This article was originally published in Fund Structures 2011 - A Private Equity International Supplement. It is reprinted here with permission.

In recent years, investment in the natural resource sector has increased, due in part to investors’ desire to diversify their portfolio, from both a risk profile and asset class standpoint, by investing in a space that is thought to be weakly correlated to public equity markets. The natural resource sector includes items such as timber, metals, crops, and alternative energy sources like wind and solar power. To capitalize on this increased investor demand, private equity funds, including U.S.-based private equity funds of funds, are seeking to exploit direct and indirect investment opportunities in the natural resource and energy sectors. Investments in companies operating within the natural resource sector, both within and outside the United States, can present challenges for investors due to the operational nature of the companies and the fact that many of the companies are deemed to hold real estate.

This article addresses potential U.S. tax consequences that U.S. investors in a domestic private equity fund may encounter when investing (directly or indirectly through offshore or onshore feeders) in a company in the natural resource and energy sectors, the potential structures that may be employed to mitigate adverse tax consequences, and additional consideration under the Investment Advisers Act of 1940 (Advisers Act) associated with these structures. Certain funds may need to take into account specific rules or regulations to which certain investors may be subject, for example tax-exempt investors subject to the Employee Retirement Income Security Act of 1974 (ERISA).

Tax Drivers

Typically, there are three general categories of investors: (i) taxable U.S. persons1 (high-net-worth individuals and non-exempt institutional investors); (ii) tax-exempt U.S. persons, including pension funds, IRAs, endowments and foundations; and (iii) non-U.S. persons (foreign persons). The latter two investor types usually have significant sensitivity to fund income attributable to a trade or business because such income may cause the investor to incur tax. For example, while U.S. tax-exempt investors are generally not subject to federal income tax on capital gain as well as dividend interest and royalty income, they are likely to have to pay tax on income derived from an unrelated trade or business (UBTI), and if they employ structures to avoid UBTI, may trigger tax on dividends, royalties and income effectively connected with a U.S. trade or business (ECI) and/or attributable to the disposition of a U.S. real property interest (USRPI), pursuant to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) and Section 897 of the Internal Revenue Code of 1986, as amended (Code).2

UBTI. A U.S. tax-exempt investor is usually exempt from tax on capital gains, dividends, interest, and royalties but will be required to pay federal income tax at the highest corporate rates3 on income derived from an unrelated trade or business. Thus, the investment focus of a U.S. tax-exempt investor is often the avoidance of UBTI. A fund will generate UBTI if it: (i) invests in an operating partnership (usually a limited liability company) directly or through another fund or pass-through entity; (ii) incurs debt to fund the acquisition of a security or investment, whether to bridge a capital call or to leverage an investment (debt financed income); or (iii) is treated as a dealer, to the extent of dealer activity.

ECI. Foreign investors are generally not subject to federal income tax on capital gain or interest income that constitutes portfolio interest. Foreign investors are subject to 30 percent withholding tax on dividend income, unless a lower rate is provided in an applicable treaty. Foreign investors are taxed as U.S. persons with respect to income effectively connected with a U.S. trade or business and a fund must withhold regardless of cash flow (generally at a 25 percent rate). Additionally, a foreign investor that is a corporation will generally be subject to another level of tax on any ECI not reinvested in a U.S. trade or business (the branch profits tax or BPT). The effective tax rate on ECI (inclusive of BPT) allocable to a corporate foreign investor is north of 50 percent.

FIRPTA. Lastly, pursuant to FIRPTA and Section 897 of the Code, gains or losses attributable to the disposition of a USRPI will generally be treated as ECI and the gross proceeds realized upon disposition may be subject to 10 percent withholding. If a domestic investment fund has a foreign feeder taxed as a corporation and invests in a USRPI, the income attributable to the disposition of that investment that is passed through to the foreign feeder is all ECI. This in effect converts capital gain that is otherwise not taxable to foreign investors into income taxed at ordinary rates and possibly subject to the BPT. A U.S. corporation with significant real estate holdings generally constitutes a U.S. real property holding corporation (USRPHC), the stock of which is treated as a USRPI. Once a corporation constitutes a USRPHC, it maintains this status for five years regardless of its real estate holdings.4

Accordingly, the tax focus of a foreign investor is typically the avoidance of ECI (including FIRPTA) and maximizing capital gains. As with UBTI, a fund may generate ECI from investments in pass-through operating entities or due to dealer status. In addition ECI may be generated by a fund that invests in real estate assets (directly or through a pass-through entity) and USRPHCs. A fund may invest in a USRPHC, and thus a USRPI unknowingly, because corporations can inadvertently constitute USRPHCs if at some point the corporation’s income and value is predominantly real estate-based.5 Many foreign investors may be willing to endure federal income tax inefficiencies in order to avoid transparency.

