Dec 11, 2023
Effectively Connected Income (ECI) can create significant tax challenges for non-U.S. investors in the United States. To mitigate these challenges, investors often use blocker structures. This article delves into the mechanics of blocker structures, their benefits and drawbacks, and recent developments in their use. Designed for tax professionals and CPAs, this comprehensive guide provides insights to help optimize tax outcomes for clients.
Effectively Connected Income (ECI) refers to income earned by non-U.S. persons that is directly connected with the conduct of a trade or business within the United States. According to the Internal Revenue Service (IRS), ECI can be generated through various activities, including:
Operating a business or enterprise in the U.S.
Providing services in the U.S.
Owning or leasing U.S. real estate
Engaging in certain other investment activities within the U.S.
ECI is subject to U.S. federal income tax, and non-U.S. investors are required to file U.S. tax returns to report this income. This can result in a significant administrative burden and potential tax liability, prompting investors to seek ways to avoid ECI.
Blocker structures are intermediary entities, typically in the form of corporations, that are inserted between the non-U.S. investor and the U.S. income-generating activity. These structures are designed to “block” the flow of ECI to the investor, transforming it into a form of income that is either not subject to U.S. tax or taxed at a lower rate.
Formation of the Blocker Corporation: A blocker corporation is established, usually in a low-tax or no-tax jurisdiction. This corporation is owned by the non-U.S. investor.
Investment Through the Blocker: The blocker corporation makes investments in U.S. assets or business activities. Any income generated from these investments is earned by the blocker corporation, not directly by the non-U.S. investor.
Income Transformation: The income that would have been ECI is transformed into dividend income when distributed by the blocker corporation to the non-U.S. investor. Dividend income is typically subject to a withholding tax, which is often lower than the tax rates applicable to ECI.
A non-U.S. investor wants to invest in a U.S. real estate partnership. Instead of investing directly, the investor sets up a blocker corporation. The blocker invests in the partnership, receives the income, pays any applicable corporate taxes, and then distributes dividends to the investor. The investor pays withholding tax on the dividends, avoiding the need to file a U.S. tax return for ECI.
Blocker structures can significantly reduce the overall tax burden for non-U.S. investors. By converting ECI into dividend income, investors benefit from lower withholding tax rates, which are often more favorable than the ECI tax rates.
Non-U.S. investors using blocker structures are not required to file U.S. tax returns for ECI, simplifying their tax compliance obligations. The blocker corporation handles U.S. tax filings, reducing administrative burdens on the investor.
Blocker structures can offer asset protection benefits. By holding U.S. investments through a separate corporate entity, non-U.S. investors can shield their personal assets from potential liabilities associated with the U.S. investments.
With a blocker structure, non-U.S. investors can more easily participate in U.S. investment opportunities that would otherwise generate ECI. This increases their investment flexibility and potential returns.
Establishing and maintaining a blocker structure can be complex and costly. Legal and administrative expenses, including formation costs, annual maintenance, and compliance, can add up.
The blocker corporation itself is subject to U.S. corporate income tax on its earnings. Although this can be mitigated through strategic tax planning, it represents an additional layer of taxation.
In some cases, income can be subject to double taxation—first at the corporate level (blocker corporation) and then at the individual level (non-U.S. investor) when dividends are distributed. This can reduce the overall tax efficiency of the structure.
Changes in tax laws and regulations can impact the effectiveness of blocker structures. Tax professionals must stay informed about regulatory developments to ensure compliance and optimize tax outcomes.
The TCJA introduced several changes affecting blocker structures, including the reduction of the U.S. corporate tax rate from 35% to 21%. This made blocker corporations more attractive by reducing the tax burden at the corporate level. However, the TCJA also introduced the Base Erosion and Anti-Abuse Tax (BEAT), which could impact the tax planning strategies involving blockers.
Under the TCJA, the deductibility of interest expenses is limited, which can affect the tax efficiency of blocker structures that rely on interest deductions to minimize taxable income. Tax professionals must carefully structure financing arrangements to optimize interest deductions within the new regulatory framework.
The IRS has increased its scrutiny of blocker structures, particularly focusing on whether they are used primarily for tax avoidance purposes. Proper documentation and adherence to substance-over-form principles are essential to withstand IRS challenges.
Global tax initiatives, such as the OECD’s Base Erosion and Profit Shifting (BEPS) project, are influencing the use of blocker structures. These initiatives aim to curb tax avoidance and ensure that profits are taxed where economic activities occur. Tax professionals must consider these international developments when advising clients on blocker structures.
The IRS has provided clarifications on the portfolio interest exemption, which allows non-U.S. investors to receive interest income free from U.S. withholding tax. These clarifications impact the structuring of blocker entities to ensure they qualify for the exemption, further enhancing their tax efficiency.
Blocker structures are a valuable tool for non-U.S. investors seeking to avoid effectively connected income (ECI) and optimize their tax outcomes. By transforming ECI into dividend income, blocker structures provide significant tax benefits and simplify compliance. However, they also come with complexities, costs, and regulatory risks that must be carefully managed.
Tax professionals and CPAs play a crucial role in advising clients on the strategic use of blocker structures. Staying informed about recent developments, regulatory changes, and best practices is essential for optimizing the tax efficiency and compliance of these structures. By leveraging their expertise, tax professionals can help clients navigate the intricate landscape of international tax planning and achieve their investment goals.
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Jeroen van der Wal
Business Development Representative
