When people hear the term Alternative Investment Vehicles (AIVs), they often confuse them with "alternative assets" or "alternative investments." With that said, AIVs are entirely different from the latter two. The term "Alternative Investment Vehicles" refers to the trend of investing funds into non-traditional asset classes, including real property and private equity.
Since AIVs are a non-traditional investment option, only some advisory firms have the knowledge or experience to guide clients, so they can park their funds as they choose. Here is a comprehensive guide on AIVs and how they work. There are different types of AIVs, each with specific features, pros, and cons. Making sense of it all is all about arming yourself with accurate information.
What is an Alternative Investment Vehicle?
For several years, the partnership agreements of many private equity firms have included the option to form AIVs (alternative investment vehicles) to make one or more investments. Funds are often allowed to establish AIVs with deep domain expertise and knowledge.
Why Alternative Investment Vehicles Are Helpful
Why have buyout funds just recently started using parallel AIVs, and why have VC funds only recently begun to include the use of parallel AIVs to meet their UBTI and ECI obligations since the option to do so has existed for years?
Operating Limited Liability Companies (LLCs) have gained popularity in the United States over the past few years. The founders of these LLCs are less likely to convert them into corporations because of the tax benefits they enjoy due to the Company's pass-through tax classification.
It has also come to the attention of funds that buyers are willing to pay more for operating LLCs (due to the tax benefit to buyers from the asset basis step-up). This aspect gives funds an extra incentive to build around the UBTI (Unrelated Business Taxable Income)and ECI (Effectively Connected Income) consequences to their investors to help maximize their overall returns.
In addition, obtaining a "good" deal flow is more challenging, so fund promoters need to make financially attractive investments. Moreover, their non-US and tax-exempt investors may incur an additional tax cost in the US, even when such investments only account for a small portion of the fund's investment portfolio (for example-less than 25% of the aggregate capital commitments).
After all, general partner principals are subject to US federal income taxes on their overall fund gains' share, but at a much-reduced rate compared to non-US and tax-exempt investors. An increasing number of fund managers are concluding that the only concern of non-US and tax-exempt investors is avoidance of filing a tax return in the US. Parallel AIVs are arguably satisfying this desire rather than avoiding an indirect tax liability in the US.
Different Types of Alternative Investment Vehicles
AIVs can be divided into two distinct categories. The first kind, a "subsidiary AIV," is directly owned by the fund itself (either in whole/ in part with other investors), while the AIV subsidiary holds the investment portfolio.
The second type of AIV is referred to as a "parallel AIV" and is held not by the fund itself but by a select group of limited partners and the general partner. The fund also has a direct stake in the portfolio company, and so does the counterpart AIV.
Although "parallel funds" can be set up to address tax, legal, or regulatory problems, they differ from AIVs in that they are created to make several investments in addition to the fund. In truth, it's standard procedure for parallel funds to invest equally across all fund investments unless it compromises the parallel fund's compliance with any tax, regulatory, or legal requirements. Taking this into account, a single portfolio company is the investment focus of a parallel AIV.
When an AIV is formed, its terms and conditions must be "essentially the same" as the fund's partnership agreement's terms and conditions, except for any changes required to meet the tax, legal, or regulatory purposes for which the Alternate Investment Vehicle was created. The AIV's economics, such as the management fee, distributions, allocations, and the general partner's clawback, may need to be coordinated with and altered per the fund's economic structure as outlined in the partnership agreement. A little more about the different types of AIVs:
Subsidiary AIVs
To take advantage of a tax treaty, many funds invest via a subsidiary AIV established in a non-US jurisdiction, such as Canada through a Barbados firm or in Asia through a Mauritian company. Subsidiary AIVs are used by funds to make investments in running LLCs (or partnerships)to allay investor fears of UBTI and ECI (ECI).
Parallel AIVs
Until recently, parallel AIVs saw far less use. The extra tax concerns that may arise for tax-exempt/non-US investors when dealing with parallel AIVs (in contrast to subsidiary AIVs) are explored in further detail below. Another factor is that it may be challenging to reach the desired comprehensive economic agreement when using a parallel AIV because of the investment "opt-outs" necessary at the fund level.
Stemming from this, several buyout firms have recently adopted parallel AIVs to ease the tax burdens of their investors. While it's not yet known if this trend will catch on in the VC sector, several VC funds have changed the tax rules in their partnership agreements to take full advantage of parallel AIVs. This change is more evident in the current alternative investment landscape than ever.
Key Facts about Alternative Investment Vehicles
Tax-exempt investors are subject to UBTI, whereas non-US investors are subject to ECI. Similarities exist between these two forms of income, both of which might result from a fund's direct investment into an operating company that is classified as a flow-through corporation for purposes of US federal income tax (LLC / partnership). A fund's borrowing might also lead to unrelated business taxable income. On the other hand, ECI can also arise through a fund's investment in real estate or in a business in the U.S that owns a threshold volume of US real estate.
