Q. So… this explains why normal US investors funnel trillions of dollars through offshore accounts and back into US hedge and private equity partnerships?
A. Yes, completely crucial for pension plans and other tax exempt investors in alternatives to understand. To start with, UBIT stands for unrelated business income tax, and it’s a tax that is imposed on tax exempt investors who are engaged in what should be taxable business; for example, a charity that runs a clothing store should pay tax on its commercial activities, and UBIT makes them do that.
Q. OK, that makes sense. But what’s it got to do with investing in hedge funds?
A. First, hedge and private equity funds are set up as partnerships. From a tax point of view, they’re flow through entities– the activities are the partnership are attributed to the partners. So if the hedge or PE funds do things that generate “UBTI”, the otherwise tax exempt investors have to file forms and pay tax. And, a lot of hedge and private equity activity will in fact throw off UBTI.
Q. But obviously lots of tax exempt investors, like pension plans, invest in hedge and private equity funds, so how are they avoiding this problem?
A. Bizarrely, they generally are forced to invest through foreign entities that “block” the UBTI. So trillions of dollars from US investors are being funneled through offshore accounts, back in to the US via hedge and PE funds. Kinda crazy. You may remember Mitt Romney caught all sorts of flack about his offshore investments in the last campaign… but actually, it was totally normal.
Q. But why? Last I checked, he’s not a tax exempt entity!
A. No, but his IRA is. Individuals investing in hedge and PE funds through their IRAs have to worry about this issue, too.