PLR 201043041

By Deborah M. Beers, Esq.  

Buchanan Ingersoll & Rooney PC, Washington, D.C. 

PLR 201043041 illustrates how the use by a charitable remainder trust of a foreign "blocker" subsidiary to hold interests in a foreign hedge fund may insulate the charitable remainder trust from the imposition of a confiscatory tax as a result of the realization of unrelated business taxable income that would otherwise flow through from the partnership.

Section 664(c) provides that a charitable remainder trust, "for any taxable year" is not subject to income tax, "unless such trust, for such year, has unrelated business taxable income [UBTI] (within the meaning of Section 512….)."

Prior to the enactment of the Tax Relief and Health Care Act of 2006 (P.L. 109-432, § 424, ("TRHCA") on December 20, 2006, charitable remainder annuity trusts and charitable remainder unitrusts that realized any UBTI during the taxable year would lose exemption from federal income tax for that year. A charitable remainder trust that lost its exemption was taxed as an ordinary complex trust.

Section 424 of TRHCA amended §664(c) to provide that, in lieu of the loss of exemption, a 100% excise tax will be imposed on the UBTI of a charitable remainder trust. The TRHCA applies to taxable years of charitable remainder trusts beginning after December 31, 2006.

Avoiding the imposition of this confiscatory tax (or, in years prior to 2007, the loss of the trust's tax exemption) is an important planning goal for many charitable remainder trusts that nevertheless want to invest in types of investments - such as debt-financed real estate and margined securities - that would produce UBTI absent some exception. One of these exceptions, illustrated in PLR 201043041, involves the use of an intermediary controlled foreign corporation ("CFC") - sometimes referred to as a "blocker" entity - to convert flow-through income from a partnership to dividend income. Dividends (and other types of passive income) are not, by reason of an exemption in §512(b)(1), UBTI, so long as they are not themselves the result of a debt-financed investment. See also PLRs 200251016, 200252096 and 199952086.

In PLR 201043041, a charitable remainder unitrust ("CRUT") established Foreign Corporation, a corporation organized under the laws of an unspecified foreign country, whose principal purpose is "the holding and managing of alternative investments such as U.S. and foreign hedge funds, partially using debt financing in conjunction with capital contributions to fund the acquisition of its portfolio of securities." One can assume that the jurisdiction in which Foreign Corporation was established was one that imposed little or no income taxes on corporations. CRUT represented (and apparently felt that it had to represent) that its "business purpose" for establishing Foreign Corporation was to allow CRUT "to invest in certain hedge funds that would not accept investments from U.S. citizens." CRUT is the sole member of Foreign Corporation, which was created solely for the purposes of investing and managing its assets.

CRUT also represented that Foreign Corporation is a separate and distinct legal entity and that CRUT (1) is not responsible for paying any debts of Foreign Corporation, (2) has no liability with regard to Foreign Corporation beyond its investment as a shareholder, and (3) is not required to make additional capital contributions to Foreign Corporation. CRUT also represented that it will not engage in any debt-financing of its ownership interests in Foreign Corporation and that any income earned by Foreign Corporation may either be reinvested by Foreign Corporation or distributed to CRUT as a dividend.

On these facts, the IRS ruled that:

  •  The distributive share of income and gains from investments in U.S. and foreign hedge funds, reportable by Foreign Corporation under §704 will not constitute unrelated business taxable income to CRUT;
  •  Amounts distributed by Foreign Corporation to CRUT as dividends will not constitute unrelated business taxable income to CRUT;
  •  The income described in Subpart F (regarding income of CFCs attributed to shareholders) of the Internal Revenue Code allocable to CRUT as a result of its ownership of Foreign Corporation will not constitute unrelated business taxable income to CRUT; and
  •  The formation and operation of Foreign Corporation by CRUT does not constitute an act of self-dealing that would subject CRUT to §4941 excise taxes. 

The key to these rulings is the characterization of Subpart F income as "dividends." In the absence of this characterization, the Subpart F income attributed to the shareholder (in this case CRUT) would most likely be either active business income and/or debt-financed income.

The IRS notes in the ruling that "[t]he House Ways and Means Committee Report on the Small Business Job Protection Act of 1996, … states that `income inclusions under Subpart F have been characterized as dividends for unrelated business income tax purposes' and that this is the correct result." [The one exception to this rule involves "insurance income" of a CFC which is, pursuant to §512(b)(17), treated as UBTI. In the PLR, CRUT represented that none of the income generated by Foreign Corporation is insurance income.]

    In ruling that the formation and operation of Foreign Corporation would not constitute an act of self-dealing under §4941, the IRS stated:In this transaction, you [CRUT] are investing certain assets of yours in Foreign Corporation. These assets are not subject to any debt or liability, and no debt is created by you or on your behalf to effectuate this purpose. Foreign Corporation is a newly created corporation, which is created by you as an investment vehicle solely for your assets, with Foreign Corporation's sole purpose to invest and manage these assets on and for your behalf. Any dividends paid by Foreign Corporation are paid solely to you as the sole member of Foreign Corporation. We find that Foreign Corporation, a wholly owned subsidiary, is not a disqualified person with respect to you, within the meaning of section 4946 of the Code and section 53.4946-1(a) of the foundation regulations, as it would not be a disqualified person with respect to a private foundation in your position. Therefore, we conclude that the formation and initial funding of Foreign Corporation by you will not constitute an act of self-dealing subjecting you to an excise tax under sections 4946 and 4941. 

The IRS expressed no opinion as to whether any entity described in the ruling may be deemed a "foreign financial account" for foreign bank account report ("FBAR") purposes and may be required to file an FBAR.

We note that a recent report to Congress by the New York State Bar Association questioned whether the unrelated business income tax should apply to debt-financed income from securities and commodities, particularly given the ready availability of foreign and other "blocker" entities (including, in addition to CFC's, private REITs or RICs) to shelter that income in cases where the exempt party has the means and sophistication to use them.

 For more information, in BNA's Tax Management Portfolios, see Freitag, 462 T.M., Unrelated Business Income Tax, and Rosepink and Bradley, 865 T.M., Charitable Remainder Trusts and Pooled Income Funds,  and in Tax Practice Series, see ¶6280, Charitable Deduction — Section 2055, ¶6350, Estate Planing, and ¶6710, The Unrelated Business Income Tax.