Bill Redefining “Acquisition Indebtedness” for UBTI Purposes Could Diminish, But Likely Would Not Eliminate, Utility of “Blockers” in Hedge Fund Structures

A significant and growing proportion of the assets invested in hedge funds globally come from U.S. tax-exempt entities such as endowments, foundations, state pension funds and corporate pension funds that are “qualified” under Internal Revenue Code (IRC) Section 501(a).  Mechanically, tax-exempt entities generally invest in a corporation organized in a low-tax or no-tax, non-U.S. jurisdiction, which in turn invests in an entity that buys and sells securities and other assets.  The buying and selling entity is often organized in a tax-advantaged, non-U.S. jurisdiction as a corporation that “checks the box” for partnership treatment for U.S. tax purposes (although other structures and entity types are also used).  See “Implications of Recent IRS Memorandum on Loan Origination Activities for Offshore Hedge Funds that Invest in U.S. Debt,” Hedge Fund Law Report, Vol. 2, No. 41 (Oct. 15, 2009).  Tax-exempt hedge fund investors go through these contortions to avoid paying tax, at corporate tax rates, on so-called Unrelated Business Taxable Income (UBTI).  As explained in more detail in this article, the portion of interest, dividends and capital gains generated by a domestic hedge fund in a tax year based on “acquisition indebtedness” will constitute UBTI on which U.S. tax-exempt investors in that fund will owe tax at corporate rates.  Specifically, a domestic hedge fund’s UBTI for a tax year generally is equal to the fund’s total interest, dividends and capital gains for the tax year times a percentage, the numerator of which is the fund’s average acquisition indebtedness and the denominator of which is the average cost basis of the fund’s investments.  For example, if a domestic hedge fund had a total return (including interest, dividends and capital gains) for the tax year of $20 million, an average cost basis of $100 million and average acquisition indebtedness of $30 million, the fund would have $6 million of UBTI for the tax year.  That UBTI would be allocated pro rata to the fund’s tax-exempt investors for tax purposes.  So if the fund had two tax-exempt investors with equal investments, at a corporate tax of 35%, each would owe tax of $1.05 million on its distributive share of the fund’s UBTI for the tax year.  By contrast, if a tax-exempt investor invests in a corporation that in turn invests in a lower-tier trading entity, the UBTI created by the trading entity’s acquisition indebtedness will not flow through to the tax-exempt investor, and the investor will not owe tax on the UBTI (unless the investor’s purchase of shares in the corporation was itself financed by acquisition indebtedness).  This is because the Internal Revenue Service respects the ability of corporations to “block” UBTI.  See “IRS ‘Managed Funds Audit Team’ Steps Up Audits of Hedge Funds and Hedge Fund Managers, and Investigations of Hedge Fund Tax Compliance Issues,” Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009).  On July 31, 2009, Rep. Sander Levin (D-MI) introduced H.R. 3497, a bill that would revise the definition in the IRC of “acquisition indebtedness” to exclude debt incurred by a U.S. partnership for investments in “qualified securities or commodities.”  (Levin had introduced similar legislation in 2007.)  In short, if Levin’s bill were to become law, it would diminish the rationale for investments by U.S. tax-exempt investors in hedge funds via offshore corporations.  However, offshore corporations exist in hedge fund structures for reasons other than blocking UBTI, so even if Levin’s bill were to become law, the case for offshore corporations could remain compelling.  This article offers a more comprehensive discussion of the taxation of UBTI; tax-exempt investor attitudes towards UBTI; structuring of hedge funds to enable tax-exempt investors to avoid UBTI; the mechanics of the Levin bill; the potential impact of the Levin bill if enacted on tax-exempt hedge fund investors as well as non-U.S. investors; and the likelihood of enactment of the Levin bill.

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