Over the past few decades, private equity sponsors have raised a substantial amount of capital from both U.S. tax-exempt organizations and non-U.S. investors (“Tax- Sensitive Investors”). While Tax-Sensitive Investors generally do not incur U.S. federal income tax on the disposition of capital investments, they require specific structuring to mitigate U.S. federal income tax filing and payment obligations that can arise with respect to certain investments. Fortunately for private equity sponsors, using a blocker corporation (i.e., an entity treated as a corporation for U.S. federal income tax purposes that is interposed between the Tax-Sensitive Investor and the underlying investment) satisfies most of these tax structuring needs, as described below.
This Article describes some of the history of blocker usage in the private equity world as well as recent developments, some of which were triggered by changes in law and some by shifts in business trends.
Overview of Tax-Sensitive Investors and Blocker Structures
Notwithstanding their moniker, most types of U.S. tax-exempt organizations are subject to tax on income that constitutes “unrelated business taxable income,” or “UBTI.” UBTI generally includes income derived by the organization from any trade or business not substantially related to the basis for its exemption from taxation. In the private equity context, UBTI arises in two principal forms. First, if the fund invests in an operating partnership (e.g., a limited liability company or other pass-through entity for U.S. tax purposes) that is engaged in a trade or business anywhere in the world, a tax-exempt partner’s share of the income of such operating partnership is generally UBTI. Second, a portion of income derived from property that was acquired using “acquisition indebtedness” also constitutes UBTI if the leverage is outstanding or only recently repaid. For example, if the fund purchases securities in part with leverage and sells securities within a year, a portion of the gain generally will be UBTI. However, many state and local government pension plans take the position that they are exempt from all taxation, including UBTI. If a U.S. tax-exempt organization incurs UBTI, it generally is required to file an income tax return with the IRS.
Non-U.S. investors are subject to U.S. federal income taxation on their income that is “effectively connected” with a U.S. trade or business, or “ECI.” Similar to UBTI, if the fund invests in an operating partnership that is engaged in a trade or business within the United States, a non-U.S. partner’s share of such operating partnership’s income and any gain from the sale of such operating partnership is usually ECI. If a non-U.S. investor has any amount of ECI or is otherwise engaged (or deemed to be engaged by virtue of its investment in a pass-through entity that is itself engaged) in a U.S. trade or business, it must file an income tax return with the Internal Revenue Service. Non-U.S. corporations are also generally subject to the “branch profits tax”, a tax at 30% (or a lower treaty rate) on the “dividend equivalent amount” of the non-U.S. corporation, which is approximately equal to the amount of the corporation’s earnings and profits attributable to ECI that is not treated as reinvested in the United States.
A unique group of non-U.S. investors, foreign governments, receive benefits under Section 892 of the Internal Revenue Code (“Code”) on certain forms of income, including dividends, interest and gains on the sale of certain securities. However, they are subject to federal income taxation on their “commercial activity income” or “CAI.” The rules on CAI are similar to those on ECI, and therefore foreign government investors often invest through a blocker alongside other non-U.S. investors. For certain foreign government investors, if they have any CAI, they can lose their “892” status. They are therefore more sensitive to incurring CAI than non-U.S. investors are to incurring ECI.
Due to the above concerns, private equity sponsors often use blockers to “block” UBTI or ECI for Tax- Sensitive Investors. The blockers shield tax-exempt investors from directly incurring UBTI in respect of operating partnerships (and some debt-financed UBTI as well depending on the structure) and shield non-U.S. persons from directly incurring ECI, in each case, together with the associated filing obligation. Furthermore, a non-U.S. corporation that invests in an operating partnership is subject to the branch profits tax but avoids such tax if it invests through a blocker. Of course, the blocker itself pays tax on its share of the operating partnership’s income at the corporate income tax rate, reducing net returns to the Tax- Sensitive Investors who invest through the blocker. The private equity sponsor, to avoid tax leakage on its own interest, often creates a partnership (i.e., a “splitter”) below the blocker, through which it runs its capital contributions and receives its carried interest.
While selling an operating partnership interest usually does not generate UBTI (unless the interest was debt-financed), it may generate ECI. Therefore, even if an operating partnership produces no current income, a foreign partner may still incur ECI when exiting an unblocked investment. Since 1991, the IRS has taken the position that foreign partners must look through to the assets of the partnership to determine whether income from disposition of a partnership interest constitutes ECI.1 Under the IRS’s view, if the partnership was engaged in a U.S. trade or business, the income from disposition of a partnership interest would constitute ECI to the extent the assets of the partnership would generate ECI if they were all sold off at fair market value. In 2017, Congress added Section 864(c)(8) to the Code to codify the IRS’s view. Moreover, a new withholding regime was added to collect taxes from sales by non-U.S. sellers of interest in partnerships unless the seller can establish an exemption from withholding.
