Impact of blockers on tax-exempt organizations and investments: PwC

In brief

Corporate blockers may provide tax-exempt entities an opportunity to enhance certain types of investment returns. With changes in US tax law brought about by the 2017 tax reform legislation, university endowments, foundations, pension trusts, and other tax-exempt entities should analyze whether the use of an alternative investment vehicle (“AIV” or “corporate blocker”) could play an appropriate part in their overall investment strategy.

For tax-exempt investors participating in funds as passive limited partners, many of the same critical decision points with respect to utilizing a corporate blocker structure that existed prior to the 2017 legislation remain relevant. For other tax-exempt investors, the 2017 legislation changes with respect to how tax-exempt entities calculate their unrelated business taxable income (UBTI) may make blocker structures more attractive for certain types of investments.

Action item: Given that corporate blockers continue to be relevant, tax-exempt entities need to understand how corporate blockers can fit into their overall investment strategy.

In detail

Tax-exempt investors should consider the following factors in analyzing how any potential investment opportunity should be structured for US federal income tax purposes.

Investing in a flow-through or blocked structure

A thorough review of underlying investments needs to be made in analyzing whether a tax-exempt entity may wish to make an investment in flow-through form or via a corporate blocker:

In certain circumstances and with proper structuring, a corporate blocker may serve to protect a tax-exempt entity from UBTI, manage the amount of US income tax cost borne, and provide relief from various administrative burdens (e.g., filing state and local income tax returns at the tax-exempt entity level).
On the other hand, if structured improperly, the use of a corporate blocker may increase the total tax burden on the investment returns and decrease visibility of the overall tax impact on the internal rate of return.

A non-exhaustive list of factors that tax-exempt entities should analyze when determining whether to invest through a corporate blocker, taking into account their particular facts and circumstances, include the following:

How much of the income generated from the underlying investments likely would be treated as UBTI?
How would any such UBTI be taxed under the 2017 tax reform legislation rules?
What types of returns (e.g., active or passive income) does the tax-exempt entity expect from the investment?
How would the relevant investment source jurisdiction(s) characterize the relevant returns (e.g., dividends or capital gains)?
How would the relevant investment source jurisdiction(s) tax the relevant returns (e.g., withholding taxes and nonresident capital gains taxes)?
Would the tax-exempt entity qualify for the benefits of any relevant income tax treaty with any investment source jurisdiction(s)?

Utilizing a corporate platform for a blocked structure

When analyzing which corporate platform should be utilized for a blocked structure, the following factors — each of which potentially is complex and warrants an in-depth analysis — should be considered:

Is there a difference in source jurisdiction taxes depending on whether a separate corporate entity holds the investment?
Does the United States have an income tax treaty with the country of incorporation of the corporate blocker?
Can the blocker qualify for treaty benefits?
Will the corporate blocker, underlying investment, or fund be levered or unlevered, and what is the overall impact on taxes resulting from such a decision?
Will the corporate blocker be managed by the fund or by the tax-exempt entity itself?
For fund-managed blockers, do all investment returns, regardless of UBTI generation, flow into the corporate blocker?
What is the overall complexity of the proposed investment structure and the associated compliance obligations?
What is the potential variability of investment returns?
Could the investor benefit from netting income and losses across different investments?

Careful consideration should be given to the jurisdiction (e.g., United States, Cayman Islands, or tax treaty country) of the corporate blocker, as the jurisdiction can significantly affect overall investment returns. The following high-level general guiding principles generally should be considered as part of a detailed investment strategy review, taking into account the particular facts and circumstances involved:

In general, US blockers may be preferable for holding exclusively US investments that generate taxable income that would be considered UBTI if earned directly by the tax-exempt investor.
In general, US blockers may be particularly inefficient when they hold non-US income-producing assets and such assets make up a material part of the investment returns.
In general, foreign blockers may be preferable for holding exclusively or primarily non-US investments that generate taxable income that would be considered UBTI if earned directly by the tax-exempt investor.
In general, foreign blockers (depending on the country of organization) may be inefficient for holding US-source income yielding investments, subject to several exceptions.
The treaty network of any foreign blocker should be considered.
Many funds contemplate both US and non-US investments. In such cases, a detailed tax-modeling exercise may be necessary in analyzing the optimal investment structure.

Utilizing self-managed blocker or fund-provided AIV for blocked structure

While fund-managed blockers can effectively shield tax-exempt investors from direct UBTI exposure and permit underlying investments to be levered, such fund-managed blockers may have several potential drawbacks:

Fund-managed blockers may not allow tax-exempt investors to offset income derived from a given fund investment with losses derived from other investments. In certain cases, the inability to net income and losses in a single corporate vehicle can result in the tax-exempt entity paying significantly more US federal income tax than if a single corporate blocker were utilized for multiple investments (e.g., the losses of an unsuccessful investment may be suspended and permanently lost upon the winding up of the investment fund and liquidation of the corporate blocker).
Fund-managed blockers often serve all investors that are sensitive to certain types of pass-through income. For example, both tax-exempt entities and foreign government investors may come together in a single blocker. While their US tax sensitivities may be similar, they are not identical, and thus a specific investment strategy tailored only to tax-exempt investors may not be feasible.
Fund-managed blockers often are organized in the Cayman Islands, which while effective for certain types of investments (due to the relatively inexpensive operations costs and lack of a corporate income tax) may increase the overall tax liability associated with certain investments given that the United States and the Cayman Islands do not have an income tax treaty.

In light of these potential drawbacks associated with fund-managed blockers, some tax-exempt entities have implemented a self-managed blocker investment strategy where the tax-exempt entity organizes and maintains its own wholly owned corporate blocker. The self-managed blocker allows for the aggregation of investments, which may decrease the likelihood of losses going unused. In addition, the self-managed blocker strategy can give the tax-exempt entity complete autonomy over the blocker jurisdiction, including utilizing a treaty jurisdiction when such a platform would yield increased investment returns as compared to a Cayman Islands blocker.

At the same time, it should be noted that a self-managed treaty-based blocker platform is more complex than operating a platform based in the Cayman Islands. Also, it should be noted that a self-managed blocker strategy may not be effective for certain types of investments.

The takeaway

Although blockers continue to be heavily utilized in the tax-exempt investment space, a one-size-fits-all approach is not appropriate for tax-exempt investors in seeking to maintain tax-efficient portfolios. In summary, the following takeaways are critical for tax-exempt investors:

A thorough review of the underlying investments needs to be made in analyzing whether a tax-exempt entity should make an investment in flow-through form or via a corporate blocker.
A strategy that goes as far as determining that an investment should be blocked but stops short of considering the proper jurisdiction may result in an investment structure that results in an increase in overall tax leakage.
Although self-managed blockers likely may not be deemed appropriate for many tax-exempt entities, consideration should be given as to whether one might be beneficial depending on the makeup of the relevant tax-exempt investor portfolio.