As appeared in the Private Equity and Venture Capital 2002 edition of the International Financial Law Review.
Tax Considerations In Structuring US-Based Private Equity Funds
By Patrick Fenn and David Goldstein
Akin, Gump, Strauss, Hauer & Feld, L.L.P.
In forming a US-based private equity fund, the fund sponsor must address tax and other
structuring issues at four levels: the investor level, the fund level, the portfolio investment level
and the fund manager level. This article principally addresses the investor level tax issues that a
fund sponsor will typically face when determining what type of entity the fund will be and in
which jurisdiction it will be formed.
Case Scenario
A group of US-based investment professionals (the sponsor) seek to organize a group of US
and non-US investors to invest in a private equity fund (the fund) with a view to making equity
investments principally, although not exclusively, in the US. Investments may be made in a
broad range of businesses eg mature, start-up, industrial, financial, technological, biochemical.
Investments typically will be held for the medium to long-term, will include some management
rights, and may or may not include control investments. The goal is to improve performance of
the respective businesses and sell at a profit after holding an investment for several years.
The target investor group will include local and foreign institutions (pension funds,
insurance companies, charities and foundations), individuals, governmental entities and perhaps
other private equity funds.
A typical business arrangement for the fund would be as follows: The sponsor would
be paid a flat management fee (eg 1% of committed capital) and would also be entitled to a
share of the profits (typically 20% after investors have realized a preferred return on and the
return of their capital invested) on the overall investment portfolio.
Investor Level Issues
In structuring the fund, there is a basic set of investor expectations that must be met, as well as
issues specific to particular investor groups.
Tax Objectives of Most US Investors
Most US investors will share the following common tax objectives when investing in the fund:
§ the fund itself should not bear tax;
Reprinted by permission. Copyright © 2002. International Financial Law Review magazine, Private Equity and
Venture Capital 2002 supplement.
§ passthrough of capital gains and losses, allowing individuals to enjoy favorable rates of tax
on capital gains (as described more fully below);
§ minimization of “phantom” income (ie the allocation of profits to the investor that are
included in the investor’s taxable income without the receipt of cash);
§ no tax-reporting obligations in non-US jurisdictions; and
§ no tax on gains in non-US jurisdictions or, if taxes are incurred, the ability to credit those
taxes against US tax on the gain.
Specific Tax Objectives of Certain US Investors
In addition, there are certain specific requirements unique to certain classes of US investors,
particularly pension plans, private foundations, charitable trusts and other tax-exempt investors.
Unrelated business taxable income (UBTI) concerns: Certain US investors who are
generally exempt from tax in the United States are taxable in respect of UBTI. In this context,
UBTI will not include dividends, interest and capital gains from the fund’s investment activities,
but will include all or a portion of the income that the fund earns from investments that are in
whole or in part financed with indebtedness (called unrelated debt financed income (UDFI).
UBTI may also include business income allocable to the fund from, for example, an operating
partnership in which the fund is an investor. Charitable remainder trusts are particularly sensitive
to UBTI and UDFI because receipt of an allocation of any such income causes the CRT to be
taxable on all of its income.
The sponsor will generally be required under the fund’s limited partnership agreement to
avoid or minimize UBTI, or may be required to give certain investors the right to opt out of
UBTI-generating investments. Alternatively, US tax-exempt investors may be given the option
of investing in the fund through a non-US feeder corporation established primarily for non-US
investors, eliminating the flow-through of taxable income to the tax-exempt investor.
Employee Retirement Income Security Act of 1974 considerations: As a consequence
of ERISA’s complex rules and high standards of conduct, many fund sponsors attempt to
structure their funds to be exempt from ERISA’s requirements. The two most utilized
exceptions for commingled private equity investment funds are the “operating company”
exception (ie venture capital operating company (VCOC) and real estate operating company
(REOC)) and “significant participation” exception (also referred to as the 25% test). If benefit
plan investors (eg pension funds, IRAs, insurance company separate accounts, and non-US
pension funds) account for 25% or more of fund capital the fund will not satisfy the 25% test
exception. In that case, the fund’s governing documents generally will require the sponsor to
operate the fund so that the fund qualifies under ERISA regulations as a VCOC or REOC.
