Happy Friday, funds family!

Last week, we discussed 💰️ tax-exempt investors and UBTI. This week, we’ll discuss UBTI’s international cousin – ECI (income effectively connected with a U.S.-based trade or business).

🌎️ Non-US investors in investment funds

Non-U.S. investors are an increasingly common source of capital. Many funds target Asia, Europe, Latin America, and the Middle East. For a primer on the international investment market, check out this article on 🛠️ Offshore Parallel Offerings. 

While outside the scope of this article, if you’re planning to fundraise in non-U.S. jurisdictions, you may want to contact local counsel in the countries where your investors will be. They can help with securities laws and required filings in offshore jurisdictions.

📊 Passive vs. active income (ECI)

Income earned by funds can be roughly split into two buckets for U.S. federal income tax purposes: passive vs. active.

• Passive income includes stuff like interest, dividends, royalties, rent, and capital gains.

• Active income (aka, “ECI”) is essentially operating income from a U.S. business.

Note that this is an oversimplification – determining whether income is “passive” or “active” (ECI) involves many nuances and exceptions in practice. But this is a helpful starting point. 🔍️ 

For example, if a foreign entity operates a U.S.-based manufacturing plant, income generated from that plant would count as “active” income.  On the other hand, if a non-U.S. person makes a loan to a U.S.-based manufacturing company bearing 10% interest per year and owns no equity in the company, the interest is likely exempt passive income.

💰️ How are passive and active income taxed for non-U.S. investors?

The “passive” regime generally applies a flat tax withholding rate on the gross amount of “U.S.-source” passive income – the 2025 default rate is 30% unless a special rate or exemption applies in particular circumstances.

Two common exceptions to this withholding tax include:

• Capital gains when a fund sells equity in its portfolio companies

• Interest income (if the fund is not a loan origination fund).

By contrast, the “active” (ECI) regime taxes non-U.S. investors on net income (gross income minus expenses) at the same marginal rates that would apply to U.S. individuals or corporations (plus, for non-U.S. corporations, an extra “branch profits” tax to approximate the 30% gross withholding tax on dividends that would apply if a U.S. corporation distributed its earnings to a non-U.S. person).

In tax world, this “active” type of income is typically referred to as income effectively connected to a U.S. trade or business, or “ECI,” and non-U.S. investors usually don’t like it for reasons we will explain below!

❌ Why do non-U.S. investors avoid ECI?

Like UBTI for tax-exempt investors, non-U.S. investors are often averse to earning ECI. Earning ECI can be “bad” for three main reasons:

1. Tax returns: ECI triggers special U.S. tax return filing requirement for non-U.S. investors. Most offshore investors don’t love the requirement to file taxes in a new country.

2. Investment returns: The high effective rates on ECI (44%+ on non-U.S. corporate investors of 44%+) plus applicable U.S. state and local taxes drive down investment returns.

3. Compliance: It creates additional compliance, administration, and tax liability for investment funds and syndications who have associated tax reporting and withholding obligations and may need to engage in special tax structuring.

Note that the usual ECI regime does not apply to sovereign wealth funds, which are subject to a different U.S. tax regime and are beyond the scope of this article.

🏘️ FIRPTA – the special tax applicable to non-US investors in real estate

If you invest in real estate, read this section twice. Then read it again. 👀 

Special rules under the Foreign Investment in Real Property Tax Act (FIRPTA), enacted in 1980, added gains from the sale or disposition of “U.S. real property interests” (USRPIs) as a special category of ECI. Without FIRPTA, this gain would typically be exempt “passive” income. With FIRPTA, this gain is generally taxed the same as ECI.

USRPIs include land, buildings, and corporations whose assets consist of 50% or more of USRPIs (this calculation is quite complex and many would argue, over-inclusive!). One notable exception to FIRPTA is any interest held solely as a creditor, which includes many real estate loans.

