Top three tax issues in co-investments

Taxes—or as tax lawyers like to say, rendering unto Caesar what is Caesar’s, but no more than what is Caesar’s—are one of the most important considerations that drive the structure and terms of co-investments. Whether a proposed co-investment has a structure optimized for the particular tax profile of an investor will often determine whether the co-investment is viable from both a return and process perspective.

There are three main issues that the tax structure of a co-investment must address. First, it must be structured to successfully obtain the expected tax treatment of the investment returns, whether that treatment occurs pursuant to a special tax status of the investor, a special tax regime, or a provision of domestic tax law. Second, the investment must protect the tax status of the investor so that it does not jeopardize their exemption or tax status with respect to other, unrelated investments. And third, it must have a workable solution for issues surrounding tax processes and procedures, such as who is responsible for filing returns, how withholding taxes are to be dealt with, and how taxes are not only allocated, but impact the sponsor’s carry and the investor’s preferred return.

The first goal of a successful co-investment structure is to obtain the benefits of the intended tax regime. These benefits can be divided into two types, and apply to two different kinds of income. The first type of benefits are those unique to a particular investor, such as entitlement to specific benefits of a tax treaty, the benefits of Section 892 of the Title 26 Code (the Code) that apply to certain foreign government investors, and the exemption afforded to certain charitable and non-profit organizations and pension plans. The second type of benefits are those potentially available to all non-U.S. investors, such as the exemption from FIRPTA tax that otherwise taxes gains from investments in U.S. real estate that is available for investments in “domestically controlled” REITs, and the exemption from U.S. withholding tax for interest that is considered “portfolio interest”.

Relatedly, the two types of income that need to be accounted for under these regimes are those that arise during the course of the investment—such as operating (business) income, dividends and leveraged (e.g., debt-financed) distributions—and those that arise on exit (e.g., capital gains).

For example, a private credit co-investment may be structured to allow investors who have access to a tax treaty to avoid being subject to net basis U.S. tax from engaging in a lending business by using a structure that avoids causing the non-U.S. treaty investor to be considered to have a permanent establishment in the U.S., without which most tax treaties reserve taxing rights only to the country of the investor’s residence. As another example, a real estate co-investment may be structured so that investors entitled to the benefits of Section 892 own less than 50 percent of a REIT that owns the investment, in order to allow operating dividends from the REIT to be exempt from U.S. withholding taxes so that the Section 982 investor can exit the investment by having the co-investment vehicle sell shares of the REIT without the Section 892 investor being subject to FIRPTA tax on any capital gains realized.

The second set of issues concerns protecting the tax status of co-investors. For example, to continue to be eligible for the benefits of Section 982, an Section 892 investor needs to ensure that the co-investment vehicle is not considered to be engaged in commercial activities. As a result, a Section 892 investor will need assurance that any investment will be “blocked” by being made only through entites treated as corporations for U.S. tax purposes, and that only investment activities are undertaken at the co-investment level. Other non-U.S. investors will typically also want to ensure that their status as a non-U.S. taxpayer that does not file a U.S. tax return is protected so that the investment will not require them to file a U.S. tax return.

Finally, the third category of considerations concern who is responsible for tax filings: how withholding taxes will be dealt with; how taxes—whether those that are expected or those that arise because the structure did not work as intended—are dealt with; and who is responsible for those taxes, both in terms of cash flow and the overall economic deal between investors who typically are entitled to a preferred return and the sponsor who earns carried interest if certain return thresholds are reached. Whether those thresholds are calculated after any taxes borne by the investor or whether those taxes are considered to be for the “account” of the investor and therefore not impact the carry can have a significant impact on when and how much carry is earned by the sponsor. 

Ensuring that taxes are not withheld unnecessarily, as they can be costly and difficult to get refunded, is another crucial part of the structure and documentation of co-investments, particularly given the myriad U.S. rules that impose strenuous requirements to avoid withholding. These include rules related to FATCA, FIRPTA rules related to investments in U.S. real estate, and the relatively new rules of Section 1446(f) of the Code that potentially impose withholding on all transfers by non-U.S. investors of a partnership that that earns or could earn U.S.-effectively connected income.

A non-U.S. co-investor will want to carefully consider and understand how these three areas of concern are managed and arranged, as they will have a major impact on net expected returns from the investment, on the investor’s ability to benefit from its particular tax status with respect to other investments, and on the investor’s ability to effectively manage their own internal tax administration and the tax filings and procedures created by the investment itself.

(And, of course, Caesar will always be in the background watching to make sure that the tax authorities collected their appropriate share.)