The Tax Cuts & Jobs Act (TCJA) enacted in December 2017 may dramatically change how U.S. organized investment funds structure investments in foreign portfolio companies.
In the past, U.S. funds (particularly private equity and venture capital funds) often structured ownership of non-U.S. portfolio companies through non-U.S. alternative investment vehicles, to avoid the portfolio companies constituting “controlled foreign corporations.”
The TCJA may change the status quo. The TCJA moves the United States closer to a territoriality system for foreign operations and implements a new tax on high-return foreign assets (the GILTI tax). The impact of these U.S. tax changes on investment funds – as well as their sponsors and limited partners – depends upon how the funds structure their investments in foreign companies:
Direct investment by a U.S. fund (that is treated as a partnership for U.S. tax purposes) in a foreign corporation.
- Dividends from the foreign corporation will generally be subject to U.S. federal income tax without any foreign tax credit offset. Depending on the location of the foreign corporation, the dividends may be eligible for capital gains rates or may be taxed as ordinary income.
- Limited partners and sponsors that are individuals (whether they hold their interests directly or through pass-through entities) will be subject to full U.S. federal income tax (at rates up to 37 percent) on any GILTI income of the foreign corporation, with no foreign tax credit offset.
Indirect investment by a U.S. fund in a foreign corporation through a U.S. holding corporation (“blocker”).
- The U.S. blocker should be eligible in many cases for a full exemption from federal income taxes on dividends from the foreign corporation.
- The U.S. blocker will likely qualify for a 10.5 percent tax rate on GILTI income and benefit from a foreign tax credit. As a result of the foreign tax credit, generally U.S. corporate owners will not pay tax on GILTI income if it is subject to a foreign income tax rate of at least 13.125 percent.
As a result of these tax changes, there may be opportunities to maximize efficiency of fund investments in foreign corporations, such as holding foreign investments through a U.S. corporate blocker. In certain cases, investing through a U.S. corporation could reduce the net tax rate on the foreign corporation’s earnings by over 20 percent. The TCJA rules apply to existing investments as well as new investments, so funds may also want to consider restructuring current investments. Any restructuring plan should also consider the tax consequences to non-U.S. investors in the fund (for whom it is likely inefficient to invest in foreign corporations indirectly through a U.S. corporation).
In any event, the optimal structure for a particular non-U.S. investment will depend on a number of variables, including the types and organizational forms of limited partners, whether distributions are expected to be made by the foreign corporation, the type of assets held by the foreign corporation and the expected return on those assets, and the tax rate in the applicable non-U.S. jurisdiction.