Very often the structure needed to be employed to comply with the VCOC or REOC rules
conflict with the structure being utilized to achieve tax objectives. Careful consideration of these
often competing objectives should be taken.
Tax Objectives of Most Non-US Investors
Most non-US investors will share the following common tax objective when investing in the
fund:
§ no US taxation of gains;
§ by investing through the fund, the investor’s tax position in the investor’s home jurisdiction is
not worse than if the investor made an investment in the portfolio company directly; and
§ anonymity, ie no obligation to disclose the identity of the fund’s investors to taxing
authorities.
Specific Tax Objectives of Certain Non-US Investors
In addition, there are certain specific requirements unique to certain classes of non-US
investors.
Non-US Pension Funds: Unlike their US counterparts, there is no special exemption
from US tax for non-US pension funds as a matter of US tax law (and similar rules may apply in
other jurisdictions in which the fund invests). However, treaties may eliminate withholding tax
on dividends and interest that otherwise may be applicable. These investors may be
particularly sensitive to the transparency issues, discussed below, potentially relevant to taxation
in their home jurisdictions and the jurisdictions in which the fund invests.
Special needs investors: Certain investors have unique structuring requirements arising from
laws in their home jurisdictions. For example:
§ in order to avoid penalties under the German Foreign Investment Act, German investors
may be required to participate in fund investments through a separate entity established
under German law (eg a GmbH & Co KG) that co-invests with the Fund.
§ French and Netherlands investors need to invest in a vehicle that is transparent for home
jurisdiction tax purposes and possibly for treaty purposes.
§ foreign governments and their controlled entities are exempt on investment income from US
securities but taxable in respect of income from commercial activities. These investors may
need to invest through a parallel fund that excludes “tainted” income or have the right to
opt-out of certain investments if the government investor is a controlled entity.
Basic US Tax Regime Applicable to Non-US Investors
The basic US tax regime applicable to non-US investors in US-based private equity funds is
that they are exempt from taxation on gains from portfolio investment activities, making the
United States a tax haven of sorts for foreign private equity capital. United States tax law
provides that a private equity fund that is investing or trading for its own account is not engaged
in a trade or business in the United States, even if the fund is managed in the United States, and
is therefore not subject to tax on gains. It is also necessary to consider the tax laws of the state
and city where the sponsor is located as different rules may apply, potentially subjecting the fund
to state or city tax liability. However, many states and cities, including New York state and
New York City, follow the federal treatment.
The significance of this basic US tax regime for non-US investors is that:
§ gains are generally exempt from US tax (but see the overriding exceptions below);
§ dividends are subject to statutory withholding at 30%, reduced under any applicable income
tax treaty between the US and the non-US investor’s home jurisdiction, provided that
certain basic information about the non-US investor has been provided to the Internal
Revenue Service (IRS) under new IRS rules; and
§ interest on portfolio indebtedness is exempt from withholding tax, assuming that the
information referred to above is provided. (Interest on indebtedness will not be exempt
from US withholding tax if the recipient owns 10% or more of the voting power of the
issuer. It is not clear whether this test is applied at the fund or investor level). Interest that
is not exempt under the portfolio debt exemption may be exempt under a treaty if
certification rules similar to the dividend withholding certification rules are satisfied.
There are a number of overriding exceptions to the basic rule exempting non-US investors
or a non-US feeder corporation from US taxation, each of which apply in circumstances where
the fund is deemed to be engaged in a trade or business and therefore subject to tax. These
categories of exceptional taxable income include:
§ gain on sales of shares of a US Real Property Holding Corporation (USRPHC) under the
FIRPTA rules;
§ financing activities (Mezzanine funds and funds that invest in distressed bank loans or similar
securities that may involve loan origination, loan syndicate participation, secondary market
purchases of revolving loans, commitment or other funding fees and participation on creditor
committees raise unsettled questions as to whether such programs constitute exempt
investing or taxable financing activities.); and
§ fees from portfolio companies.