Structure alternatives

Offshore feeder. Private equity funds that generally do not invest in pass-through operating entities often utilize “offshore feeder” structures whereby their U.S.-based tax-exempt investors, as well as their foreign investors, make their capital commitments through an offshore vehicle (such as a Cayman Islands or BVI entity) that makes an 8832 election to be taxed as a corporation for U.S. income tax purposes. An offshore feeder taxed as a corporation effectively blocks UBTI from debt-financed income and may effectively eliminate transparency for foreign investors. The offshore feeder is generally treated as the beneficial owner of the fund and therefore the offshore feeder, and not its owners, must provide a tax identification number and report to the Internal Revenue Service (IRS). However, as a result of the FATCA rules passed as part of the HIRE Act6 in 2010, beginning in 2013, the ability to eliminate transparency through an offshore feeder will be significantly reduced.7 It may be important for transparency purposes, including IRS reporting, to house foreign investors in one offshore feeder and U.S. investors (generally tax-exempts) in another.

An offshore feeder taxed as a corporation is not a tax-efficient UBTI blocker or ECI blocker if the fund generates income from a U.S. trade or business. Such income will constitute ECI to the offshore feeder and therefore, the fund will be required to withhold at a rate of 35 percent (most offshore feeders are formed in non-treaty jurisdictions) on such income. Moreover, there will be FIRPTA implications to the extent real property or a USRPHC is involved.

A fund utilizing the offshore feeder structure and desiring to invest in the natural resource and energy sectors will at the outset need to plan for alternative structures that are flexible enough to address multiple structuring considerations. Many natural resource and energy-related companies are formed as pass-through entities to provide for flow-through treatment of the tax benefits, mainly in the form of deductions and tax credits. As a result, investment by private equity funds in such companies will typically be beneficial to U.S. taxable investors who want the flow-through treatment (which may come at the price of additional state tax reporting obligations); however, the investments often generate UBTI and ECI for tax-exempt and foreign investors. Although these investments are tax-efficient for U.S. taxable investors, certain investors may find that the burden of additional state tax reporting obligations, as well as the complexity of obtaining and calculating certain deductions and credits, outweighs the tax benefits.

Private equity funds typically have a provision in their governing documents that enable the manager of such funds to use one or more alternative investment vehicles (AIVs) to house a particular investment in order to accommodate tax, regulatory or other planning. Such AIV provisions typically provide funds and their managers with flexibility to form multiple AIVs above, below or parallel to the fund and to use different entity forms. Consideration must be given to how the cost of an AIV, as well as the ongoing expenses of administration of the AIV, will be shared among the fund investors and how the calculation of the manager’s carried interest should take the AIV into account.

Domestic feeder. When a fund utilizes the “offshore feeder structure” for its U.S. tax-exempt investors and it invests in a natural resource-related pass-through entity, it should consider bringing its U.S. tax-exempt investors onshore.8 This will eliminate ECI and FIRPTA concerns for such U.S. tax-exempt investors. In deciding what type of AIV to use for U.S. tax-exempt investors, consideration should be given to (i) whether the tax benefits expected in the ultimate investment will significantly offset the UBTI expected to be generated, and (ii) how much of the investors’ return is projected to be from operating income in contrast to gain on disposition. If the tax benefits are significant and the return is expected predominantly from exit, U.S. tax-exempt investors should consider using a pass-through vehicle and not a blocker corporation. However, if the investors desire to avoid UBTI regardless of the tax cost, an onshore domestic corporation should be interposed to block UBTI.

Certain regulatory provisions such as ERISA can be drivers to the structure ultimately employed by the fund. For example, if the offshore feeder is considered to hold plan assets,9 unless the fund obtains the consent of the offshore feeder investors, a domestic AIV housing such investors must generally come directly into the fund and cannot invest on a parallel basis with the fund. In this instance, there are generally three alternative blocker structures that a fund may utilise.10 The first is to impose a “blocker” structure above the fund that only “blocks” UBTI to the U.S. tax-exempt investors coming in through the AIV. The blocker corporation will cause all income earned from the investment to be subject to a corporate-level tax. Tax benefits from the investment may offset this corporate-level tax (although generally the gain on exit will not be offset). In certain cases, the corporate-level tax may be mitigated by bifurcating the U.S. tax-exempt investors’ investment into part debt at the AIV level and part equity into the blocker corporation.11 Because the blocker corporation is above the fund, the U.S. taxable investors enjoy pass-through tax treatment, including the pass-through of tax benefits, if any. However, it also may result in additional reporting obligations to such investors.