The Early Days: Before Widespread Blocker Usage
Before the use of blockers as the preferred method for private equity funds to accommodate Tax-Sensitive Investors, such investors relied on ECI and UBTI covenants for protection. These covenants would prohibit funds from making any investment that would generate ECI or UBTI or provide for a cap on the amount of ECI or UBTI investment that could be made. However, these covenants often constrained investment opportunities to corporate investments and were disliked by private equity sponsors.
Nonetheless, private equity sponsors often agreed to such covenants because many potential portfolio companies were in corporate form, and so the real-world limitations created by these covenants were somewhat low.
The Rise of Blocker Usage
During the 1990s, use of limited liability companies (“LLCs”) rose as state legislatures enacted LLC statutes.2 Entrepreneurs became more comfortable with the entity in part because the corporate law on LLCs started to develop and become more stable. Preference for LLCs also grew because they afforded limited liability to all owners, flexible sharing of economics and, perhaps most importantly, pass-through taxation. Coinciding with this development was the advent of the check-the-box regulations in 1996, under which business owners could simply choose to treat an LLC as a partnership for tax purposes (as opposed to running through a multi-factor test to determine whether it was a corporation or a partnership for tax purposes).
As a consequence, the investment opportunities for private equity sponsors in pass-through entities grew rapidly, putting tension between sponsors who wanted the flexibility to pursue such opportunities and Tax-Sensitive Investors who wanted to avoid the negative tax impacts to them from operating partnership investments. Investments in operating partnerships are attractive in part because the buyer generally receives an amortizable step-up in the basis of the assets of the company. In addition, the buyer can generally obtain a higher price on exit since their next buyer will also receive a step-up. To accommodate Tax-Sensitive Investors while retaining flexibility to pursue operating partnership deals, sponsors began to rely more on using blocker structures rather than on ECI and UBTI covenants. Some sponsors also started to utilize shareholder leverage to reduce a blocker’s tax liability. Typically, this involved the fund entity structuring a portion of their investment in the blocker as a loan. The loan would generate deductible payments for the blocker, subject to the business interest limitation rules. As an added benefit, repayment of the loans would be treated as return of capital rather than as a dividend and would not be subject to dividend withholding tax.
Over the same decade, tax-exempt investors became savvier and began to focus more on after-tax returns, as opposed to avoiding UBTI entirely. As tax-exempt investors are not subject to UBTI on sales of interests in operating partnerships (unless the interests are debt-financed and the debt is still outstanding or recently repaid), such investors are often comfortable receiving UBTI from current income, if any, in exchange for maximizing their after-tax returns on exiting the investment. As such, many began to invest unblocked because they did not want to incur the tax leakage at the blocker level. They also became more comfortable with the tax filing obligation to report UBTI as a matter of course.
Non-U.S. investors, on the other hand, generally preferred to invest through blockers in most cases to avoid the tax return filing obligation. Moreover, unlike tax-exempt investors where blockers were largely tax inefficient, blockers had a tax-neutral impact on non-U.S. investors. Indeed, for non-U.S. corporations, using a blocker often is more tax efficient because it avoids the branch profits tax. Over time, these investors too became savvier and began to push for blocker leverage to reduce tax leakage. The blocker corporation is able to use interest deductions (subject to the business interest limitation rules) to reduce its tax liability, and the non-U.S. tax-sensitive investors are able to repatriate cash tax-free as return of principal. This was aided by a clarification in the Treasury regulations that for purposes of applying the portfolio interest exemption from withholding taxes, the IRS will look through a partnership for determining if an investor is under the 10% ownership threshold and therefore qualifies for the exemption.4 The clarification allowed non-U.S. investors to take the position that they qualify for the exemption if they own less than 10% of the blocker.
Modern Issues in Blocker Usage—Exiting Blocked Investments
Potential Tax Leakage when Exiting Blocked Investments
With the proliferation of blocker usage, sponsors and limited partners started to think more carefully about exiting blocked investments. A fund generally faces two options when exiting a blocked investment. The fund and the blocker can each sell their interests in the investment, and the blocker can then distribute the after-tax proceeds to the fund (possibly in liquidation, if the blocker only held a single investment). Alternatively, the fund can sell the blocker itself along with the interests it holds directly in the investment.
