Pesos, pounds and drachmas: code hassles caused by foreign investments.

Many nonprofits are broadening their investment portfolios to include "alternative investments." These include hedge funds, funds-of-funds and other investment vehicles that hopefully will increase overall return. However, many organizations are not informed of the administrative burdens that these investments might impose.

There are tax consequences and additional filing requirements that you should consider before investing off-shore. Both the financing and structure of investments can affect treatment by the Internal Revenue Service (IRS).

Financing

If a tax-exempt organization acquires investments unrelated to its exempt purpose using borrowed funds, then the unrelated debt-financed income rules apply. These rules subject income that would otherwise be excluded from unrelated business income (UBI), (e.g. interest, dividends, rents, and capital gains) to tax, to the extent that the property generating it was acquired using borrowed funds.

For example, if a tax-exempt organization borrows $10 million and invests the money to yield interest at a rate higher than the rate it is paying on the borrowed money (arbitrage), then the income from the investments is taxable under the debt-financed income rules. Under these rules, the ratio of acquisition indebtedness to the basis of the property determines how much of the income is taxable.

If an organization finances the investments through borrowed funds, the resulting income is treated as debt-financed regardless of whether the investments are foreign or domestic, their structure, and whether the investments are collateral for the debt.

Investments in partnerships

Some offshore hedge funds and absolute return funds use partnerships as their preferred organizational form. If you invest in United States partnerships, you will recognize income in the same year the partnership earns it and there is no taxation at the partnership level, regardless of whether there are distributions to the partners.

The IRS treats a tax-exempt partner as performing the activities of the partnership. That is, partnership activities pass directly through to their partners. This means that the income and deductions flowing to the partners keep the same character they had when earned by the partnership. If the partnership borrows funds, the tax law treats it as the individual partners borrowing funds.

For a tax-exempt entity, the debt-financed rules could apply to flow-through income even though it is otherwise excluded income. Thus, you can have debt-financed income if you borrow to acquire the partnership interest or if the partnership borrows to acquire its investment property.

In addition to UBI concerns, investing in foreign partnerships could trigger other filing requirements with the IRS. Some investments in foreign partnerships are reported on Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships. This generally includes the purchase or sale of any investments of $100,000 or more. Many offshore investments require minimum initial investments much greater than this, so you are likely to have to file Form 8865 in most of these cases. You will recognize income from a foreign partnership in the year the partnership earns it, regardless of whether the partnership issues a Form K-1 or whether you receive any distributions.

Investments in corporations

Some hedge funds structure investments as a corporation, often one that will then invest in an offshore partnership. Shareholders of a U.S. corporation do not recognize income in the year the corporation earns it; instead they recognize it as they receive dividends from the corporation. The income is taxable at the corporate level in the United States.

However, the United States cannot tax corporations in other countries on income earned outside of the U.S., and the laws of some countries do not impose a separate layer of taxation on the corporation. The IRS does not generally treat a tax-exempt organization as performing the activities of the corporation. Unlike an investment in a partnership, income and deduction items do not retain their character when remitted to shareholders.

Instead, shareholders receive dividend income, regardless of how the corporation earned it, as well as capital gains and losses on the purchase and sale of stock. Unless the underlying investments are debt-financed, a tax-exempt organization does not report the dividends and capital gains as UBI. For a tax-exempt entity, there is no concern that the borrowings of the corporation will create debt-financed income. However, if you borrowed to make the investment in the corporation, dividends will be subject to the debt-financed income rules.

Investing in foreign corporations might trigger more filing requirements with the IRS. Any investments of $100,000 or more in a foreign corporation will generally require you to file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation.

Many foreign funds are organized as partnerships. However, in many cases investments in the partnership can be made through a separate foreign corporation. Under such arrangements, the corporate form serves, in essence, to block the activities and the debt flowing from the partnership to the tax-exempt investor, thereby shielding you from potential debt-financed UBI. There are multiple ways that you can utilize a corporate form to block debt flow through in an offshore investment structure.

CFC and PFIC concerns

U.S. investors using foreign corporations for investments should be aware of two potential traps under U.S. tax law: the controlled foreign corporation (CFC) and the passive foreign investment company (PFIC).

A CFC is generally any foreign corporation in which U.S. shareholders own 50 percent or more of the total voting power of all classes of stock or the total value of the stock. Even if the corporation qualifies as a CFC under this definition, the exempt organization has to own 10 percent or more of the stock to qualify as a U.S. shareholder and fall under the CFC rules. If your organization owns 10 percent or more of a foreign corporation, you might have to file Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations.

A PFIC is any foreign corporation 75 percent or more of whose gross income is passive income, or the average percentage of assets held by the corporation during the tax year which produces, or is held for production of, passive income is 50 percent or more. Under an ordinary investment in a corporation, shareholders do not realize income until the corporation remits dividends to investors or there is gain on the disposition of stock.

However, with a PFIC, there is tax and an interest charge on excess distributions and disposition of the stock.

Additionally, the IRS treats gain or dividends from any portion of income considered to be an excess distribution as ordinary income earned pro rata over the period which the investor held the stock. For income attributed to earlier years, the shareholder owes deferred tax and interest. Under the PFIC rules, the shareholder owes this extra tax because of the deferral of income.

A shareholder of a PFIC could elect to treat the PFIC as a qualified electing fund (QEF). If you make this election, you will recognize income each year on your share of the PFIC's earnings. If you make the QEF election the first year you own stock, the excess distribution tax described above is not applicable. Investing in a PFIC might result in the tax-exempt organization having to file Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Trust.

For tax-exempt organizations, this acceleration of income recognition through a CFC or PFIC QEF does not pose much of an issue, unless they financed the purchase of the investments with debt as discussed above. Generally, the PFIC rules only apply if the income is taxable to your organization as UBI. As the income will be in the form of dividends or gains on sale, it will only be taxable ff it is debt-financed.

For private foundations, the PFIC rules do not generally apply to the excise tax on investment income. If you financed the investment with debt, you could be in for an unpleasant surprise in the form of a tax liability owed to the IRS sooner than you expected.

Penalties

Failure to file the disclosure forms comes with penalties that mostly range from $10,000 to $100,000 per form. That is, for each form you fail to file, there could be up to a $100,000 penalty.

You need to be particularly wary of partnership investments where the partnership invests off-shore. In most cases the partners are required to make these filings and even if you invest in a U.S. partnership this information would be in the footnotes to the Schedule K-1. An active partnership may generate quite a few filings for the partners.

Tax-exempt organizations need to become aware of the structure of their foreign investments when entering into them. The mere fact that you are tax exempt does not equate to there being no tax consequences associated with your foreign investments.

If you do not file the additional forms to report foreign interests timely, you may be exposing yourself to penalties for failure to file. Tax-exempt organizations should utilize the corporate form somewhere in the investment structure to avoid an unpleasant debt-financed UBI liability on passive income.

Harvey Berger, CPA, is a partner and national director of not-for-profit tax services in Vienna, Va., for the accounting and management consulting firm Grant Thornton LLP. His email address is: [e-mail]. David Cottone is a senior tax associate Grant Thornton's Washington, D.C., Not-for-Profit tax practice. His email is David. [e-mail].