Note: The tax reform bill is H.R. 1, entitled Tax Cuts and Jobs Act. To read the entire text of the proposed bill, click here.

Application of UBIT to State and Local Entities

Section 501(c) lists numerous categories of exempt organizations that are exempt from income taxes. Notwithstanding the exemptions, most exempt organizations are nevertheless subject to the unrelated business income tax. State instrumentalities are not mentioned in §501(c) but are exempt from taxation under §115. The exemption applies to income derived from a public utility or the exercise of any essential governmental function and accruing to a state or political subdivision thereof, or the District of Columbia.

The UBIT applies to organizations described in §501(a), employer provided pension plans described in §401(a), and state colleges and universities. Because the UBIT expressly applies to state colleges and universities but not to other state instrumentalities, state and local entities, including pension plans, had been thought to be outside the scope of the UBIT.

The proposed House bill specifically states that an organization or trust shall not fail to be treated as exempt from taxation under this subtitle by reason of section 501(a) solely because such organization is also exempt, or excludes amounts from gross income, by reason of any other provision of this title. H.R. 1, §5001(a). Thus, for purposes of the UBIT, state and local entities are treated as described in §501(a) notwithstanding the fact that their income is also excluded under §115.

Limitation on Exclusion for Research Income

Section 512(b)(9) contains an exclusion from UBTI that applies to organizations operated primarily for purposes of carrying on fundamental research the results of which are freely available to the general public. Under present law, such organizations can exclude from UBTI all income from research performed for any person. The requirement that the organization be operated primarily to carry on fundamental research that is made freely available to the general public means that the organization remains eligible for the exclusion when it performs fundamental research that is not made freely available to the general public so long as the primary purpose requirement is met.

The proposed bill would narrow the exclusion to cover only income from research the results of which are freely available to the general public. H.R. 1, §5002(a) Thus, if an organization operated primarily for purposes of carrying on fundamental research with results freely available to the general public performs fundamental research that is not made freely available, income from such research is subject to the UBIT.

Effective Date

The proposed effective date for both amendments is December 31, 2017.

Recent publicity about former Governor Mitt Romney’s $23 million IRA and its investments in foreign tax havens has raised the profile of so-called UBIT blocker corporations. What is a UBIT blocker and how does it work to the advantage of retirement accounts and other exempt organizations?

 Income from Debt-Financed Property is UBTI

 If an exempt organization borrows funds to acquire an asset, income from the asset is treated as debt-financed income to the extent of the debt financing. Debt-financed income is included in the organization’s UBTI, unless an exception applies. For example, rents from real property are generally excluded from UBTI. If, however, an exempt organization leases mortgaged property as an investment, part of the rental income is treated as debt-financed income. Similarly, if an exempt organization invests in a partnership that uses borrowed funds to acquire an asset, the debt-financed income rules apply to the organization’s distributive share of the partnership’s income from the asset. Because most alternative asset investments, such as hedge funds, use debt financing, exempt organizations cannot invest directly in hedge funds and other non-traditional investments without incurring UBTI.

Note: Under a special exception, debt incurred by educational organizations and qualified pension and retirement plans to purchase or improve real property is not treated as acquisition indebtedness. Thus, the real property is not debt-financed property and income from the property is excluded from UBTI. The exception is limited to real property and does not apply to hedge fund investments.

 Blocking Debt-Financed Income

 The debt-financed income rules reduce an exempt organization’s ability to take advantage of leveraged investments without suffering adverse UBIT consequences. Seeking to get around this restriction, some exempt organizations have interposed a corporation between themselves and the investment partnership. The result of such an arrangement is that dividends paid from the corporation to the exempt organization are treated as excludible dividends rather than debt-financed income. The taint of the debt financing does not flow through from the partnership to the corporation to the exempt organization.

Increasing the Advantage by Using Foreign Corporations

 Where do tax havens come in? If the UBIT blocker is a U.S. corporation, the corporation will owe income tax on its distributive share of the partnership income. To minimize the income taxation at the corporate level, exempt organizations use a foreign corporation to invest in the partnership owning the mortgaged property. Income of foreign corporations is not taxed until the income is repatriated to the U.S. Some foreign jurisdictions do not impose corporate taxes on corporations owned by non-citizens. Other countries impose very limited corporate taxes. Either way, by using a foreign corporation, an exempt organization can eliminate or minimize the tax payable at the corporate level, reducing the overall cost of the UBIT avoidance strategy.

UBIT Blockers Are Not Illegal

 The strategy of using UBIT blocker corporations is not illegal or contrary to any tax laws. Large retirement funds and exempt organizations are seeking to diversify their investment portfolios into non-traditional investments and to increase their returns using leveraged investments. Under the tax laws, income of foreign corporations owned by U.S. citizens or corporations is not subject to U.S. income tax until the income is brought into the country. Giant multinational corporations routinely use these tax principles to avoid billions in U.S. income tax on income of their foreign subsidiaries. The avoidance is permanent if the corporations use the income in their foreign operations rather than repatriate it. In contrast to business corporations, tax-exempt organizations may repatriate dividends from a foreign corporation without adverse UBIT consequences because of the dividend exclusion.

 Despite their legal status, the use of UBIT blockers by exempt organizations has resulted in millions of dollars in lost taxes that would have been paid as unrelated business income tax if exempt organizations made direct investments or invested in partnerships without using the intervening corporation. Federal legislators are well aware of the lost revenues resulting from UBIT blockers. In the current political climate emphasizing deficit reduction, Congress may act to reduce or eliminate the use of UBIT blockers by exempt organizations. More than likely, any changes will come as part of an overhaul of the whole system for taxing foreign income and will occur after the election year.

 For other articles discussing the use of UBIT blockers by exempt organizations, see Weisman, Romney’s Returns Revive Scrutiny of Lawful Offshore Tax Shelters (Feb. 2012); David Wheeler Newman, Recent Rulings Illustrate Creative Strategies to Deal with UBTI (2011); Council on Foundations, Statement Regarding Unrelated Debt-Financed Income and “Blocker Corporations” (2007)

 For a more detailed discussion of the UBTI and debt-financed income rules in the context of UBIT blockers, see Joint Committee on Taxation, Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interests and Related Issues, Part II (2007).