Senate Readying Legislation on Offshore Entities and Unrealized Business Income Tax, Energy Commodities Speculation

Legislation ending the tax breaks that speculators in energy and other commodities enjoy is being readied in the Senate Finance Committee. The legislation would also prevent tax-exempt organizations such as pension funds from avoiding tax on unrelated business taxable income by holding commodities through an offshore foreign blocker company.

Under current tax law, commercial buyers, such as airlines, who need to buy energy futures contracts in order to run their businesses pay ordinary income tax on any profits from such trading. By contrast, for-profit speculators pay lower capital gains rates on their profits and tax-exempt investors, such as pension funds and university endowments, pay no taxes on these investments. Under a bipartisan bill being drafted by Senators Ron Wyden and Charles Grassley, everyone directly purchasing oil and natural gas, or indirectly through futures contracts, commodity index funds or other investment strategies, would be taxed as if they were commercial commodity traders.

Foreign Blocker Companies

The Senate Finance Committee has long been concerned that non-profit entities such a pension funds, which represent some of the largest investors in hedge funds, are using offshore structures to avoid the unrealized business income tax. Federal tax law requires non-profit investors that invest directly in hedge fund partnerships to pay the unrealized business income tax.

Specifically, Internal Revenue Code section 511 imposes tax on the unrelated business taxable income (UBTI) of organizations that otherwise are exempt from tax, such as charities and pension funds. UBTI generally is taxed at the rates applicable to business corporations. A primary reason for imposing the unrelated business income tax was to end a source of unfair competition by placing the unrelated business activities of exempt organizations on the same tax basis as the nonexempt business endeavors with which they compete.

To avoid UBTI, non-profit investors sometimes invest in hedge funds through offshore entities incorporated in low or no tax jurisdictions. These offshore entities are known as foreign blocker companies. The tax-exempt organization invests in the blocker company, which in turn invests in a hedge fund or other similar debt-financed investment. Income from the hedge fund is distributed to the blocker corporation, which pays little or no tax on the income as a result of the jurisdiction in which it is established. The corporation in turn pays the income to the tax-exempt investor as a dividend. Because dividends are not subject to UBTI, the income from the hedge fund is not taxable to the tax-exempt investor and the debt-financed income rules are avoided.

Commenters have observed that most hedge funds are partnerships and, absent the blocker entity, debt-financed income would be passed through to the tax-exempt investor as debt-financed income and would be subject to tax. Thus, there is reliance currently being placed on the IRS private letter rulings upholding the treatment of income received from a foreign corporation used as a blocker entity as a dividend that is not subject to UBTI.

The IRS has concluded in a series of private letter rulings that when UBTI-producing assets are owned by a corporation and an exempt organization invests directly or indirectly in such corporation the exempt organization will not recognize UBTI as a result of the investment. Thus, blocker companies are interposed between an exempt organization investor and assets that would give rise to UBTI if owned by the exempt organization directly.

The legislation would amends the Code to require tax exempt organizations to take income, gain, or loss with respect to applicable commodities into account as income, gain, or loss as unrelated business taxable income, which is taxable at the rates applicable to corporations or trusts. In order to prevent a tax-exempt organization from avoiding tax on UBTI by holding commodities through a foreign blocker corporation, the bill imposes a look-through rule requiring a tax-exempt organization that directly or indirectly owns stock in a foreign corporation to treat as UBTI its pro rata share any income, gain, or loss of such corporation with respect to any applicable commodity. Where a tax-exempt organization sells stock of a foreign corporation that holds applicable commodities, the portion of the tax exempt organization’s gain or loss that is attributable to unrecognized gain or loss of the foreign corporation with respect to applicable commodities is treated as UBTI.