Private equity describes investment partnerships that buy and manage companies before selling them. Private equity firms operate these investment funds on behalf of institutional and accredited investors.
Private equity funds may acquire private companies or public ones in their entirety or invest in such buyouts as part of a consortium. They typically do not hold stakes in companies that remain listed on a stock exchange.
Private equity is often grouped with venture capital and hedge funds as an alternative investment. For many of today’s investors, diversification goes beyond owning companies in a variety of industries—it means adding securities from different parts of the globe, too. In fact, many experts recommend diverting a third or more of one’s stock allocation into foreign enterprises to create a more efficient portfolio.
Private equity investments in foreign private equity funds offer U.S. investors unique opportunities for portfolio diversification and potentially attractive returns.
For U.S. investors investing in foreign funds there is a risk of PFIC treatment. While many portions of the U.S. tax code possess confusing and sometimes harsh rulings, the tax regime for Passive Foreign Investment Companies (PFIC) is almost unmatched in its complexity and almost draconian features. Countless times, our international clients have come to us to prepare what they thought would be straightforward tax returns- only to later learn that the investment they had made in a non-US fund was now subjecting them to all the concomitant filing requirements and tax obligations.
In Singapore eg, VCC fund structures are increasingly popular. The Variable Capital Company (VCC) is a new corporate structure for investment funds constituted under the Variable Capital Companies Act which took effect on 14 Jan 2020.
Some key features of a VCC
- A VCC has a variable capital structure that provides flexibility in the issuance and redemption of its shares. It can also pay dividends out of capital, which gives fund managers flexibility to meet dividend payment obligations.
- A VCC can be set up as a single standalone fund or an umbrella fund with two or more sub-funds, each holding a portfolio of segregated assets and liabilities. For fund managers that structure their funds as umbrella VCCs, there may be cost efficiencies from using common service providers across the umbrella and its sub-funds.
- A VCC can be used for both open-ended and closed-end fund strategies
- Fund managers may incorporate new VCCs or re-domicile their existing overseas investment funds with comparable structures by transferring their registration to Singapore as VCCs.
- VCCs must maintain a register of shareholders, which need not be made public. However, this register must be disclosed to public authorities upon request for regulatory, supervisory and law enforcement purposes.
For funds such as a VCC structure that are not required to file U.S. Form 1065, U.S. Partnership Return (and therefore would not normally issue K1s), generally there are 2 options for the US exposed investor.
Firstly there is a pro forma schedule K-1, or a pro forma K-1. It is a simulated tax document that outlines an investor’s share of a foreign fund’s income, deductions, and other tax-related items according to US tax and reporting standards. A pro forma K-1 provides the necessary information to enable U.S. investors to report their foreign income more efficiently, reducing the risk of errors or omissions on their tax returns. A check the box election may be required in order for the US exposed investors to get partnership treatment on the foreign fund.
Secondly, a simpler option for shareholders of PFICs is the QEF election. A first glance, it would appear to be a much better option for most investors since effectively results in the PFIC being treated like a US based mutual fund- the ordinary and capital gains income of the PFIC separately flow through to the shareholder according to percentage of ownership. For example, a taxpayer with a 1% stake in a PFIC that earns $100,000 in ordinary income and another $50,000 in capital gains income will report $1,000 as “other income” on the tax return while $500 will be reported on Schedule D. However, there is one huge obstacle to making this election- most PFICs are unable to be classified as a QEF since the IRS demands that a QEF comply with IRS reporting requirements (a large request for a non-US based company). Consequently, the QEF election is not frequently available.