Blocker corporation
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A '"blocker" corporation is a C Corporation that can be used to protect tax exempt individuals. In private equity or with hedge funds in particular, a problem can arise when a fund contains foreign or tax exempt investors, who are not subject to US tax. Most private equity funds and hedge funds are composed as limited partnerships, or as LLC's (Limited Liability Company) which for tax purposes is considered a Limited Partnership, unless it formally elects to be taxed as a corporation. This allows the fund itself to avoid taxation, as each of the individual investors is taxed as a partner, for his or her personal equity interest. By comparison, a fund set up as a "C" Corporation would be subject to tax for its earnings, and then the limited partners would be subject to tax when they received their profit which would technically be classified as dividends of the corporation. Thus, the LLC or LP format allows a fund to avoid double taxation.
When there are foreign or tax exempt investors in a fund, they are not subject to US income tax, but are still required to declare and pay taxes on "Unrelated Business Taxable Income" or "UBTI". For tax exempt investors, dividends, royalties, rents, capital gains and interest income are not considered "UBTI", but any money earned from conduct unrelated to the entity's tax exempt purpose is considered "UBTI". Foreign investors are not required to declare capital gains from the sale of stock, however, if the a fund with a foreign investor conducts any business or trade in the United States, it is required by US tax law to automatically withhold the tax income attributable to its foreign partners. To combat this, a private equity fund can set up an offshore feeder corporation known as a "Blocker" corporation. The foreign and tax exempt investors can invest through the "blocker" corporation, and then they are no longer personally considered to be partners, as it is the foreign corporation that is the owner of equity in the fund. For tax exempt investors, their share of the "blocker" corporation is considered dividend income, and thus they are not subject to tax. Foreign investors must still pay dividend taxes, but they avoid US trade or business income tax. Furthermore, if a portfolio investment is acquired from an outside entity and the purchaser can be convinced to also purchase the "blocker" corporation (to obtain its holding in the investment) then the earnings are no longer dividends, and are subject to no US tax.
Sources:
- http://www.altassets.net/casefor/sectors/2003/nz2458.php
- http://www.drinkerbiddle.com/publications/Detail.aspx?id=4e6f18d3-2555-4fad-a926-03fc8b81acad
