Blocker Legal Entity

Blocking companies are corporations that effectively “freeze” taxable income at the corporate level for U.S. federal, state, and local income tax purposes. When a private equity firm structures an LBO transaction, some private equity investors, typically tax-exempt and foreign, invest directly or indirectly in holding company shares through one or more newly formed Delaware C companies (the Blocker Company). The right of tax-exempt and foreign investors to use blocking companies and the provisions protecting the economic rights of tax-exempt and foreign investors are often set out in the private equity company`s fund documents and limited partnership agreement. The impact of blockers on tax-exempt organizations and investments outside the U.S., on the other hand, investors generally preferred to invest through blockers in most cases to circumvent the tax reporting requirement. In addition, unlike tax-exempt investors, where blockers were largely tax-inefficient, blockers had a tax-neutral impact on non-U.S. citizens. investor. In fact, for non-U.S.

businesses, using a blocker is often more tax-efficient because it avoids tax on the branch`s profits. Over time, these investors also became smarter and began to push for blocking leverage to reduce tax losses. Blocker Corporation is able to use interest deductions (subject to business interest limitation rules) to reduce its tax liability, and non-tax-sensitive investors from the U.S. government can repatriate cash free of tax as a return of principal. This was supported by a clarification in Treasury Department regulations that the IRS will consider a partnership for the purposes of applying the portfolio interest exemption from withholding taxes to determine whether an investor is below the 10% participation threshold and is therefore eligible for the exemption.4 The clarification allowed non-Americans. Investors must take the position that they are eligible for the exemption if they own less than 10% of the blocker. Action Point: Since business blockers remain relevant, tax-exempt companies need to understand how business blockers can fit into their overall investment strategy. The need for a lock-in structure is typically triggered when a fund invests in a limited liability company or other corporation designed as a transfer for tax purposes (i.e.

The company`s tax obligations are passed on to its owners). Since the 1990s, the LLC has become an increasingly common organizational structure under various state laws and is often used in place of the C-Corp structure because of its potential tax advantages. This article describes part of the history of the use of blockers in the private equity world, as well as recent developments, some of which have been triggered by legislative changes and others by changes in business trends. In another structure, a buyer of a private equity fund can avoid the problem of double lock-in by effectively acquiring the blocked and unlocked parts of the holding company as two separate investments. The acquired blocker would be acquired in the usual way the fund acquires corporate stakes, while the flow-through portion of the investment would be acquired through a structure blocked for tax-sensitive investors. If this is the preferred route for the private equity buyer, the purchase agreement should generally be designed to reflect this structure. In addition, in this structure, rolling shares or new management shares are likely to be issued to the existing flow-through unit of the holding company (as there is no new aggregator as in the first structure). This may result in costs for the private equity sponsor, as working and management shareholders would not suffer the corporate tax loss attributable to the acquired blocker (including with respect to the acquired blocker`s historical taxes, if any). Finally, a factor to consider with respect to foreign investors who invest through blocking companies is that, in their home jurisdiction, they may be subject to tax on profits from the sale of their shares in Blocker Corporation. For example, if Blocker Corporation shares held by a Canadian resident are sold, the Canadian investor may escape withholding tax or income tax in the United States, but will be subject to tax on profits in Canada. On the other hand, this may not apply to foreign investors residing in tax havens, who may not be subject to U.S. federal withholding or income tax or foreign tax on the sale of Blocker Corporation shares.

Given the popularity of the LLC, the blocking structure has become a widely used tool for funds and their foreign and tax-exempt investors. The language that protects the rights of these investors is often incorporated directly into the authoritative documents or partnership agreements of a private equity or venture capital firm. The Blocker Tax Guide illustrates the U.S. tax consequences of operating and disposing of a domestic or foreign blocker in several common scenarios. 1 This guide is intended to describe the U.S. tax consequences of different blocking structures in general. No specific structure is recommended. The structure of any investment by a fund in the United States must be done on a case-by-case basis and depends on the specific facts of the transaction. Foreign taxpayers should consult with a U.S.

tax advisor at the beginning of all discussions about a proposed investment in the U.S. In a previous article titled “Rollover Equity Transactions 2019,” we discussed the various business and tax issues related to transactions with private equity (PE) buyers that involve stock rollovers of target owners in their leveraged buyback (LBO) transactions. Here, we delve deeper into the impact of some private equity investors investing in target companies through blocking companies. A unique group of non-U.S. investors, foreign governments, receives benefits under Section 892 of the Internal Revenue Code (“Code”) for certain forms of income, including dividends, interest, and gains from the sale of certain securities. However, they are subject to federal income tax on their “business income” or “CAI”. The rules for CAI are similar to those for ECI, and so investors from foreign states often invest through a blocker alongside other non-U.S. citizens. investor.

For some foreign government investors, if they have a CAI, they may lose their “892” status. They are therefore more sensitive to the CAI than non-Americans. Investors must pocket the ECI. Before using blockers as the preferred method for private equity funds to absorb tax-sensitive investors, these investors relied on the ECI and UBTI clauses to protect themselves.

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