On September 7, 2007, Rep. Sander Levin (D-MI) issued a draft bill (H.R. 3501) that would allow tax-exempt organizations to invest directly and tax-efficiently into private equity and hedge funds, eliminating the need to use offshore corporations in these investments. The bill was introduced one day after the House Ways and Means Committee conducted marathon hearings on private equity taxation. Also on September 7, Rep. Rahm Emanuel (D-IL) issued a press release indicating his intention to introduce a bill that would substantially limit the amount of compensation managers of hedge funds are able to defer.

Tax-Exempt Organizations — Current Law 

Tax-exempt organizations such as pension funds, universities and endowments do not generally pay federal income taxes, but do pay taxes on a category of income called "unrelated business taxable income" (UBTI). In general, UBTI is income from a trade or business unrelated to a tax-exempt organization's exempt purpose. Congress enacted the UBTI rules over 50 years ago to prevent tax-exempt organizations from using their tax-exempt status to unfairly compete with taxable entities. Congress excluded from UBTI, however, certain categories of passive income, such as interest, dividends and gains from sales of capital assets.

In spite of the general exclusion from UBTI for passive income, tax-exempt organizations still must pay tax on a class of UBTI called "unrelated debt-financed income" (UDFI). In general, UDFI is income (including the passive types of income normally excluded from UBTI) derived from debt-financed assets. Gain from disposal of an asset is treated as UDFI if there was debt outstanding on such asset at any time within 12 months prior to disposal of the asset. Other "current" income such as dividends and interest is UDFI if there was debt outstanding on the income-generating asset during the taxable year in which the income is received.

UBTI (including UDFI) generally "flows through" a partnership (or other entity taxed as such) so that a tax-exempt organization that is a partner in a partnership that realizes UDFI is taxed on its pro rata share of such UDFI. Thus, a hedge fund or private equity fund that borrows to make an investment may generate UDFI for a tax-exempt organization that is a partner in such fund. An investment by a hedge fund on margin or leverage taken out by a private equity fund to facilitate a typical buyout transaction are examples of common transactions that would trigger the UDFI rules under current law.

One significant carve-out from the UDFI rules relates to leveraged real estate investments. An extremely complicated set of rules colloquially called the "Fractions Rule" allows certain tax-exempt organizations (pension trusts, universities and endowments) to receive income from leveraged real estate investments made by a real estate fund without incurring UDFI.

Witnesses testified at the House hearings that the UDFI rules were never intended to apply to tax-exempt investors realizing debt-financed income through hedge and private equity funds. The UDFI rules, according to the speakers, were instigated to shut down a particular type of tax-advantaged transaction (that likely would not be allowable under other rules put in place since then). Still, under current law, the rules do apply and require tax-exempt organizations to specially structure their investments into funds to prevent the rules' application.

Use of Offshore Corporations

Many tax-exempt organizations avoid UDFI on their hedge and private equity fund investments by investing into these funds through corporations domiciled in a low-tax jurisdiction, such as the Cayman Islands. The corporate vehicle typically pays little or no income tax on its income and serves to "block" the debt-financed aspect of the income (and is often called a "blocker" corporation as a result). The tax-exempt organization receives its return from the fund in the form of tax-free dividends from the blocker corporation.

This approach, however, is not always perfectly tax-efficient. Often a blocker corporation will realize income subject to US withholding taxes (such as dividends) that a tax-exempt investor would not have borne if it invested directly into a fund, rather than through a blocker corporation (assuming the income was not debt-financed). In addition, tax-exempt investors incur additional administrative and transaction costs by investing through a blocker corporation.

Proposed Legislation

In an apparent response to the testimony at the House hearings, and in a stated desire to encourage tax-exempt organizations to bring their investments back onshore, Rep. Levin introduced a bill that would allow tax-exempt organizations to invest directly into hedge and private equity funds without incurring tax on income from leveraged investments, so long as certain conditions are met

The bill generally provides that "acquisition indebtedness", which is the trigger for the UDFI rules to apply, will not include debt which is incurred by a partnership for the purpose of making an investment in "securities" or "commodities". Securities for this purpose includes stock, debt instruments and many financial instruments, such as options, currency and interest rate swaps and forward contracts. The bill requires that the partnership fulfill the complicated requirements of the Fractions Rule in order for its benefits to apply

Thus, if the bill becomes law, tax-exempt organizations should no longer need to invest into hedge funds through offshore corporations. In addition, because of the way private equity and hedge funds invest in securities (generally through shares of corporate stock), the bill would allow tax-exempt organizations to receive current income from leveraged investments, such as dividends and interest, tax-free. By comparison, because of the way funds invest in real property (generally through flow-through vehicles), the existing rules applicable to real property generally only provide a tax benefit for gains, not many kinds of current income.

The bill would be effective beginning with the taxable year following the year in which the bill is enacted.

Unresolved Questions

The bill, while generally favorable to taxpayers, leaves open several questions. First, does the bill apply to all tax-exempt organizations, or solely to the same "qualified organizations" to which the Fractions Rule currently applies (i.e., qualified pension trusts, universities and endowments)? At least one witness at the House hearings urged that foundations be entitled to the same relief from taxes afforded to other tax-exempt organizations. Second, if the bill is enacted, can hedge funds that currently employ the blocker corporation structure reorganize their structures to allow tax-exempt organizations to invest directly without incurring any tax on UDFI?

We will be monitoring the progress of the bill and the resolution of these questions.

Deferred Compensation — Current Structures and Proposed Changes

Rep. Emanuel's release highlighted a relatively common practice among hedge fund managers that Rep. Levin's bill, if it were made law, would dramatically reduce.

Managers of hedge funds that use an offshore corporation as part of the fund's structure often receive incentive compensation directly from the offshore corporation (i.e., the "20" in the "2 and 20" formulation). This compensation is generally ordinary compensation income when paid to a fund manager, taxed at 35%. Fund managers often defer receipt of this compensation and reinvest the incentive fees back into the hedge funds they manage. The reinvested amount rises and falls with the performance of the fund and is only subject to income tax when the manager ultimately receives the deferred compensation, along with any related earnings.

According to the release, Rep. Emanuel intends to introduce legislation to limit the amount that a fund manager may defer in this manner to the combined 401(k) and IRA limits (about $20,000). The intent appears to apply the same limits on the ability to defer taxes on earned income for all taxpayers. Interestingly, if Rep. Levin's bill is enacted, the amount of money flowing through offshore components of hedge funds, and therefore the amount of incentive fees that will be deferred, will likely be dramatically reduced, minimizing the tax impact of the issue Rep. Emanuel is targeting.

No bill has yet been introduced, but we will monitor any developments in this area.