The second method imposes a blocker structure between the fund and the portfolio company. This blocks all investors in the fund and generally eliminates the pass-through tax benefits associated with partnerships, as well as any tax benefits specific to the type of investment. This structure is helpful for funds with taxable investors that are not inclined to file multiple state tax returns and to calculate or report complicated tax benefits. Because the blocker corporation is below the fund, there is a corporate-level tax on all income generated from the investment. On exit, the corporate-level tax may be avoided if an agreement can be reached to ensure that the blocker corporation is purchased on exit, rather than the blocker selling its interest in the underlying portfolio company. The purchase of the blocker corporation would eliminate the second level of tax on exit, and any gain should be taxable at the capital gains rate. Such an exit structure generally, however, will reduce basis write-ups for the purchaser and may therefore impact the price realizable.

The third option contemplates a blocker structure under the fund (as in method two) and in addition, a parallel AIV taxed as a partnership through which the taxable investors may elect to invest. This method is effective for funds that have both (i) U.S.-taxable investors that are not inclined to file multiple state tax returns or to calculate or report complicated tax benefits and (ii) U.S.-taxable investors that desire pass-through treatment and do not mind additional reporting requirements. This method is also effective to facilitate a fund’s investment in another fund with a natural resource or energy focus (New Resource Fund) and that has a blocker structure already in place. In such case, (i) the tax-exempt investors would be brought onshore through a pass-through AIV that invests in the fund, (ii) the fund would invest in the New Resource Fund’s blocker structure, and (iii) the electing U.S.-taxable investors of the fund would go into the New Resource Fund through a pass-through parallel AIV. The New Resource Fund’s blocker structure may employ a leverage mechanism to reduce the corporate-level tax, but there will generally not be an ability to sell the blocker corporation.

Advisers Act Considerations

In creating AIVs, fund managers will need to consider whether the AIVs will have an impact on their compliance with the Advisers Act. AIVs are considered to be private funds12 and clients of an investment adviser. Accordingly, fund managers may need to disclose information about the AIVs in their Form ADV and comply with the custody rules for the AIVs.

Reporting requirements. In 2010, the SEC proposed rules13 that significantly amend Form ADV to provide for enhanced disclosures and impose reporting requirements on registered investment advisers and “private fund advisers” that are exempt from registration under the proposed rules (exempt reporting advisers).14 The proposed rules are due to become effective on July 21, 2011. At that time, registered investment advisers and exempt reporting advisers would need to disclose on their Form ADVs information about all of their private fund clients (including the AIVs). Specifically, they would be required to disclose information about the size, investment strategy, assets and liabilities, number of investors and service providers of their private fund clients. This information must be filed electronically and will be publicly available.

Custody. AIV users also should focus on the custody rules of the Advisers Act. An investment adviser is deemed to have custody of client assets if it or a related person in any capacity (such as general partner of a limited partnership) has legal ownership of or access to client funds or securities. In the typical AIV structure, a related person of the fund manager will serve as the general partner of the AIV and, as a result, the manager generally will have custody of the AIV’s assets. With custody, the AIV’s funds and assets need to be held by a “qualified custodian” and subject to surprise examinations and quarterly account statement delivery requirements. An adviser may be deemed to comply with the surprise examination requirements with respect to its private fund clients (including AIVs) and is not required to comply with the account statement delivery requirements if (i) an audit of the private fund is conducted by an accounting firm registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (PCAOB), (ii) the private fund’s audited financial statements are prepared in accordance with GAAP, and (iii) such audited financial statements are delivered to investors in the private fund within 120 days after the end of its fiscal year. AIVs would be no exception and must be audited by an appropriate accounting firm.

To be qualified to prepare the audited financial statements under the custody rules, the accounting firm must be “subject to regular inspection” by the PCAOB. While an accounting firm may be registered with the PCAOB, it may not be subject to regular inspection by the PCAOB and would thus fail to be qualified to prepare the audited financial statements under the custody rules, rendering the fund manager subject to the surprise audit and account statement delivery requirements of the custody rules. The net result for the fund complex is enhanced auditing requirements that can drive up costs of the fund’s administration significantly.


Structuring fund investments into natural resource- and energy-related companies is complicated and may result in multiple entities in the final structure. Offshore vehicles and AIVs can be structured as series partnerships and segregated portfolio companies to reduce entity proliferation, but those often trigger increased corporate governance, tax planning and regulatory complexities. The key is to plan at the initial stages of fund formation and to build in the flexibility that will be needed to address multiple future structuring contingencies while maintaining both the overall intended economics and investor confidence about the manager’s integrity and transparency. Fund managers need to ask the right questions of investors in the subscription materials so that the fund does not have to go back to investors to ask for elections, consent, permission, or forgiveness.