Mitt Romney’s holdings in the Cayman Islands have generated lots of interest in investment funds that are managed from the U.S. but incorporated in foreign jurisdictions. But taxable U.S. investors like Romney don’t get much benefit from such funds. The real winners are U.S. tax-exempt entities, such as charities, pension funds, university endowments, and IRAs, as well as foreign investors. And investment fund managers can benefit too.
Here’s why: When tax-exempt investors make money that is separate from their tax-exempt purpose, they are subject to a special tax, known as the “UBIT” or the unrelated business income tax. A special rule also deems all debt-financed income to be unrelated business income. Because deals put together by private equity firms are often heavily leveraged (as are investments by hedge funds), debt-financed income often is generated.
If a tax-exempt entity were a partner in one of these deals, it would be taxed as if it earned the income that was earned by the partnership and, thus, be subject to the UBIT.
But tax-exempts (including individuals who invest through their IRAs) can avoid this tax by investing in a corporation which, in turn, invests in the partnership (or invests directly in the deal). The tax-exempt’s income from its investment then comes either as dividends or capital gains, neither of which is subject to the UBIT. But there is a problem: If the corporation were based in the U.S., it would have to pay corporate-level tax on the earnings from the partnership, thus lowering returns to the tax-exempt. But, if the corporation located in a tax haven, it would owe no tax (U.S. or foreign) on the earnings.
Similarly, foreign investors could use a corporation to block tainted income from a partnership. Normally, foreign investors would be subject to tax on U.S. income that is effectively connected to a U.S. trade or business. But a foreign investor who received distributions from another foreign corporation or realized gains from the sale of its stock could avoid any direct U.S. tax and would not have to file any U.S. returns.
Setting up as a foreign corporation may also benefit the investment fund managers by allowing them to defer compensation. By now, most readers of Tax Vox know that these managers often are paid for their services with profits of a partnership (“carried interest”). But they can also be compensated with a contractual right to payment from a foreign corporation which, like carried interest, can be based on an investment fund’s performance.
Income from a carried interest often is taxed as capital gains rather than as ordinary income, and thus enjoys a lower rate (15 percent v. 35 percent). But the tax is owed right away. The contractual right is taxed as ordinary income, but generally is deferred until the manager is actually paid. If the investments are throwing off long-term capital gains, the manager may prefer to be paid through carried interest. But if the fund is turning over frequently and thus generating lots of short-term gains (which are taxed at ordinary rates anyway), the manager may prefer a contract payment that is deferred—and taxed later.
These arrangements don’t entirely wipe out every investor’s tax liability. U.S. taxpayers, such as Romney, pay tax on their income regardless of where they earn it, so they can’t avoid U.S. tax by investing in Cayman entities. In addition, although U.S. taxpayers generally are not taxed on income derived through a foreign corporation until the income is distributed as a dividend, U.S. investors often must accrue income currently if the foreign corporation primarily has passive income or assets or U.S. owners.
Of course, investment funds may want to incorporate abroad for non-tax reasons, such as fewer regulations and less disclosures. But tax advantages are a major factor. Despite the headlines, tax-exempt investors, and fund managers, and not U.S. taxable investors often benefit most from these arrangements.