Direct investments in United States funds are either direct investments of the first order in private equity funds or direct investments of the second order in private equity funds-of-funds, which then invest in a number of private equity funds. Corresponding investments can be executed either by individuals, fiscally transparent partnerships (including limited liability companies, which, under US law, may be treated as partnerships for tax purposes) or corporations.

US vehicles in the private equity domain exist mainly in two legal forms: on one hand, as a (classic) Limited Partnership (LP), on the other as a Limited Liability Company (LLC). The LLC, however, is not a widely used fund structure, so the following analysis will be limited to the LP.

Limited Partnership

The Delaware LP is regularly used as a US fund vehicle, as it is a secure structure that is both reliable and assures the investors, as limited partners, of limited liability, guarantees tax transparency, and allows for a flexible distribution of power.

The transparency of a partnership for US tax purposes can be foregone when using the so-called “check-the-box rules” (Treas. Reg. § 301.7701-3) by electing to have the limited partnership treated as a corporation. Otherwise, in the absence of any election to the contrary, a US partnership or a partnership organized under non-US law, assuming at least one partner has personal liability for the obligations of the entity, will generally be treated as a partnership, or tax-transparent, entity for US tax purposes. (If the general partner is very thinly capitalized, such that “liability” can be said not to be real, then consideration could be given to making a “protective” election to ensure tax transparency.) Alternatively, an election can be made to treat a limited partnership as a corporation for US tax purposes. The same rules apply to limited liability companies formed under US law. In the case of limited liability companies formed under non-US law, by contrast, e.g., a German GmbH, the entity will be treated as a corporation in the absence of any election. Thus, if tax transparency is desired in such case, an affirmative election must be made to obtain this treatment.

According to the basic structure, a General Partner LP has shares in a Delaware Fund LP of, for example, 1-5 percent. This General Partner LP is, again, 100 percent owned by a General Partner LLC, which then, on the highest level, comprises the actual fund management. The Limited Partners have shares of 95-99 percent generally directly of the Delaware Fund LP.

Generally, non-US investors in a US private equity fund that are not otherwise engaged in business in the US will not be subject to US net income tax and will not be not required to file US income tax returns, except with respect to so-called “effectively connected income” (ECI), as discussed below, or, under the “Foreign Investment in Real Property Tax Act” (FIRPTA), on gains on sales of US real estate or US corporations with a preponderance of real estate assets, as also discussed below.

Otherwise, a non-US investor should only be subject to US withholding tax on certain US-source investment income, including stock dividends and certain interest income (so-called FDAP), as discussed below. Where tax liability is satisfied through payor withholding on FDAP income, no tax returns must be filed.


“Income effectively connected with a US trade or business” (ECI) constitutes an increased US tax burden for foreign investors.

For foreign individuals, there is currently a tax rate of 35 percent on the net taxable income, 15 percent in case of privileged long-term capital gains (i.e., gains from assets held over a year). For foreign corporations, it is generally 35 percent on all income. Moreover, corporations may also be subject to an additional “branch profits tax” (BPT) in the amount of 30 percent of after-tax income (as if that amount had been paid from a US subsidiary), subject to a reduction to 0 percent under the US-German Treaty (the Treaty). In addition, a partnership earning ECI must withhold tax against a foreign partner’s share of such income. This withheld tax is creditable against tax due upon filing of a return. Foreign investors earning ECI (including through a partnership) must file US tax returns reporting their income.

Whether a non-US investor is treated as engaged in a US trade or business, such that the investor could be subject to tax on ECI related thereto, depends upon an examination of relevant facts and circumstances. If the fund partnership into which an investment is made is engaged in a trade or business, then the investor will be treated as so engaged. Merely investing in stock or securities for one’s own account, however, does not constitute the conduct of a trade or business under a statutory “safe harbor” rule. This could prevent at least some funds from having any ECI. Leasing real property under a triple net lease, where the lessee pays all costs, also is likely not a “trade or business” for this purpose. Beyond this, there are few bright-line tests. Under the Treaty, a German investor will not be liable for tax on ECI unless the investor has a “permanent establishment,” e.g., an office or other place of business in the US. Again, however, a “permanent establishment” of a fund will be attributed to the investors therein for this purpose.


A non-US investor in a limited partnership that is anticipated to generate ECI may wish to invest through a blocker corporation, which operates between fund vehicle(s) and the transparent target company.