For example, assume a fund owns 50% of an operating partnership directly and 50% through a blocker. The total cost of the investment was $200 and its fair market value at the time of exit, ignoring the blocker, is $400. Further assume that there is no depreciation during the holding period so that tax basis in the assets remains $200. If the blocker sells its partnership interests, it and the fund will each receive $200. This is because the buyer is not purchasing the blocker and therefore will pay full fair market value. Of the $200 the blocker receives, it must pay $21 of taxes on the $100 of profit based on a corporate tax rate of 21%, leaving the fund with a total of $379. On the other hand, the buyer gets the benefit of a full basis step-up of $200, which generally will be amortizable over 15 years.
However, if the fund instead sells the blocker alongside its direct interest in the operating partnership, the buyer is losing out on $100 of tax basis to amortize, which is $21 of tax shield. However, this tax shield is spread over 15 years, whereas the $21 of cost to the fund in the first scenario is immediate. Overall, the benefit to the sponsor of selling the blocker outweighs the cost to the buyer, and, in a rational world, the tax saved by the selling fund will be greater than the discount in price paid by the buyer due to the reduction in amortizable tax basis, the so-called “blocker discount.” Sales of blockers have become increasingly common in a competitive sale process.
Sharing the Blocker Discount
If a fund decides to sell a blocker, it must decide who must bear the blocker discount economically. Some fund agreements have all partners share the discount, usually for one of two reasons. First, the fund needed capital from all partners to make the investment and so it is only fair for everyone to bear the discount. Second, it can be difficult to calculate the blocker discount.
Most funds, however, allocate the blocker discount only to the investors who chose to invest through the blocker. While this approach is often more burdensome to implement, many sponsors and investors see it as a fair way to address the issue. With respect to the general partner and its carried interest, most funds calculate carried interest on a pre-blocker taxes basis and a pre-blocker discount basis.
Some complications may arise at the deal level if the operating partnership has co-investors and management who own interests alongside the fund. Under the joint venture agreement with the co-investors and management, it is common for all selling parties to receive the same price per unit irrespective of whether they are selling direct interests or blocker stock. This effectively means that the blocker discount, if any, is borne by all holders. If that is the case, it can be harder to separate at the fund level what the blocker discount amount is and how to allocate it among the limited partners, other than on a pro rata basis. For an unblocked limited partner, they may prefer having the blocked limited partners bear the entirety of the blocker discount at the fund level, even if that means that, at the deal level, the co-investors and management will not bear any of it.
Buying an Existing Blocker and Using it as the Fund’s Blocker
When a private equity funds buys an operating partnership from another private equity fund, the selling fund will likely want the purchasing fund to acquire its blocker. The purchasing fund has two main options when it comes to addressing the existing blocker. Historically, funds generally viewed the purchase as two investments: one investment in a corporation and one investment in the operating partnership. The fund would then add a blocker for the investment in the operating partnership. For example, assume a fund is buying an operating partnership that is 50% owned directly by the selling sponsor and 50% owned by a blocker and that the purchasing fund also needs to be blocked for 50% for its investment in the operating partnership. For the investment in the operating partnership, most fund sponsors have historically set up a second blocker. As a result, 75% (50% held by the fund for all investors through the existing blocker and 25% held by the fund for its tax-sensitive investors through the second blocker) of the interests in the underlying operating partnership are held through blocker, while the fund only needs 50% to be blocked. Because the exit will be structured as a sale of the blockers, creating multiple blockers shrinks the amount of step-up available that can be offered to a future buyer.
It would be tempting in this scenario to try a second option—namely, to use the selling fund’s blocker as the blocker for the purchasing fund’s blocked investors and therefore to avoid creating excess tax leakage due to setting up a second blocker. While tempting, there are tax detriments to the purchasing fund’s blocked investors in purchasing the existing blockers—most significantly, there is no amortizable step-up associated with a purchase of the blocker. However, it may be possible to implement this second option in a manner that is fair to all investors, for example, by having the blocked investors of the purchasing fund receive the full benefit of any blocker discount associated with the purchase of the blocker. Needless to say, this approach creates additional complexity and may still raise structuring concerns, especially where the existing blocker is larger than necessary for the purchasing fund.
Private equity sponsors and investors have become more sophisticated in their approach to UBTI or ECI and in structuring investments through blockers, with more focus on tax efficiency, including reducing tax leakage through the use of leverage and the sale of blockers. More recently, as investments are increasingly sold from one private equity sponsor to another, we may see purchasing funds looking for creative ways to use a selling fund’s existing blocker for their Tax-Sensitive Investors.
The Private Equity Report Fall 2020, Vol 20, No 3