ROPES & GRAY LLP

Private Equity Tax Practices 2009

11943836

ROPES & GRAY2

Private Equity Tax Practices 2009

Ensuring Accurate Withholding And Regulatory Compliance with Your Inbound

Foreign Investors

June 17, 2009

Rom WatsonRopes & Gray LLP

rom.watson@ropesgray.com(617) 951-7672

Elaine B. MurphyRopes & Gray LLP

elaine.murphy@ropesgray.com(617) 951-7568

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General Overview: U.S. Tax Rates for Inbound Foreign Investors

• Withholding tax rates if no U.S. “permanent establishment”– Dividends: 30% (15% under most tax treaties)

– Interest: Generally 0% (“portfolio interest” exemption)

– Capital Gain: 0% for non-real estate investments

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General Overview: U.S. Tax Rates for Inbound Foreign Investors Cont’d.

• U.S. rates on taxable business income– “Effectively Connected Income” (ECI) if no treaty

– “Attributable to a PE” if treaty context

• 35% corporate tax

• 30% branch profits tax (or 5% under treaty) on earnings after corporate tax

• Up to 54.5% combined U.S. tax rate for ECI/PE distributed profits

• Potential state income taxation can follow

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General Overview: U.S. Tax Rates for Inbound Foreign Investors Cont’d.

– U.S. has broad protection from ECI/PE status for investments or trading in “stocks and securities” by foreign persons. Note this type of safe harbor is not generally available in other countries.

– Potential withholding by PE Fund equal to 35% of amount of ECI allocated to foreign investors

– Triggers U.S. income tax return obligation

• Foreign partner in a partnership with ECI must file, even if no tax liability

• Withholding by PE Fund is credited as “advance payment”

• Failure to file can result in penalties, including denial of deductions and credits

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Role of PE Fund Organized in The U.S.

• U.S. PE Fund– Provides IRS Form W-9 for U.S. investments

– Collects and diligences IRS Forms W-8 from foreign investors

– Files U.S. partnership return and provides information returns (Schedules K-1) to foreign investors

– Withholds from foreign investors’ share of FDAP (e.g. dividends) and files related reports (e.g., IRS Forms 1042 and 1042-S)

– Withholds from foreign investors’ share of ECI investments, including sale or redemption of partnership interests and FIRPTA investments, and files related reports

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Role of PE Fund Organized outside The U.S.

• Non-U.S. PE Fund– Provides IRS Form W-8IMY for U.S. investments

– Non-Withholding Foreign Partnership

• Approach to collection and provision of underlying tax forms and allocation information of non-U.S. investors

• Fund generally is subject to full withholding tax on FDAP from U.S. investments, will not have U.S. tax return obligation, and may have U.S. reporting obligation to foreign investors

• Fund generally is subject to 35% withholding on ECI investments, will have U.S. tax return obligations and U.S. reporting obligations to foreign investors

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Role of PE Fund Organized Outside The U.S. Cont’d.

– Withholding Foreign Partnership

• Approach to collection of underlying tax forms and allocation information of foreign investors

• Fund generally is not subject to withholding tax on FDAP from U.S. investments, but generally will have U.S. reporting obligation

• Agreement limited to FDAP withholding and does not cover ECI withholding

• Agreement limited to certain categories of investors

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Legend

Partnership for both U.S. and foreign tax purposes

Corporation for both U.S. and foreign tax purposes

Corporation for U.S. tax purposes, flow-through for foreign tax purposes

Investors

Ownership

Flow of Forms

Payment

Withholding Tax to IRS

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Examples: Withholding on Dividend

Foreign Investors

PEFund I

U.S.

ForeignInvestors

ForeignInvestors

PEFund II

Non-U.S.

PEFund III

Non-U.S.

U.S. Corp.IRS

Foreign Corp.

AppropriateForm W-8

AppropriateForm W-8

AppropriateForm W-8

Form W-9

Form W-8BEN

Form W-8IMY Form W-8IMY

Possible depending on status

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Examples: Withholding on Dividend Cont’d.• U.S. corp. pays a dividend to its 3 shareholders• PE Fund I provides Form W-9 to U.S. corp. PE Fund I

collects appropriate Forms W-8 from its foreign investors. PE Fund I pays withholding tax in respect of share of dividends allocated to foreign investors

• Foreign corp. provides Form W-8BEN to U.S. corp. U.S. corp. withholds 30% (subject to reduced treaty rate) from payment to Foreign corp. Foreign corp. distributes net amount to PE Fund II, which in turn distributes net amount to its foreign investors.

