketability;
• Anticipated total capital commitments;
• Tax profiles of anticipated largest/ most important investors;
• Anticipated target assets and jurisdictions/geographies;
• Relevant U.S. and non-U.S. tax rules that may be implicated with respect to a particular fund mandate (e.g., the portfolio-interest exemption and securities or commodities trading U.S. trade or business exceptions);
• Ability to sell blocker stock compared to blocker assets; and
• Operational/administrative costs.

Although each factor needs to be considered in detail, fund managers should confirm that appropriate attention is given to certain key general areas of focus outlined below (each with a few short examples):

Managing investor-specific tax sensitivities: In a relatively straightforward fund structure, a manager may elect to use a single blocker to serve all investors that are sensitive to certain types of passthrough income (e.g., UBTI, CAI, or ECI). For example, both tax-exempt entities and Sec. 892 investors may invest side by side in a single blocker. But while their U.S. tax sensitivities may be similar (e.g., a common desire to not invest in a flowthrough structure), they are not identical (given that the tax exemptions for such investors are governed by different sets of rules). Therefore, a tailored investment strategy for specific investor groups may not be feasible in a single blocker structure.

Scenario A: Consider a fund that makes a U.S. real estate investment where both Sec. 892 investors and ECI-sensitive investors have committed capital. In general, it would be expected that both types of investors would wish to have the investment blocked, but the blocker setup preferences may be different. Specifically, a Sec. 892 investor may prefer to hold an interest directly in a U.S. corporate blocker that would be considered a USRPHC so that it may have increased flexibility on exit (e.g., flexibility to sell to a U.S. buyer that would not want to purchase shares of a foreign blocker).

On the other hand, a general ECIsensitive investor may prefer to hold shares in a non-U.S. blocker that in turn owns the shares of the USRPHC so that it may sell the shares of the non- U.S. blocker without triggering U.S. tax under the Foreign Investment in Real Property Tax Act (FIRPTA) rules on the sale of non-U.S. blocker shares.

Scenario B: Fund investors may capitalize a blocker with both equity and debt in order to provide additional financing for investments and manage the taxable income profile of the blocker. As managers evaluate potential debt packages, the use of single or multiple blockers may affect both the quantum of debt able to be issued as well as the relevant interest rate (e.g., increased collateral under a single corporate borrower may result in more favorable terms).

In addition, withholding tax considerations with respect to interest payments from the blocker to the investors need to be analyzed. For example, in the context of a U.S. corporate blocker that issues debt, investors may need to rely on the portfolio-interest exemption if a tax treaty does not otherwise eliminate the statutory 30% U.S. withholding tax on such interest payments. In funds with a smaller pool of investors, the portfolio-interest exemption may be more available if all investors loan to the same blocker corporation (given that 10% shareholders are unable to apply the exemption).

Certain structure considerations: Structures that use multiple blockers for discrete investments (socalled deal-by-deal blockers) generally do not allow income derived from one investment to be offset with losses derived from another investment. In certain cases, the inability to net income and losses in a single corporate vehicle can result in the ultimate investor paying significantly more tax than if a single blocker had been used for multiple investments (e.g., the losses of an unsuccessful investment may be suspended and permanently lost upon the winding up of the investment fund and liquidation of the corporate blocker).

In addition, as mentioned above, deal-by-deal blocker structures may limit the amount of debt that can be issued by a blocker. In general, a corporation’s ability to issue debt and the interest rate of the respective loan are directly correlated to its ability to service the debt. Thus, a single blocker that holds multiple investments may be able to secure a more advantageous debt package, as opposed to separately leveraging deal-by-deal blockers on an individual basis.

Certain exit considerations: A deal-by-deal blocker structure may be better for exit purposes as compared to a single blocker that holds multiple investments. For example, in the context of an exit via sale of a blocker, a deal-bydeal blocker structure generally allows increased flexibility for funds to dispose of unwanted assets without engaging in potentially complex and costly reorganizations to carve out assets to be retained.

In addition, given that in certain circumstances it may be more efficient for a U.S. blocker corporation to make a liquidating distribution rather than pay a dividend (i.e., due to withholding tax implications), fund managers may prefer that discrete investments are held by separate blockers such that the blockers may be able to liquidate at the end of an investment, as opposed to paying out proceeds via a dividend that may be subject to U.S. withholding tax.

Structure is key to return on investment

Strategic use of blocker corporations in any investment structure can be critical to the overall success of the manager from a business perspective, given that the chosen structure directly affects the investment return rate for investors. Managers should take into account the tax considerations outlined above (e.g., jurisdiction of the blocker and number of blockers), among others, as well as potential tax modeling, in analyzing how a particular fund should be structured, considering the tax sensitivities of expected fund investors.

Editor Notes

Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City. For additional information about these items, contact Turgeon at christine.turgeon@pwc.com. Contributors are members of or associated with PricewaterhouseCoopers LLP.