Tuesday, December 18, 2007
A Los Angeles Times article yesterday briefly describes Mitt Romney's investments in offshore hedge funds that used "blocker corporations" to shield tax exempt investors (hospitals, pension plans and universities, primarily) from unrelated debt financed income imposed by IRC 514. A blocker corporation is essentially a foreign organized corporation inserted between an exempt investor and a hedge fund usually organized and taxed as a pass-through entity (i.e., a partnership). Oftentimes, the exempt organization will use borrowed money to invest in the hedge fund, thus creating the potential for unrelated debt financed income (taxable at normal corporate rates). That happens when the yield from the hedge fund is allocated directly to the exempt partner whose ownership in the partnership is debt-financed. Briefly described, if the debt is incurred by the exempt organization indirectly via the foreign corporation, and the hedge fund yield is allocated to that corporation and then paid out to the corporation's exempt parent, it is characterized as a dividend not financed by the exempt parent's debt and thus not subject to the unrelated debt financed rules. The UDFI taint has been successfully "blocked." The IRS has blessed these conclusions. The House Ways and Means Committee held hearings on this matter last fall. Janne G. Gallagher, Vice President & General Counsel, Council on Foundations testified on the use of blocker corporations by colleges and universities. So did Suzanne Ross McDowell, Partner, Steptoe & Johnson LLP. The Council on Foundations also has a nice primer on blocker corporations. I attended the hearing and it seemed to me that the House, at least, was favorably disposed to changing the UDFI laws to make it unnecessary that exempt organizations incur the transaction costs incurred by the use of blocker corporations to avoid UDFI.