The fund’s partnership agreement usually will prohibit the sponsor from making investments
that generate these categories of exceptional taxable income, other than fees from portfolio
companies, which typically, are permitted to be earned by the sponsor and then offset in whole
or in part against management fees.
Choice of Entity and Jurisdiction
The Base Case – Delaware Limited Partnership
As outlined above, US investors will prefer that the fund be structured as a partnership or entity
treated as partnership for US federal income tax purposes. Partnerships are not taxable entities
for US tax purposes; instead, each partner includes in its gross income its distributive share of
partnership income based generally upon the partnership agreement (hence the reference to
partnerships as passthrough entities). Furthermore, a partnership will pass through to the
partners the character of its income. As the fund generally will derive most of its gains from
securities held for more than one year, US partners who are individuals will be subject to tax on
their share of such fund’s gains at favorable long-term capital gains rates.
In addition, structuring the fund as a partnership permits the general partner to receive a
performance-based allocation of partnership profits (called a carried interest). (More recent
funds have permitted the sponsor to waive management fees in exchange for an increased
profits interest.) If structured properly, the receipt of the carried interest by the general partner
at the inception of the fund will not be a taxable event for US tax purposes. Further, an
allocation (and related distribution) to the general partner in respect of its carried interest of
partnership gains results in favorable tax treatment for the sponsor compared to the receipt of
performance-based fee compensation.
Non-US investors may not want to invest in a US partnership due in part to
confidentiality concerns. (While the fund will not be subject to tax, it will be required to file an
annual partnership return with the IRS, attaching a schedule K-1 for each limited partner
reflecting that limited partner’s share of the partnership’s income and losses for the year.) These
investors may invest in the fund through a foreign “feeder” corporation (usually organized in a
tax haven jurisdiction), that in turn invests in the fund. The use of the foreign feeder generally
will ensure that the non-US investor’s identity will not have to be disclosed to any taxing
authority.
Note, however, that the foreign feeder entity may conflict with anti-tax haven legislation
in the investor’s home jurisdiction and may cut off treaty benefits (for example, with respect to
dividends from the United States). As a result, non-US investors are typically given a choice,
based on individual circumstances and concerns, to invest either directly in the partnership
vehicle or through a feeder vehicle. Alternatively, it may be necessary to offer certain investors
the ability to invest in a parallel or co-investment vehicle, which itself acquires an interest in
portfolio companies alongside or in parallel with the fund, as discussed below.
Diagram A is an example of a basic private equity fund structure with a single Delaware
limited partnership and an offshore feeder corporation for non-US investors.
Diagram A
Basic Private Equity Fund Structure
Non-U.S. Investors
Principals/
Individuals
Certain Non-U.S.
Investors, and
U.S. Investors
Feeder Corporation
Manager Partnership
or Management G.P. (Non-U.S.)
S Corporation
x% and
carried interest
Partnership
Fee for
management services
Target Investments
Factors Affecting The Choice Of Jurisdiction
US investors largely will be indifferent to the place of organization of the fund. Typically,
especially if the sponsor is a US-based organization, the fund will be structured as a US limited
partnership because of the developed body of US partnership law. However, a number of
factors may cause the sponsor to consider forming the fund in a non-US jurisdiction:
Investment Company Act considerations: The fund typically will be structured to avoid
registration under the US Investment Company Act of 1940. If the sponsor is seeking to avoid
registration by restricting the number of investors in the fund to not more than 100, using a non-
US jurisdiction provides an advantage. Under the Investment Company Act, non-US investors
will count toward the 100-person limit if the fund is a US-based entity, but they will not count if
the fund is formed in a non-US jurisdiction. Similarly, if the fund relies on the so-called qualified
purchaser exemption, the asset-based qualified purchaser test must be met by all investors in a
US-based fund, but only by US investors if the fund is formed in a non-US jurisdiction.
Publicly traded partnership rules: If there are concerns that, because of the manner in
which investors are permitted to transfer or redeem interests in the fund, the fund would be
characterized as a publicly traded partnership for US tax purposes, organizing the fund in a non-
US jurisdiction may be prudent (although publicly traded partnership issues are not likely in
most private equity funds).
