A common investment structure presented to domestic tax-exempt entities involves investing in flow-through operating businesses through a “blocker corporation.” Avoiding unrelated business taxable income (“UBTI”) is a key focus for many tax-exempt entities. By investing through a blocker corporation, the blocker corporation pays any applicable income tax and then passes on the remaining profits to the tax-exempt entity as a dividend. Corporate dividends are considered passive income and as such, are not subject to the UBIT tax, except in limited situations.

Fund sponsors often are quick to offer up a “blocker corporation” when courting investment dollars from tax-exempt entities, but sometimes little thought is put into the question of whether the blocker should be located within or without the United States.  For example, some fund sponsors will establish offshore blockers in a no-tax jurisdiction, such as the Cayman Islands or the British Virgin Islands.  The use of such jurisdictions is generally based on the absence of an income tax and the relative low cost of administration. However, the choice between a domestic or foreign blocker can have material implications for the tax-exempt investor’s overall return.

Specifically, tax-exempt entities generally should avoid the use of a foreign blocker corporation if the intended underlying investment (e.g., the investment strategy of a private equity or venture capital fund) is targeted at domestic flow-through businesses.  This is because even though the foreign blocker will be taxed at the same corporate rate as a domestic blocker, the foreign blocker will also be subject to the full U.S. branch profits tax in the absence of an applicable tax treaty.  The combined income and branch profits tax results in an overall effective U.S. federal tax rate of 44.7 percent. By contrast, if a domestic blocker is utilized for such an investment, the effective tax rate would equal the federal corporate tax rate of 21 percent.

By contrast, if the fund’s investment strategy is aimed at non-U.S. flow-through businesses, a foreign blocker can be highly advantageous.  None of the blocker’s income would be subject to U.S. tax and the dividends the tax-exempt investor receives generally would not constitute UBTI.  If such investment were made through a domestic blocker, U.S. corporate tax would be owed on such income.

As in all things involving investment structures, the devil remains in the details.  For example, the generic results above can change dramatically, depending on the use of leverage (by the tax-exempt investor or the fund), the type (or types) of underlying investments the fund intends to make, the potential availability of foreign tax credits, and the making or omission of certain “elections” that are often left to the full discretion of the fund’s sponsor. 

Bottom Line: Professionals directing investments for tax-exempt entities should consider their options carefully when presented with a blocker structure and should thoroughly review the investment fund’s intended underlying investment strategy

“This is too difficult for a mathematician. It takes a philosopher.” – Albert Einstein, on filing tax returns.

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Photo of Todd C. Lady Todd C. Lady

Todd is chair of Taft’s Tax practice and focuses his work on general corporate taxation and international tax matters. He frequently represents clients with respect to domestic and cross-border M&A, inbound investment by non-U.S. persons, taxation of financial instruments and foreign currency denominated

Todd is chair of Taft’s Tax practice and focuses his work on general corporate taxation and international tax matters. He frequently represents clients with respect to domestic and cross-border M&A, inbound investment by non-U.S. persons, taxation of financial instruments and foreign currency denominated investments, choice of legal entity and the application of the United States tax-treaty network.

A significant component of Todd’s practice includes advising U.S. clients with respect to the U.S. reporting of foreign activities, representing clients in seeking administrative relief through the private ruling process and representing clients under examination by the IRS. Todd’s practice also includes assisting clients with preserving tax attributes in connection with financial restructurings and the proper taxation of damage awards and settlements.

Todd’s experience includes representing both FORTUNE 500 companies and closely held businesses with respect to corporate and international tax matters. He is a frequent speaker on the topics of corporate and international taxation and a member of the Council of the Taxation Section of the Indiana State Bar Association. Todd has been recognized by Best Lawyers in America® for tax law and has been selected by Law & Politics Magazine as an Indiana Rising Star in tax. He is also a member of the firm’s Executive Committee.