By:
Albert Francke
William B. Sherman
New York
In the January 1995 issue of the International Report, we discussed the use of limited partnerships as useful investment entities for pools of capital of U.S. investors.
Increasingly, U.S. institutional investors are investing their assets outside of the United States under the professional management of overseas money managers. If this is done on a collective or pooled basis, tax transparency can be an important characteristic to assure that the U.S. investors are not unnecessarily subject to taxation in the country of investment. Tax transparency can be achieved by using a limited partnership as the investment vehicle in which to pool U.S. investors' assets.
This article will expand upon the prior article and discuss (a) the benefits of using limited partnerships organized outside the United States for this purpose, and (b) certain U.S. tax treaty benefits that could be obtained by investing through limited partnerships as opposed to other investment entities, such as offshore companies.
Partnerships Organized Outside the U.S.
While U.S. investment partnerships are organized in various states under their versions of the Uniform Limited Partnership Act, there are other jurisdictions in which organizations can be created which will be treated as limited partnerships for U.S. tax purposes. They range from limited partnerships in common law jurisdictions to other organizations with similar characteristics created in civil law jurisdictions. Provided that the structures permit U.S. counsel to conclude that they contain the characteristics of partnerships for U.S. tax purposes, these organizations can be used as tax transparent capital bridges between the domicile of the investor and the country of investment.
U.S. Tax Issues
The important U.S. tax question that arises utilizing a limited partnership is whether a non-U.S. limited partner of the partnership will be subject to U.S. tax on its share of the partnership's income connected with the U.S. trade or business of the partnership.
If the partnership is organized in the United States, it will have to file a U.S. Federal income tax return annually for the purpose of reporting each partner's allocable portion of income and gains, whether or not the partnership is engaged in trade or business in the United States ("ETB"). On the other hand, a partnership organized outside of the United States must file a U.S. tax return only if it is ETB. If one general partner of a partnership formed outside of the United States is domiciled outside of the United States and that general partner properly manages the affairs of the partnership outside of the United States, the partnership, and therefore the partners, will not be ETB even if the investment decisions are made in the United States. Consequently, the offshore partnership will not have to file a Federal income tax return.
Potential U.S. Tax Treaty Benefits
Certain U.S. tax benefits that are not available to other nontransparent, investment entities can be obtained by using a limited partnership. Of particular note to U.S. investors investing outside the U.S. are the following:
(1) Tax treaty benefits may be obtained under U.S. tax treaties with various countries around the world. An investment entity engaged in a cross-border investment may be subject to withholding or other tax on dividends, interest and/or capital gains in the country of investment. But, subject to local law and the application of the U.S. tax treaty with the country of investment, those taxes may be recovered in whole or in part or directly abated by the country of investment to the U.S. investor in a tax transparent investment entity such as a partnership. This benefit from the country of investment cannot be obtained by U.S. investors investing through companies or trusts (with the exception of certain trusts exempted specifically by legislative provision).
For example, if the U.S. investor invests in Korea through a Cayman Islands investment company, the Korean withholding tax on dividends and interest paid to the Cayman Islands investment company would be 25% and there would be a capital gains withholding tax of 10% on the proceeds of sale, as there is no double tax treaty between Korea and the Cayman Islands. The withholding taxes paid by the Cayman Islands investment company cannot be recovered by its U.S. investor, unless it is a ten-percent or greater corporate shareholder. On the other hand, a U.S. investor investing in Korean securities directly or through a partnership can benefit from the reduced withholding rates under the U.S./Korea double tax treaty, which reduces the Korean withholding tax to the U.S. investor to 10-15% on dividends and 12% on interest and eliminates the withholding tax on capital gains. In addition, under many tax treaties, a U.S. tax-exempt investor can apply for a refund of withholding tax paid in the country of investment.
Most recently, limited liability companies and business trusts that are taxable in the United States as partnerships have been used to provide tax transparency. However, their treatment under U.S. tax treaties, their entitlement to reduced withholding in the countries of investment, and the ability of a tax-exempt investor in them to obtain a refund of withholding tax, are presently not as clear as in the case of partnerships.
(2) A tax transparent entity eliminates the application of the passive foreign investment company (or PFIC) provisions of the U.S. Internal Revenue Code that apply to foreign investment entities that are considered corporations for U.S. tax purposes, e.g., a Cayman Islands investment company. For example, a U.S. investor that invests in Korean securities through a Cayman Islands investment company will be subject to the reporting and taxation provisions applicable to any U.S. investor in a PFIC, while the investor in the partnership will not be subject to those provisions.
(3) A tax-exempt U.S. investor, such as a U.S. pension fund, may not be adversely affected by PFIC taxation and income characterization issues arising from investment through a PFIC because of its tax-exempt status. As noted above, however, a tax-exempt U.S. investor will not get the benefit of the income tax treaties that may apply between the United States and the country of investment if the investment is made through a PFIC. The withholding tax rate that will be applied in the country of investment will be the rate applicable to the tax treaty between the country of organization of the PFIC and the country of investment, or in the absence of such a treaty, the highest withholding rate applicable in the country of investment. That withholding tax will not be refundable to the U.S. tax-exempt investor. The net effect to the U.S. tax-exempt investor of investment through a PFIC is a reduced yield on dividends, interest and/or capital gains.
(4) In a tax transparent entity such as a partnership, the character of the income earned by the entity flows through to the investor, e.g., capital gains or ordinary income. On the other hand, capital gains earned by a corporate investment company will result in ordinary income to the U.S. investor when paid as a dividend to the U.S. investor.