Non-US portfolio investment activities: If the fund intends to invest in non-US
corporations, use of a US partnership could be detrimental to US-taxable investors and the
sponsor. Understanding this issue requires an understanding of the US tax treatment of US
shareholders of controlled foreign corporations (CFCs). A CFC is a foreign corporation
owned (directly, indirectly or under applicable attribution rules) more than 50% by vote or value
by US persons who own at least 10% of the corporation’s voting power. Gain recognized by a
US shareholder on the sale of the shares of a CFC will be recharacterized and taxed as
ordinary income (at higher rates than capital gains) to the extent of the CFC’s accumulated
earnings. For purposes of determining whether a foreign corporation is a CFC (that is, whether
it has a majority of US shareholders), a US partnership is treated as a single US shareholder
(regardless of whether any of the partners in the partnership are US persons). By comparison,
a partnership that is organized in a non-US jurisdiction will not itself be treated as a US
shareholder for CFC determination purposes (even if all of the partners in such partnership are
US persons). Instead the US ownership of a foreign portfolio company owned by a non-US
partnership is determined at the partner level, as though each partner owned an interest in the
portfolio company in proportion to its interest in the partnership. Thus, by organizing the fund as
a non-US partnership, the likelihood that a foreign portfolio company acquired by the fund
would be classified as a CFC might be remote. (Note that the general partner of the non-US
partnership also should be organized as a non-US entity.)
Unless the sponsor insists on utilizing only one investment vehicle, the fund’s partnership
agreement will typically permit the sponsor to establish alternative investment vehicles when
necessary to accomplish a regulatory or fiscal objective that cannot be achieved by the US fund.
Such alternative investment vehicles include parallel partnerships formed to avoid CFC status of
a particular foreign portfolio company, as the need arises. However, use of the parallel vehicle
to address CFC issues might perhaps be subject to challenge if the performance results of the
“main” fund and the parallel vehicle are aggregated (as investors would expect).
Diagram B is an example of a private equity fund structured with basic parallel or co-
investment vehicles.
Diagram B
Parallel Investment Structure
Principals/
Individuals
Non-U.S. Investors
U.S. Investors
U.S. Feeder Corporation
Management G.P. (Non-U.S.) Non-U.S.
Management G.P.
Manager Partnership
or
S Corporation
U.S. Partnership Non-U.S. Partnership
Fee for
management
services
U.S. Target Investments Non-U.S. Target Investments
Even without regard to the issues US investors present, non-US investors may have
concerns with investing through a US limited partnership. As noted earlier, one such concern
involves the disclosure requirements that may be applicable to non-US investors in the fund,
although this concern could be addressed with the use of a non-US feeder vehicle. More
significantly, a US limited partnership may present tax problems for certain non-US investors in
their home jurisdictions, where favourable tax treatment may depend upon the transparency of
the partnership vehicle applying home jurisdiction (rather than US) legal principles. For
instance, the UK, the Netherlands and France require transparency of a partnership or hybrid
entity in order for an investor who is a resident of those jurisdictions to obtain more favorable
tax treatment of capital gains. While each of those jurisdictions recently appears to recognize
the transparency of a US limited partnership, such recognition may not apply for all purposes.
For example, France may not permit treaty claims for non-US investors in a US partnership and
may not recognize the transparency of a US partnership with respect to French investor
treatment. In addition, in the absence of transparency in the investor’s home jurisdiction, the
investor may be deprived of the ability to claim benefits under a treaty the United States
maintains with the investor’s home jurisdiction under the US hybrid entity rules.
Alternative Jurisdictions and Co-Investment Entities
After considering all of the above factors (or where a parallel fund is utilized), consideration
might be given to organizing the fund in a non-US jurisdiction such as the British Virgin Islands
or the Cayman Islands. Each of these has a limited partnership law that is in substance very
similar to Delaware partnership law. However, use of such an entity is not without potential
problems. For instance, certain non-US investors may be disadvantaged in their home
jurisdictions due to anti-tax haven legislation in such jurisdiction, which could result in denial of
certain otherwise-available, favorable home jurisdiction tax treatment or income imputation. In
addition, certain jurisdictions in which the fund may invest might impose penalties on tax haven
residents investing in the jurisdiction. Others might deny transparency to such entities with the
results outlined earlier. Finally, while US investors generally will be indifferent to the use of a
non-US partnership, additional reporting will be imposed on US investors with respect to an
investment in a non-US partnership.
