Many tax-exempt organizations invest frequently in foreign alternative investments (e.g., hedge, private equity, real estate and venture capital funds). When investing into such funds, these tax-exempt organizations’ primary tax concern is generally to mitigate their risk of Unrelated Business Taxable Income (“UBTI”).
Funds commonly avoid this UBTI issue for their tax-exempt organization investors by structuring funds so that the tax-exempt organizations invest through a non-U.S. entity that is treated as a corporation for U.S. tax purposes (often referred to as a “foreign blocker corporation”). This offshore corporation “blocks” the potential flow-through business income that could generate UBTI for the tax-exempt organization (generally, a dividend received from a foreign blocker should not be treated as UBTI).
What is often missed by U.S.-based tax-exempt organizations that are investing in these foreign funds is their potential Form 926 – Return by a U.S. Transferor of Property to a Foreign Corporation filing requirement that would be attached to their annual U.S. federal income tax return (e.g., Form 990 – Return of Organization Exempt from Income Tax and Form 990-PF Return of Private Foundation). An organization may potentially abate penalties assessed for failure to file Form 926 if the failure is due to reasonable cause and not willful neglect. Reasonable cause may be demonstrated by submitting a written explanation to the IRS detailing the nature of the taxpayer’s failure to comply.
A U.S. citizen or resident, a domestic corporation or a domestic estate or trust must complete and file Form 926 to report certain transfers of property to a foreign corporation. Specifically, a transfer of cash to a foreign corporation must be reported on Form 926 if immediately after the transfer, the U.S. person holds directly or indirectly at least 10 percent of the total voting power or the total value of the foreign corporation or the amount of cash transferred by the person to the foreign corporation during the 12-month period ending on the date of the transfer exceeds $100,000. Below are two examples that would trigger a filing requirement.
The following are two basic examples of a U.S. tax exempt organization triggering a Form 926 filing requirement as a result of their offshore investments.
There is an exception to file Form 926 for tax-exempt organizations; however, this exception only applies to non-cash transfers of certain stock or securities and the related income was not UBTI. The vast majority of transfers by tax-exempt organizations to foreign corporations are cash (e.g., capital calls via foreign blocker structures for offshore investments). As such, this narrow exception to filing Form 926 relating to transfers of stock or securities rarely is applicable.
Based on the above, for any offshore investment through a foreign blocker corporation, a tax-exempt organization should keep a close eye on its cash investments to determine if it meets either the 10-percent ownership or $100,000 threshold test. In practice, we have often seen the inadvertent mistake of overlooking the $100,000 test and focusing only on the 10-percent test (likely due to the similarity to other U.S. tax filing rules such as controlled foreign corporations).
Due to the complexity of U.S. tax filings and their associated potential penalties, we recommend that tax-exempt organizations review their historical offshore investments and proactively exercise oversight on their prospective offshore investments to ensure it is and continues to be U.S. tax compliant. If you have any questions regarding the above and/or potential U.S. tax filings, please contact us at 310.873.1600.
This article is not intended to discuss UBTI. Please contact us if you would like to further discuss the UBTI rules.
There may be other informational filings required such as Form 8865 – Return of U.S Persons with Respect to Certain Foreign Partnerships and Form 5471- Information Return of U.S Persons with Respect to Certain Foreign Corporations. However, the discussion of these other foreign informational filings are outside the discussion of this article.
In addition to the potential penalties, failure to file does extend the statute of limitations. Further, depending on the facts and circumstances around a failure to file a complete and correct Form 926, a taxpayer may be subject to certain accuracy related penalties.
Generally, a tax-exempt organization is formed as a domestic corporation