The use of subscription lines of credit by private market funds has significant tax implications for their tax-exempt limited partners that both LPs and fund managers should be aware of. Howard Marks, co-chairman of Oaktree Capital Management, brought this issue up in his list of negatives when he wrote about fund finance in April.
“Some LPs seek to avoid so-called unrelated business taxable income,” he wrote in his Lines in the sand memo to clients. “Without getting into further details, suffice it to say the use of subscription lines increases the risk of UBTI to these LPs.” Unrelated business taxable income is generated by a tax-exempt entity as a result of taxable activities.
If a fund uses a line of credit to purchase an investment, the income from that investment may make a tax-exempt investor taxable. But there are ways a fund manager can forestall this.
General partners have used lines of credit for years, but now some are lengthening the period they keep these facilities open. If this is for more than a year, it can trigger UBTI for tax-exempt investors like certain pension plans and endowments.
“There’s limited IRS rules that allow this to happen and get away with not having UBTI,” says Mike Laveman, a tax partner and co-chair of the New York tax practice at EisnerAmper.
Here’s how it works: as long as there is no income coming from an investment made with money borrowed by a fund during the period of the loan and for 12 months after a GP has paid off the line of credit, tax-exempt investors aren’t subject to UBTI. But if there is income through a recap or an early sale within that period, the LP will be liable for tax.
“There’s a lot of investors that are very sensitive to this so a lot of the CFOs are managing the expectations of these tax-exempt investors,” Laveman says.
“Certain tax-exempt limited partners who want minimal UBTI risk will enter into side letters with the fund that provide that they will be given the chance to pre-fund their share of any drawdown from a subscription facility,” law firm Schulte Roth & Zabel wrote in a research document for its private investment funds seminar in January.
Some funds may also put such tax-exempt investors in a corporate blocker entity so the UBTI doesn’t pass through, Laveman notes.
“But there’s a tax cost of doing that too, because the blocker will pay US tax which reduces net returns to the investor,” he says.
A US tax-exempt investor therefore would need to weigh up the tax costs of being invested in a blocker, which will be taxed as a corporation, versus not going through the blocker and potentially being allocated UBTI through a partnership vehicle.
It’s up to the LP and GP to find the best solutions for their situation.