Foreign investors can avoid US taxes in the same way non-US investors can. Unless an applicable tax treaty exists, a non-US investor will not be subject to a tax on interest, capital gains, or dividends on US investments. US withholding taxes (which currently stand at 30%) will be paid on dividends and some forms of interest income obtained by a non-U.S. investor. However, capital gains realized by non-US investors are not subject to federal income taxes unless the gains are related to U.S. real property. This is a critical technicality to keep in view.
However, non-American US federal income tax is due on any ECI (effectively connected) earned by investors, regardless of whether the income is dividends, capital gains, or interest. ECI is taxed at the identical rates applicable to US persons, trusts, or corporations (at a maximum rate of 35%). Non-US Foreign investors who conduct business in the United States are required by law to submit federal and, in some cases, state income tax returns.
Venture capital funds, like UBTI, typically invest in corporate stock and other securities. This is not considered a U.S. trade or business unless the fund invests in United States real property (or a company that owns a specific amount of real property) or invests actively in an operating LLC in the United States. Any fund that directly holds ownership interests in an active LLC will have its non-U.S. investors taxed on the income generated by the operating LLC in the United States, just as is the case with UBTI.
If non-US residents receive ECI, they must pay U.S. federal income taxes in addition to their own country's income tax, which they can't avoid. An ECI made by a corporate investor might be liable to US "branch profits" taxation. This levy is meant to simulate the withholding tax, which would be levied on dividends distributed by a US-based company to a foreign investor.
The effective US federal income tax rate on ECI earned by foreign corporate entities may equal up to 54.5% unless a tax treaty reduces the rate. The branch profits tax is currently imposed at a rate of 30% on the ECI of the foreign corporation, which is net of the standard US federal income tax and is regarded repatriated to that corporation.
Why Investors Avoid UBTI and ECI
There are a few main reasons why investors try to steer clear of UBTI and ECI:
They prefer that their investment profits not be taxed at the federal level in the United States. Historically most Venture Capital and private equity funds have already been able to accomplish this result for their non-US and tax-exempt investors.
These investors choose to stay out of the US income tax system as it benefits them immensely. This objective may be less pressing for certain tax-exempt investors now that many of them are filing returns and reporting UBTI in connection with a wide range of activities and investments, while filing state tax returns may still be a hardship. Despite this, many non-Americans continue to place a premium on submitting US returns, which far outweighs the complication of indirectly paying US federal income tax.
Further, some tax-exempt investors nevertheless choose to report the lowest possible amount of UBTI to the IRS, even if doing so results in a higher effective rate of US tax paid by the investment. Furthermore, some tax-exempt individuals have yet to report UBTI and have no plans to start now.
Regarding these two goals of minimizing US federal income taxes and avoiding US income tax return liability, parallel AIVs address the tax return filing question. They may not solve this issue for non-US investors.
About Excess Holdings
Private foundation investors must exercise caution to avoid having "excess business holdings," even if tax-exempt investors shouldn't be required to declare UBTI as a consequence of a parallel AIV transaction. In general, the Code levies excise taxes on the private foundations that own a stake of more than 20% in any "commercial entity." It's unclear if a parallel AIV with interest in an operational LLC would be recognized as a business venture for this purpose since it relies on the nature of the revenue that the entity receives.
How are Alternative Investment Vehicles Established?
Parallel AIVs
Parallel AIV taxation is straightforward. When a fund is considering investing in an operational LLC, it will often provide its tax-exempt and non-US investors the choice of contributing directly to a parallel AIV instead. To avoid paying taxes in its home country, the parallel AIV registers as a foreign corporation in a tax haven like the Cayman Islands.
Limited Partners who "opt out" of the leading fund's investment by investing in the operating LLC via the parallel AIV are still invested in the operating LLC through the leading fund. Similarly to the main fund, the ancillary AIV will purchase ownership in the operational LLC, with investments usually made pro-rata.
Subsidiary AIVs
An increasing number of buyout funds are using parallel AIVs to avoid the UBTI/ECI problem associated with investing in an operational LLC. However, many funds still rely on subsidiary AIVs for this purpose. Subsidiary AIVs often have a fund investment in the operating LLC via US Blocker Corporation that the fund entirely controls.
The corporate-level tax paid by a subsidiary AIV can be minimized in various ways by deviating from the standard subsidiary AIV structure. To earn interest deductions, the fund may have the option to purchase interests in the operating Company held by the subsidiary AIV, or the fund may use debt to partially finance the subsidiary AIV.
Understanding AIVs
Parallel AIVs do not shield non-U.S and tax-exempt investors from bearing U.S. federal income tax directly. On the other hand, it may increase the indirect tax cost due to the branch profits tax, and this is something to keep in view while considering AIVs. In relation to this, a well-drafted partnership agreement for the fund should avert the possibility of such investors from receiving UBTI and ECI allocations.
Today, there is a range of investment vehicles, each with upsides and downsides. Making informed investment choices is about getting a 360-degree view.
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