United States real estate has always been a very attractive investment for offshore investors. High rates of return, stable values, and a stable economy have always driven massive interest from overseas.
Private lending is no different. However, raising capital from offshore investors is somewhat complex. This article will explore the top 3 issues when raising capital from offshore investors.
Taxation
The issue of taxation for offshore investors in domestic private lending investment opportunities is a treatise in its own right. This is a very high-level summary of these concerns, as well as some solutions.
For Fund Managers
Many debt fund managers are presented with offshore investors. Unfortunately, income received by a non-US investor’s investment in a fund is typically considered ECI as such income is “effectively connected” with a US trade or business (ECI). As a result, the non-IS investor must file a US income tax return for the ECI incurred. Additionally, non-US investors are subject to a flat 37% withholding in most situations. As such, offshore investors often seek to minimize or eliminate the realization of ECI and look to structure their investments in a manner that does not require filing US tax returns or be subject to withholding.
Outlined below are two commonplace solutions to reduce or eliminate ECI and withholdings: (1) REITs and (2) the leveraged blocker.
Blocking ECI and Reducing the 37% Withholding for Offshore Investors: REITs
REITs block ECI and offer a reduction to the withholding based on the country’s current tax treaty with the U.S. It’s important to note, however, that they are very country specific. For example, for individuals, the withholding for REIT dividends in China is 10%, while it is 15% in Canada.
Blocking ECI and Reducing the 37% Withholding for Offshore Investors: Leveraged Blockers and Feeder Funds
Leveraged blockers are a bit more complex. They utilize the portfolio interest exemption to create a balance of debt from the offshore investor to the leveraged blocker (usually a Delaware c-corporation) and equity placement to reduce the withholding. The blocker pays taxes here domestically and the offshore investor avoids the withholding thanks to the portfolio interest treatment. Additionally, the blocker shields non-U.S. investors from directly incurring ECI and the associated tax filing obligation.
Typically, a feeder fund would be established to pool capital from offshore investors and feed that capital into a master fund via the blocker. This involves the feeder fund structuring a portion of its investment in the blocker as a loan. The loan would generate deductible payments for the blocker, and repayment of the loans would be treated as return of capital rather than as a dividend and would not be subject to dividend withholding tax.
Now, for fund managers, it is not common to create a generalized leveraged blocker to raise capital overseas. It is considerably challenging to predict the outcome. It is typically done by the investor(s) themselves or on their behalf. Why? Because the tax treaties vary wildly from country to country.
For Loan Purchase/Sale
In most scenarios, selling seasoned loans to offshore investors is a very simple, straightforward process. The offshore investor is simply buying the asset; any tax concerns they have will be managed by them.
One common strategy used by offshore investors is the “season and sell” strategy. This reduces the risk of onshore taxation or withholding for the investor. The big concern here is that the loans must season for 30 days to 6 months. In addition, the loans must be funded independently. Loan brokerage arrangements and debt instrument investing for loans are also popular strategies because through these, investors may become eligible for the portfolio interest exemption.
Securities Compliance
Many sponsors wonder – how do we raise capital from offshore investors legally? Are there any exemptions we can use, or do we register in their home country?
The answer is straightforward. Funds and other investment opportunities will typically utilize Regulation S in conjunction with their domestic regulation to offer and sell the securities. The nice part of Regulation S is that it can be offered simultaneously with a Regulation D or other domestic offering.
It is important to note that the sponsor may be responsible for ensuring compliance in the other country as well. This depends highly on the volume, frequency, and method of offer/sale in the country in question.
Additional AML/KYC Concerns
Money laundering concerns and Know Your Customer compliance are significant concerns when working with offshore investors. Oftentimes, funds are sent from offshore banks that do not have the robust FINCEN oversight U.S. banks have. To that end, we advise our clients to ensure they protect themselves through certain due diligence measures and avoiding red flags.
For example, obtaining government identification and conducting OFAC and INTERPOL searches are a great place to start. They should also ensure the offshore investor or their country of origin is not subject to any sanctions or warrants. These searches are usually free or included in various global background check services.
Another recommended example is to avoid money laundering red flags. Examples of this include:
- Multiple wires from various accounts owned by people who are not the investor
- Requesting distributions be made to non-U.S. accounts or to various non-U.S. accounts
- High frequency investing with high frequency liquidation