FIRPTA is bad news for similar reasons that ECI generally is bad news (see above)—it taxes income that would otherwise be exempt from U.S. tax at ECI rates, can impose U.S. tax return filing requirements on the non-U.S. investor in the year FIRPTA gain is recognized, and imposes withholding tax obligations on certain fund or portfolio entities.

⚒️ Generating ECI in investment funds

For investment funds, ECI issues can arise in three common contexts:

1. Fund-level trade or business. The fund is directly engaged in a “trade or business”, such as loan origination in a private credit fund. In this case, all interest, fees, and gain from the originated loans may be ECI.

2. Pass-through PortCo trade or business. The fund makes an equity investment in a pass-through entity (like an LLC taxed as a partnership) that is engaged in a U.S. trade or business. This is less common in venture capital (where companies are typically taxed as c-corporations) and more common in lower-middle-market private equity.

3. U.S. Real Estate. The fund has an ownership interest in U.S. real estate or U.S. companies whose assets consist of enough assets that the IRS treats as real property.

You may notice that, aside from U.S. real estate, this is eerily similar to the list of UBTI-generating activities discussed in 💰️ last week’s article. 

🛡️ How to valiantly protect LPs from the terrors of ECI

Like tax-exempts and UBTI, using a “blocker” (an entity taxed a U.S. c corporation) is one common mechanism to block attribution of ECI up to the non-U.S. investor, but at the cost of U.S. corporate tax at the blocker level. 💰️ Last week's article discussed this strategy.

However, unlike tax-exempts and UBTI, using blockers to manage ECI has an additional tax wrinkle to manage—in addition to the U.S. corporate tax at the blocker level, distributions of funds from the blocker up to the non-U.S. investors must be structured carefully to mitigate or avoid another level of “passive income” withholding tax on dividends. There are a range of techniques that can be utilized that are beyond the scope of this discussion, such as adjusting the timing of distributions, selling blocker equity in lieu of receiving blocker distributions and capitalizing blockers with a combination of equity and debt since a return of debt principal is not typically taxable.

Blockers for non-U.S. investors in real estate funds face additional structural challenges avoiding FIRPTA-generated ECI from certain blocker distributions or gain on the sale of their blocker interest, which may require more special structuring, such as creating one or more 🛠️ offshore vehicles in jurisdictions like the Cayman Islands, British Virgin Islands, or Luxembourg.

As with UBTI and tax-exempts, each investment fund should consult its tax advisors on whether the fund is expected to generate ECI for non-U.S. investors and if so, tax planning options to address ECI concerns.

🤝 How to handle ECI conversations with LPs

Like with UBTI, GPs have three options to deal with UBTI situations.

1. Do nothing. Some managers – especially smaller funds and syndications – disclose the ECI risks to investors and do not undertake special structuring to mitigate ECI issues. In these cases, non-US LPs can decide whether they’re willing to deal with ECI or do their own structuring.

2. Special structuring. Some managers – larger funds with more non-US investors – may choose to implement a blocker or other special structure to accommodate non-US investors. This can benefit the non-US investors but requires more legal fees, entity formation, and complexity.

3. Avoid ECI in the first place. Some funds, especially venture capital funds, will require that all companies convert to c-corporations before the fund will invest. Among other reasons, this helps eliminate the ECI concerns for non-US investors. Of course, if you’re a real estate fund, “avoid real estate” isn’t really a viable option, so you’ll likely need to choose option #1 or #2 above.

Sometimes, GPs and non-US LPs do the math and conclude that generating some ECI is preferable to the expense (e.g. U.S. corporate income tax in a blocker structure) and/or opportunity costs of special structuring or avoiding ECI-producing investments.

In some cases, large LPs might ask for an ECI covenant. This may require the GP to take “commercially reasonable efforts” (or some other level of efforts) to mitigate ECI concerns for non-US investors. If you’re a GP that agrees to a ECI covenant, you’ll need to proactively limit ECI for your investors. This is often a nice carrot 🥕 to offer to non-US LPs to entice them to invest (and some will insist).

Next week, we’ll review our last advanced tax topic in this series – cashless contributions to fund your GP commitment.

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.