Florida Tax Attorney Blog

Private equity funds are typically organized as limited partnerships ("LP") in order to obtain both limited legal liability and the tax benefits associated with the flow-through entity structure. In this respect, the limited partnership is often organized in a favorable foreign tax jurisdiction (e.g., the Caymans) rather than in the United States. In addition, private equity funds are making more and more foreign investments, which often involves the acquisition of foreign companies. But although private equity funds are often organized abroad and investing abroad, they continue to be managed out of the United States.

This raises a significant tax question: If a foreign corporation is owned 100% by a foreign limited partnership which is managed by a U.S. general partner does the U.S. general partner taint the corporation so that it constitutes a controlled foreign corporation ("CFC") for tax purposes?

The concern with the U.S. general partner is that the general partner is effectively in control of the foreign corporation by virtue of its status as general partner of the private equity fund. In many ways, a general partner can be analogized to a board of directors. And given this element of control, the foreign corporation would likely be treated as a CFC for tax purposes absent certain unique terms in the limited partnership agreement. As a result, the investors become subject to Subpart F of the Internal Revenue Code. The specific tax implications of Subpart F are beyond the scope of this article, but they may be adverse. This is not to say that a private equity fund should never be structured as described above. And indeed, this structure may be unavoidable in some contexts giving the increasingly globalized investment climate. What's important is that management be aware of the potential tax implications in order to ensure compliance and avoid IRS penalties.

If you would like assistance evaluating the international tax consequences of a potential or existing private equity fund, feel free to contact me via phone or email. Initial consultations are always free!

Private equity funds typically seek to attract three types of investors:

(1) U.S. Investors - both individual and corporate, but mostly corporate
(2) U.S. Tax-Exempt Investors - e.g., pension funds
(3) Foreign Investors

Critical to the investment decision for tax-exempt and foreign investors is that the private equity fund not be engaged in a U.S. trade or business for tax purposes. This is because the tax-exempt investor could realize unrelated taxable business income and the foreign investor could be subject to U.S. taxation if the fund is considered to be engaged in a trade or business for U.S. tax purposes. Consequently, it is absolutely crucial for private equity funds to take appropriate steps to avoid being characterized as engaged in an active U.S. trade or business.

In today's market, many private equity funds are investing in distressed debt. The challenge in this context is acquiring and managing distressed debt without being viewed as engaged in the business of lending for tax purposes. Unfortunately, there is little guidance regarding when acquisition of debt rises to the level of an active lending business. However, there are some protective measures that a private equity fund can and should take if it seeks to attract foreign and/or tax-exempt investors. For instance, loans cannot be acquired by the private equity fund too soon after the initial borrowing transaction. In addition, it is critical for the private equity fund to avoid involvement in negotiations of loan terms. Given the potential impact on investment decisions, private equity funds would be well-advised to seek an opinion letter from a tax or consulting firm as to whether its activities rise to the level of an active lending business for tax purposes.