Organizing the fund in certain other non-US jurisdictions may avoid these issues while
also addressing any issues raised by the use of a US limited partnership. These possible
compromise jurisdictions include the UK and Canada. Each of these jurisdictions has a limited
partnership law, although not as flexible as that of Delaware or the tax haven jurisdictions. For
instance, UK limited partnership law currently limits the number of partners permitted in the
partnership to 20 (although recent proposed amendments would eliminate this limitation).
Canadian partnership law construes participation in management of a partnership narrowly,
which in certain circumstances may cause the sponsor and even limited partners participating on
an investor advisory committee to risk losing their limited liability protection. Transparency
issues further complicate the stacking of non-US partnerships for purposes of using feeder
vehicles or selecting a jurisdiction for the sponsor’s vehicle.
Additional co-investment entities may be required for certain non-US investors. For
instance, as mentioned earlier, German investors who invest in non-German investment funds
that are not registered, or white funds, under German law will be subject to significant tax
penalties. Those penalties could be avoided if the sponsor forms a special-purpose GmbH &
Co. KG for German investors, which would co-invest with the fund (subject to certain
limitations). French and Dutch investors may require similar special purpose vehicles organized
as transparent entities under the laws of France or the Netherlands, respectively.
Diagram C is an example of a parallel and co-investment structure with separate feeder
entities and parallel fund vehicles designed to accommodate the needs of non-US investors.
Diagram C
Parallel and Co-Investment Structure
Non-U.S.
Principals/ Special Needs G.P.
Individuals
Special Needs
Non-U.S. Investors Investors
Non-U.S.
•German
U.S. Management G.P. •Dutch
Management G.P. •French
U.S. Investors Feeder Corporation
(Non-U.S.)
Manager Partnership Co-Investors
or •GmbH & Co. KG
S Corporation
•Dutch CV
•French SCS
U.S. Partnership Non-U.S. Partnership
Fee for
management
services
U.S. Target Investments Non-U.S. Target Investments
Conclusion
The presumptive use of US and tax haven partnerships as effective vehicles for private equity
funds requires close scrutiny in light of the myriad tax concerns such entities may raise for fund
investors. Fund sponsors need to be able to balance the need for legal certainties against the
different tax needs of investors as dictated by tax rules in the investors’ home jurisdictions, as
well the tax regimes of jurisdictions in which the fund’s target portfolio companies are located.
The evolution of tax regimes throughout the world to deal with hybrid entities and the increased
focus of such regimes on perceived tax haven abuses continue to challenge previously accepted
norms. However, with careful planning, even special-needs investors should be able to invest in
pooled private equity opportunities on a tax-effective basis.
-end-
Reprinted by permission. Copyright © 2002. International Financial Law Review magazine, Private Equity and
Venture Capital 2002 supplement.
BIOS: Patrick Fenn heads the tax practice group in the New York office of Akin, Gump,
Strauss, Hauer & Feld. His practice includes providing taxation advice to US and non-US
private equity and hedge funds and to managers of such funds. Mr. Fenn can be reached by
email at pfenn@[Link]
David Goldstein is a partner in the investment funds practice group of Akin, Gump, Strauss,
Hauer & Feld, in New York. Mr. Goldstein’s practice focuses on private investment funds,
both US and non-US, in the areas of direct equity, merchant banking, real estate, emerging
markets and securities trading. He has represented funds that have closed on more than $12.5
billion of third-party capital commitments, sponsors of those funds in structuring their
governance and compensation arrangements, and investors in other funds. Mr. Goldstein also
has extensive experience in structuring private fund investments, negotiating joint ventures and
handling regulatory matters pertaining to investment managers. He will be the chairman of the
2002 Private Equity Fund Formation Conferences sponsored by the Institute for International
Research. Mr. Goldstein can be reached by email dgolstein@[Link]
