Operators of manufacturing companies, especially those considering a sale or capital raise, should understand investors’ concerns regarding direct investment. Today, investment funds with investors and investments in multiple jurisdictions constitute a large part of the U.S. manufacturing direct investment landscape. However, tax challenges exist for these fund managers and investors.
The tax treatment of foreign investors depends largely on the type of income generated by a fund. For example, assume that an investment fund is structured as a domestic limited partnership, with both U.S. and foreign investors. Further, assume that the fund acquires a U.S.-based manufacturing company, which is also structured as a domestic limited partnership. Unless structured properly, the foreign investors will have to file U.S. income tax returns and pay U.S. income tax on their share of the income from the manufacturing operations. This structure poses little concern for those American investors, but it is quite troublesome for foreign investors.
Effects on Foreign Investors & Fund Managers
The income derived by foreign fund investors from manufacturing operations conducted through an entity that is treated for U.S. federal income tax purposes as a flowthrough entity will generally be deemed to be “effectively connected” to a U.S. “trade or business.” As a result, the foreign investors will be (1) subject to U.S. tax on their income generated via the investment fund, (2) required to make annual U.S. tax filings, and (3) subject to U.S. withholding taxes on fund income. Additionally, a foreign investor that is classified for U.S. federal income tax purposes as a corporation will generally be subject to U.S. branch-profits tax. Similarly, if the fund manager invests fund assets in loans originated by the fund manager, then such loan origination activity could also give rise to mandatory U.S. taxes and filings for foreign fund investors. This treatment of ordinary operating income also applies to capital gains.
There are two ways to limit a foreign investor’s U.S. tax and reporting obligations. First, the investor can hold its fund investment through an entity treated as a C-corporation for U.S. income tax purposes. Alternatively, the investment fund can hold its interest in the flowthrough manufacturing entity through an entity treated as a C-corporation. These structuring methods are referred to as using a “blocker” corporation because it blocks the foreign investor from income otherwise considered “effectively connected” income. Instead, the blocker converts such income into “FDAP-type” income which generally does not necessitate a direct U.S. tax or reporting obligation for the foreign investor. The only downside is that the blocker entity itself will be a taxable entity for U.S. tax purposes. The blocker will be subject to U.S. federal income tax at a 35% rate and to possible state income tax. However, this cost may be lowered by implementing a capital structure that employs both debt and equity. Any distributions paid by the blocker will generally be subject to a U.S. dividend withholding tax at a rate of 30% (or a lower rate if a treaty is applicable). In many situations, this withholding tax is not expected to be material, because the amount of distributions paid by the blocker before final exit is expected to be relatively small. So long as the blocker is not a “United States real property holding corporation” (i.e., does not derive most of its value from U.S. real property interests), an exit in the form of a sale of the shares of the blocker will generally not trigger U.S. income tax.
There are a number of tax issues that investment funds and their investors face when structuring their funds and investments. Given the magnitude of foreign investment, American manufacturing companies would be wise to understand the myriad tax issues affecting their potential sources of capital.