Blocker Corporations are off-shore vehicles that allow tax-exempt investors to avoid “unrelated business income,” and any possible related taxes. By investing in PE and hedge funds through these off-shore (think Cayman Islands) vehicles, such investors can convert taxable UBI into tax-exempt dividends.

Q. So, we’re suddenly seeing a lot of ink about this topic. I know you mentioned it a few weeks ago the buzzword segment on master-feeder hedge fund structures, but maybe it deserves a little drill down?
A. Yep, the Romney tax returns have a lot of folks, even very knowledgeable ones on Capital Hill, asking: what a minute, what’s up with all these offshore investments he has? In one sentence he – and countless other IRA, pension plans, not-for-profit and other tax exempt investors — are avoiding so called “unrelated business income” by investing in private equity and hedge funds through “blocker” corporations based in, say, the Cayman Islands.

Q. OK, let’s break that down… because on the surface, that sounds just a bit fishy.
A. It does initially, but you have to hear the whole story to decide. The key driver of these structures is the fact that tax exempt entities – charities, endowments, pension plans, IRAs –still do have to pay tax in some cases, for example, when the entity earns money from the active conduct of a regular business “unrelated” to their tax exempt purpose. That much makes sense, right?

Q. Sure: You don’t want a tax exempt competing with normal taxable companies.
A. Exactly. And that’s why the unrelated business income tax exists… and why tax exempt investors have to be careful about their sources of income.

Q. OK, but how’s all that relate to investments in hedge funds and PE funds?
A. Because they’re structured as partnerships, and the partners in a partnership are treated as being involved in the activities of that partnership. Most PE and hedge funds engage in activities which, if conducted directly by the pension plan or charity, would give rise to UBTI. As partners, those investors would be infected with UBI.

Q. And the blocker corporation solves that?
A. Yes. Dividends from a corporation don’t throw off UBI. So the tax exempts invest into the hedge or PE fund through a corporation. The UBI is “blocked”.

Q. But that would work with a US corporation as blocker. Why are these located offshore?
A. Because the offshore jurisdictions have ultra low corporate income tax rates, essentially zero, obviously unlike onshore corporations. So they’re the ideal way to block UBI. So, is this “tax evasion”? Well, it’s a perfectly legal structure, and just avoids a tax many think shouldn’t really apply anyway. So: you make the call.