The United States knows the capital of foreign investors. Perhaps this is no more obvious in South Florida than in the real estate market, especially with investors from Latin America. However, over the years, overseas clients have diversified their tastes as more and more money flows into US capital markets. More recently, foreign investors have diversified their holdings even further and have entered the US private equity market. This post quickly highlights some of the US tax considerations that are relevant to overseas clients making US private equity investments. These are usually structured by a type of US company (usually referred to as “funds” in the private equity environment)).
For most overseas customers, the most pressing question is likely to be, “How will the income or profits from my investment in the US be taxed?” This is an income tax consideration. In terms of income from an investment, the answer lies in the type of income that the investment generates. Foreign investors are only subject to US income tax on their US income, and that income can be divided into two main categories: (i) passive income (e.g. interest and dividends on passive investments); and (ii) active income (income related to or connected with active trade or business in the United States). For tax purposes, these types of income are referred to by the acronyms “FDAP” or “FDAPI” (which stands for fixed, determinable, annual or periodic income) and “ECI” (which stands for effectively linked income).
In the case of FDAPI, foreigners are generally subject to U.S. income tax under a withholding tax system that levies a 30% withholding tax on income at source.1 It is important that this withholding tax is on a gross basis, which means that no deductions are possible are used to offset income.2 ECI, on the other hand, is subject to tax at the same rates as US taxpayers and is taxable on a net basis, which means that deductions can be made to determine the amount of taxable income for US – Tax purposes 3
Also in terms of profit from an investment, the type of asset that generates the profit will ultimately determine how a foreign investor will be taxed. While it is beyond the scope of this article to fully discuss the subject, the following are some general guiding principles:
- Gains from portfolio investments in US non-real estate companies and most publicly traded securities are not subject to US income tax (for example, a foreign individual sells Apple stock for a profit).
- Profits from the active conduct of a US trade or business (whether directly from a foreign investor or indirectly as a partner in a partnership engaged in a US trade or business) are generally treated as an ECI and taxed accordingly.
- Profits from the sale of US real estate or investments in US companies that primarily own US real estate are automatically treated as an ECI under the Foreign Investment In Property Tax Act 1980 (commonly referred to as “FIRPTA”) and are treated accordingly taxed.
In addition to these key tax considerations, the US income tax filing requirements may be of interest to a foreign investor. In the case of FDAPI, the foreign investor is not required to file an income tax return as long as the US tax liability is met in full by withholding tax (i.e. the income payer does their job and transfers the full amount of withholding tax to the IRS) to report the income. However, in the case of ECI, a foreign investor must file an income tax return to report the amount of income and pay the US tax owed. This registration requirement is gaining in importance as available deductions can only be claimed if an income tax return is filed on time.
With this in mind, overseas investors should understand what type of investment they are making and what the expected returns will consist of. For example, is the investment a debt investment that only generates interest? Is the investment a passive portfolio investment where the return is primarily a gain on a sale? Or is it an investment in an actively owned and operated business (which is usually the case with a commercial real estate investment)? To get these answers, overseas investors can consult the private equity fund’s offering documents, which should contain a general discussion that provides a comprehensive overview of the nature of the investment. The US tax implications and considerations are often found in a fund’s offering memorandum (or private placement memorandum), which typically includes a section that discusses the “tax risks” or “tax considerations” associated with the investment
For larger-scale or professionally managed funds, the fund sponsor or manager may already have structures in place that are tax-friendly for foreign investors in order to maximize tax efficiency (e.g., use of a US blocker) society for certain types However, like most things in U.S. tax planning, the case of each foreign investor may be different, and what makes sense for one overseas investor may not be ideal for another.
In addition to the above considerations that focus on US income tax considerations, a foreign investor should also consider US estate tax considerations in relation to the investment. Similar to income tax, foreign investors are only subject to US estate tax on assets that were in the US at the time of death (or for tax purposes, assets with a US “situs”). An investment in a US fund structure made directly by a foreign investor may present a US estate tax risk, while an investment through an appropriate and properly managed non-US holding vehicle may provide US estate tax protection. While this may not be intended for this purpose, in the private equity context a company known as a “Foreign Feeder Fund” may serve as an appropriate tool from a US estate tax planning perspective.
To go a step further, a foreign investor should also consider their estate or succession planning in relation to the investment. For example, who will inherit the investment after the foreigner’s death? Foreign beneficiaries? US beneficiaries? A mixture of both? Does the foreign investor have a succession plan, either a will or a trust? It is likely that the US tax impact on the beneficiaries who inherit the investment will also need to be considered, particularly all US beneficiaries.
While it would be impossible in one article to address all of the U.S. tax planning considerations that are relevant to a foreign client making a U.S. private equity investment, below is a list of the most common questions and considerations that are likely are of interest to foreign investors based on our previous experience (in no particular order of importance):
- Is the investment a debt investment or an equity investment?
- If it is a debt investment, is the interest subject to US income tax or does it qualify for an exemption? 5
- Is an interest a passive interest in a portfolio company or an actively managed business or business in the United States?
- In general, how does the Fund structure entry for its overseas investors and specifically does the Fund implement alternative vehicles or structures in relation to these investments in an active US trade or business? 6th
- Does the fund use an overseas feeder fund, and if so, how is that overseas feeder fund classified for US tax purposes?
- Are there requirements for the holding period (ie does an investor have to remain invested in the fund for a certain period of time) and what is the expected exit strategy for the investment?
- What is the process (or does the fund allow at all) for moving from the “offshore” or “offshore” side of the fund to the “domestic” or “onshore” side of the fund (e.g. if a foreign investor is in the US? while the investment is still being held or when a US beneficiary inherits the investment).
While private equity offers for foreign investors can offer attractive investment opportunities (which must be assessed independently for each investor), the associated tax implications for the USA should be considered early on in the run-up to an investment.