• PE Fund III provides Form W-8IMY to U.S. corp. Result depends on if it is a withholding foreign partnership or non-withholding foreign partnership, and if the latter, the information it provides to U.S. corp.

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Examples: Direct Investment by Foreign Investors in PE Fund

• 30% tax on FDAP income, e.g. dividends, except as reduced by an applicable income tax treaty

• 35% federal tax on share of ECI investments

• Withholding on share of ECI may result in overpayment of tax (need to claim refunds)

• Corporate foreign investors may be subject to additional branch profits tax (unless reduced by treaty)

• Foreign investors required to file federal (and possible state) tax returns

Foreign Investors

PE Fund

Non-ECI and ECI Investments

AppropriateForm W-8

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Examples: PE Fund with U.S. Corporate Feeder

• 35% federal tax rate at U.S. corp. level on both non-ECI and ECI investments

• Dividends from U.S. corp. subject to 30% withholding (unless reduced by treaty)

• Results in effective federal tax rate of up to 54.5% on non-ECI and ECI investments

• Leveraging U.S. corp. may reduce but will not eliminate U.S. tax costs

• Foreign investors not required to file U.S. tax returns

Foreign Investors

PE Fund

Non-ECI and ECI Investments

AppropriateForm W-8

U.S. Corp.

Form W-9

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Examples: PE Fund with Feeders And Special Allocations

• 35% federal tax rate at U.S. corp. level on ECI investments only

• Dividends from U.S. corp. subject to U.S. withholding

• Result effective federal tax rate of up to 54.5% on ECI

• No U.S. corp. level tax on non-ECI investments

• Leveraging U.S. corp. may reduce but will not eliminate U.S. tax costs

• Foreign investors not required to file U.S. tax returns

• Foreign investors would have U.S. tax and filing requirements if special allocations are not respected

Foreign Investors

U.S. Partnership

Non-ECI and ECI Investments

Appropriate Form W-8

Non-U.S. Entity

From W-9

U.S. Corp.

PEFund

Appropriate Form W-8

Non-ECI Investments

ECI Investments

AppropriateForm W-8

Form W-9

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Examples: PE Fund with Parallel Fund Structure

• Use separate U.S. corp. for each ECI investment. 35% federal tax at U.S. corp. on ECI investments only. Regular distributions from U.S. corp. subject to 30% withholding (unless reduced by treaty). Effective federal tax rate of up to 54.5%

• Exit from ECI investments may be structured as sale of stock of U.S. corp. which would not be subject to U.S. tax (unless U.S. corp. is a USRPHC in which case 35% tax applies)

• If ECI investment exit is an asset sale, 35% tax on gain will apply but may not be additional 30% withholding or branch profits tax if U.S. corp. is liquidated

• Non-U.S. investors invest through non-U.S. hybrid entity. No U.S. tax and filing obligations if U.S. corp. is USRPHC, but non-U.S. hybrid is subject to 35% federal tax

• FDAP on non-ECI investments generally would be subject to 30% withholding tax (unless reduced by treaty)

• Structure variations: (1) lower-tier partnership structure for carry structuring, (2) direct investment by foreign government investors, (3) separate treaty and non-treaty investors for flexibility on current distributions from U.S. corp.

Foreign Investors

Non-U.S. Entity

PEFund

U.S. Corp.Non-ECI Investments

AppropriateForm W-8

Appropriate Form W-8

Form W-9

ECI Investments

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Special Rules for Foreign Investors

• Foreign Tax-Exempt Investors– Code §501(c)(3) exemption also applies to

foreign entities

– Requires IRS ruling or U.S. tax opinion

– Provides broader tax exemption than tax treaties

• Exempts withholding tax on U.S. dividends

• Exemption claimed on Form W-8EXP

– No protection if PE Fund income is UBTI

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Special Rules for Foreign Investors Cont’d.• Foreign Governments and Sovereign Wealth Funds

– Separate exemption regime under §892• Does not rely on income tax treaties• Generally limited to “investment income”• Does not apply to “commercial activities” (which has a broad overlap

with ECI)

– Pension Funds and “controlled entities” of foreign government covered, subject to limits on types of income received

– FIRPTA Rules• Sale of interests in U.S. real estate is taxable• Sale of stock in USRPHC is exempt• REIT distributions attributable to gain on USRPI are taxable• Sale of REIT stock is exempt