This “blocker” should be a US corporation, at least if there will be significant ECI. This is because using a non-US blocker can result in the imposition of branch profits tax and, assuming the blocker is formed in a tax haven jurisdiction, will preclude access to treaty benefits on dividends paid. A US corporation will, however, be subject to tax on all of its income, including income that is not ECI. Thus, if a mix of ECI and non-ECI is anticipated, a parallel fund structure, whereby only ECI investments are made through the US blocker, is most advantageous. Dividends from the US blocker will be subject to withholding tax but may qualify for the treaty benefits, depending upon where the investor is tax resident.

ECI of the blocker will, of course, be reduced by deductions for depreciation and/or amortization and other business expenses. Leveraging the blocker can also create deductions for interest expense, assuming the debt is respected as debt for tax purposes. If related party debt is used, however (or debt guaranteed by a related party), deductions may be limited under the so-called “earnings stripping” rules.

In any event, use of a corporate blocker (whether US or non-US) avoids the need for the investor to file US income tax returns in its own right.

ECI in relation to UBTI

Finally, it should be mentioned that ECI is not the same as Unrelated Business Taxable Income (UBTI). The latter is a critical issue for tax-exempt US private equity investors, such as private foundations, university endowments and private, and possibly also public, pension funds. UBTI generally includes commercial income from performance of activities outside the scope of the actual tax-exempt purpose of the tax-exempt entity, with certain exceptions. For foreign, including German, investors, UBTI is generally not relevant.


Until 1980, it was possible for foreign investors to divest themselves of interests in US real property free of tax. This fundamentally changed when the Foreign Investment in Real Property Tax Act 1980 (FIRPTA) came into effect. Gain on disposition of a US real property interest (USRPI) or of shares of a US real property holding corporation (USRPHC) is treated as ECI. A USRPHC is generally present if—within the last 5 years—at least 50 percent of the corporation’s real property and other business assets consists of USRPIs. (Certain exceptions apply in the case of small interests held in publicly traded entities and in the case of so-called “domestically controlled REITS.”) The FIRPTA tax rate is currently 35 percent, reduced to 15 percent in case of individual(s) who recognize long-term gains, i.e., gains from property held more than a year. Foreign pension funds formed as trusts may possibly benefit from this reduced tax rate as well but should, to be on the safe side, obtain a corresponding ruling from the US Internal Revenue Service confirming their entitlement to such rate. Foreign investors must file US tax returns with respect to dispositions of USRPIs or USRPHCs. Amounts realized on such dispositions are also subject to a withholding tax regime. Withheld tax is then creditable against tax due upon filing of a return.


A US withholding tax is generally applicable for FDAP, i.e., in case of dividends, certain interest payments, certain rental payments, licensing fees etc. The withholding rate for this type of passive income currently is 30 percent. Significant reductions are available under the Treaty for dividends (a reduction to 15 percent, or even 5 percent or 0 percent, depending on proprietor structure) and for interest payments (generally a reduction to 0 percent). There is also a statutory exemption from withholding tax for so-called “portfolio” interest on obligations issued in registered form. This exemption is generally available for obligations not held by banks lending in the ordinary course, but not available with respect to certain contingent interest (including interest based on gross or net profits of the debtor or a related person or changes in the value of property of the debtor or a related person) or interest paid between certain related persons. Finally, US treaty benefits will be denied if an item of income is not treated in the investor’s home jurisdiction as an item of income of the investor, the treaty does not contain a provision addressing its applicability to income derived through partnerships, and the investor’s home jurisdiction does not impose a tax on the distribution of the income from the partnership to the investor.

Characteristics of Funds-of-Funds

To save foreign investors from any possible burden of a US tax declaration, a so-called blocker feeder, a non-US corporation, which is treated as a corporation for US tax purposes, is also regularly used for fundsof- funds. Otherwise, there are no significant differences.


US private equity funds generally represent attractive targets for German investors. As easy as the direct shareholding in such a vehicle—that is generally tax transparent—is, it should be taken into account that such direct holding may lead not only to US tax filing obligations, but potentially also to various US (withholding) taxes. Interposition of a “blocker vehicle” can at least eliminate the first problem. Further solutions such as, for example, parallel funds structures or fund interests based on a variable annuity contract with a US insurance company or regarding a total return swap, might be taken into consideration.

A longer version of this piece appeared in the second edition of the German volume “Private Banking and Family Office” (eds. Farkas-Richling/Fischer/ Richter, Schaeffer-Poeschel Publishers, 2012).