David Winter and Adam Feuerstein are partners at law firm Hogan & Hartson LLP in Washington, DC. Both have practices in the areas of private equity, real estate investment trusts and tax. Winter can be contacted at email@example.com and Feuerstein at firstname.lastname@example.org.
Tax-exempt investors such as pension plans and university endowments represent an important class of private equity fund investors. As those private equity firms that have raised money from these investors can attest, it is equally unremarkable to posit that unrelated business income tax, or UBIT, can play an important role in the investment decisions that these investors make. Beyond these two simple assertions lie some complexity and confusion.
For those unfamiliar with unrelated business income tax, UBIT is a tax assessed on tax-exempt organizations with respect to income generated from business activities that are unrelated to the organization's exempt purposes. This income is referred to as unrelated business taxable income, or UBTI.
This article will discuss the expanding range of UBIT attitudes that private equity funds can expect to encounter from tax-exempt organizations. It will also discuss some of the approaches and trends toward addressing UBIT issues that can be found in the market, focusing on the UBIT-related covenants contained in private equity fund governing documents. This topic has become more timely as a trend towards fund structures today that allow for the possibility of more UBTI than in the past has emerged.
How to think about UBIT
UBIT is an issue for a tax-exempt investor because it can reduce the return on the organization's investment. However, many tax-exempt organizations do not measure success strictly in financial terms. They have many parties that may scrutinize their activities including students, faculty, alumni, donors, members, the press and various levels of government. How these tax-exempt organizations are perceived by these various groups is often an important factor that affects their decision making and attitude towards UBIT.
Although the attitudes of tax-exempt organizations cannot be divided into rigid categories, it may be helpful for private equity fund managers to think of these investors as taking one of the following four attitudes towards UBIT. This will allow the managers to offer fund structures with UBIT tolerance and minimization goals that will appropriately address the tax-exempt organizations' concerns.
Minimize UBIT even if so doing may depress financial returns. One position that some tax-exempt organizations have taken is that making an investment that will generate UBIT is itself problematic. These ?UBIT-allergic? investors are concerned that the receipt of UBTI from a private equity fund in and of itself may be perceived as engaging inappropriately in an activity outside the scope of their exempt purposes. Organizations with this view might propose a structure that would minimize UBIT, even though the structure might subject the organization's investment to an increased overall level of taxation. This view appears to have waned over the years as fewer organizations seem to view the receipt of UBTI itself as problematic.
Minimize UBIT so long as the structures used are at least neutral from a financial return perspective. A second position taken by taxexempt organizations, and one that appears to be growing in popularity, is that UBIT should be minimized, but only to the extent that structures used to minimize UBTI do not depress the overall financial return of the tax-exempt organization. These organizations, for example, would not be attracted to a proposed structure that enabled them to avoid UBIT under the debt-financed rules that may have an effective tax rate to them of 20 percent by requiring them to hold their investment through a corporation that pays tax on the same income at a rate of 35 percent.
Minimize UBIT only if the structures used produce substantial financial benefits. A third position taken by tax-exempt organizations is that UBIT should be minimized only to the extent that structures used to accomplish the minimization create substantial tax savings. These organizations may be driven by concerns regarding the costs of UBIT-minimizing structures and/or by the existence of their own net operating losses that may be available to offset UBTI generated by a fund investment.
Minimize UBIT only if the structures used do not pose an adverse publicity risk. A fourth position on this issue taken by tax-exempt organizations, and one that also appears to be growing in popularity, centers around the potential non-financial ramifications of entering into structures that may minimize UBIT. The concern of an organization taking this position is that it may be perceived as aggressively trying to minimize the tax that it would otherwise be obligated to pay and that this may hurt the public image of the organization or subject it to costly and distracting public scrutiny. The recent adverse publicity surrounding the use of offshore ?blockers? highlights this concern.
While tax-exempt organizations may be more accepting of UBIT, they still prefer investments that will not generate UBTI because, all else being equal, those investments will yield a higher after-tax return. Tax-exempt organizations' willingness to accept some UBIT, accompanied by a desire to limit the effect of UBIT on their overall economic returns, has led to varied approaches to regulate the incurrence of UBTI, which will be discussed below.
Addressing UBTI in fund agreements
The governing documents of most private equity funds that include tax-exempt investors include a covenant relating to UBTI. This provision is relevant not only to the private equity fund manager and the tax-exempt investors, but also to investors that are not tax-exempt as it puts such investors on notice regarding the intentions of the fund managers regarding costs that may be incurred in an effort to minimize UBTI.
Traditional Standard: Efforts to avoid UBTI ? Traditionally, many private equity fund agreements provided that the manger of the fund would endeavor to avoid UBTI, requiring the general partner to use its ?best efforts? or its ?commercially reasonable efforts? to do so. This remains a popular covenant, and for many tax-exempt investors it will be sufficient. However, such a covenant applied in certain circumstances could result in requiring the fund manager to structure an investment in a manner that actually reduces the financial return to all investors, including the tax-exempt investors. Accordingly, some funds have moved away from this standard. Nevertheless, it remains common, and is probably most appropriate for funds where the expected activities are not supposed to generate UBTI.
Requiring consideration of a tax-exempt organization's after-tax return ? One potential alternative to the standard covenant described above is a covenant by the fund manager to structure investments taking into account the after-tax returns of tax-exempt organizations. Rather than minimize UBTI, a fund governed by this standard will take all taxes into consideration and will seek a structure that minimizes taxation in the aggregate, although it may produce substantial UBTI. This type of covenant will be unattractive to UBIT-allergic tax-exempt investors, but often will be attractive to those tax-exempt investors that have one of the other attitudes towards UBIT described above.
Specific return requirements ? Another alternative is for the parties to agree on an expected required return for each investment, and provide that the required return would be higher if the investment would be subject to UBIT. For example, the agreement might require an expected internal rate of return of 20 percent to the fund before making any investment, but require a 24 percent internal rate of return if the investment might generate UBTI. This type of specific return requirement may not lend itself to certain types of private equity funds, where returns are more speculative and forecasts less meaningful. In those cases where it is determined to be appropriate, however, it may be attractive to certain tax-exempt investors, particularly where the additional expected return on UBTIgenerating investments is designed to be equivalent to the UBIT expected to be incurred on such investments.
Specific percentage of UBTI investments ? A relatively simple alternative that some fund managers and tax-exempt investors have found acceptable provides for a bucket of investments that are permitted to be made even though they are expected to generate UBTI. This is usually expressed as a percentage of fund capital. For example, a fund would be permitted to invest 15 percent of its capital in investments expected to generate UBTI. While attractive in its simplicity, some tax-exempt investors balk at the structure because it could result in all fund profits being subject to UBIT and because it is not narrowly tailored to the goal of maximizing their after-tax returns.
Calculate the promote on an after-tax basis ? Some tax-exempt investors in the group most accepting of UBIT appear to be willing to enter into fund governing documents that contain no UBTI-related covenant or a very limited UBTI-related covenant, but in exchange for doing so, they request that the carried interest of the fund manager be calculated on an after-tax basis. These provisions effectively reduce the returns paid to investors for purposes of determining the carried interest by an amount equal to the UBIT paid by the investors.
As can be seen, there are many different ways that parties can address UBIT in their fund agreements. The best option in a particular case will depend on a variety of factors not the least of which will be the tax exempt investors' attitudes towards UBIT. Understanding these attitudes, and determining which attitudes are held by the tax exempt investors in a particular fund, will help a fund manager properly address the UBIT issue.