Funds with US investments or operations – considerations for non-US investors

21 June 2022

In recent years, investors have flocked to closed-end investment funds such as private equity funds, credit funds, real estate funds, and the like. While funds of this type have the potential to produce attractive returns, investors should be mindful that they also present a unique array of tax and regulatory challenges, particularly in the case of US-based fund structures and non-US based funds themselves investing into the US.

We are well positioned to guide non-US individual, corporate, trust and family office investors on the key tax and regulatory issues that arise when subscribing to US-based investment funds and/or non-US funds with US investments or operations.

Tax issues

Blocker structures

When a non-US investor acquires an interest in an active US-based investment fund which is classified as a partnership for US tax purposes, that investor will sometimes be required to file a US income tax return directly with the Internal Revenue Service (‘IRS’) merely by virtue of holding that fund interest—specifically, the fund’s activities may generate income which is treated as effectively connected with a US trade or business income (commonly referred to as ‘ECI’). ECI exposure may also arise even through an investment into a non-US fund if that fund is classified as a partnership for US tax purposes and has certain US assets or activities. For non-US investors wishing to avoid direct contact with the US tax system, a fund will typically, though not always, offer non-US investors the choice of investing through a so-called ‘blocker’ structure consisting of one or more special purpose holding vehicles designed to insulate electing non-US investors from any tax return-filing obligation. Yet it is important to note that not all blocker structures are created alike. Some blocker structures act as a significant drag on an investor’s overall after-tax yield from their investment, often in ways that are not apparent from the face of the fund’s investor-level reporting documents. We can identify situations where blockers are appropriate, analyze a fund’s blocker structure offerings, if any, and spot tax inefficiencies that have the potential to create US tax return filing obligations and / or significantly alter an investor’s bottom line.

Estate tax protection

A non-US individual who owns ‘US situs’ assets—such as some limited partnership interests in US-based investment funds—may face US estate tax exposure in respect of those assets. Estate tax exposure may arise through either direct or indirect ownership, in particular through tax-transparent entity structures or certain kinds of tax-transparent trusts. This estate tax exposure may be curtailed or eliminated, however, through careful use of intermediate trust or corporate holding structures. We advise on estate tax-efficient holding structures for US investment fund positions.

Trust issues

Non-US family trusts and their underlying holding companies face special tax challenges and opportunities when subscribing to US investment funds and non-US funds with significant US assets or operations. For example, although many family trusts are administered in tax-neutral or tax-free jurisdictions, the trust settlor and/or beneficiaries often reside in countries that have double tax treaties with the United States. With careful structuring, trust subscribers can sometimes save substantial US taxes by claiming treaty-based withholding tax rates on US-source fund income, merely by virtue of the fact that the trust’s settlor or beneficiaries reside in those treaty jurisdictions. Conversely, a non-US trust with US beneficiaries may face concerns under the punitive ‘Controlled Foreign Corporation’ (‘CFC’) and ‘Passive Foreign Investment Company’ (‘PFIC’) corporate anti-deferral rules. We have extensive experience in optimizing the US tax position of family trust fund investors and minimizing the risk of tax leakage in connection with fund investments.

Commercial/economic issues

We can confirm whether the legal terms of the fund’s limited partnership agreements match the fund’s own summary of those terms in its marketing and subscription materials. We also provide insight on whether the key economic terms of the investment fund—such as economic waterfall, carried interest entitlement, fund expense allocations, governance mechanisms, and limited partner commitment provisions—are within market practice. In addition, we negotiate with investment fund sponsors on behalf of our investor clients for more favorable commercial terms and investment protections.

Side letters

We routinely assist in negotiating and drafting side letter arrangements to ensure that investors gain access to more favorable commercial, tax, and regulatory terms. For example, certain investors will be able to obtain ‘most favoured nations’ terms that provide that investor with the option of matching whatever side letter benefits may be provided to other investors in the fund. We also can negotiate for a broad range of other items, including (but not limited to) more detailed breakdowns regarding management expenses (making the economics more transparent in terms of the general partner’s share of the fund’s earnings), limitations on powers of attorney that the fund may request from its investors, enhanced confidentiality provisions, adequate notice of certain potential fund events, and other potential issues.

Representations, warranties and regulatory issues

A fund’s subscription agreement, investor questionnaire and limited partnership agreement will typically require a subscribing investor to make numerous representations and warranties including their status under a host of US regulatory regimes administered by the Securities Exchange Commission (‘SEC’), the Commodity Futures Trading Commission (‘CFTC’), and the Financial Industry Regulatory Authority (‘FINRA’). These regulatory regimes will generally apply in the context of both US and non-US investors. We can guide investor clients as to which representations an investor should make or refrain from making, depending upon their particular circumstances. We also advise on whether and to what extent an investor should qualify their representations to minimize their potential legal liability to the fund.

Certain investor structures will be better suited than others to addressing and overcoming the US regulatory issues that crop up in the course of a fund subscription process. We can advise on a proactive basis to identity suitable investment vehicles that will maximize the chances of a smooth and hassle-free fund subscription process.

For more information, please get in touch with your usual Withers contact, or either of the authors of this article.

This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.


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