Domestic corporate blockers are used in Regulated Investment Company (RIC) structures to facilitate investments that may generate nonqualifying income. While RICs generally avoid entity-level taxation, the domestic blockers beneath them live in a world of ASC 740, quarterly estimated tax payments and occasional caffeine fueled nights over deferred tax amounts.
Understanding both current and deferred tax at the blocker level is important for compliance, net asset value (NAV) reporting and cash management.
Wholly owned domestic subsidiaries are generally C Corporations used as blockers between a RIC and certain investments. These taxable entities are often used in RIC structures for several reasons, including, but not limited to, the following:
The corporate tax, along with certain filing complexities, is generally the reason taxpayers would not use a U.S. blocker over a foreign blocker. A foreign blocker is generally advantageous when it can avoid being treated as engaged in a U.S. trade or business. Absent that exception, a foreign blocker (due to exposure to effectively connected income and the branch profits tax) can result in a higher effective tax rate than a domestic blocker, which would be the least beneficial result. Therefore, domestic blockers may be preferred in such cases due to their more predictable tax profile and ability to use NOLs and certain freedoms to manage timing of distributions up to the RIC. The determination on whether to use a domestic or a foreign blocker is complex and should be considered carefully.
>> Read more on domestic and foreign blockers in “How Blocker Entities Can Help Regulated Investment Companies Expand Their Portfolios”
Deferred tax arises when book income and taxable income have different recognition treatment. This creates temporary book-to-tax accounting differences that will reverse in future periods, hence deferred taxes. ASC 740, Accounting for Income Taxes, requires measuring and recording of deferred taxes based on the expected future tax effects of temporary differences.
Temporary differences often seen in blockers include unrealized gains or losses on investments, timing differences in recognition of income from underlying partnership investments, depreciation or amortization differences, NOLs and capital loss carryforwards.
For example, a domestic blocker holding a U.S. operating entity might reflect unrealized appreciation on its books, but the gain is not taxable until realized and recognized for tax purposes. ASC 740 requires the blocker to record a deferred tax liability (DTL) for that difference, so the financial statements reflect the future tax consequence, despite the fact that there is no current cash movement for tax payments.
Another typical example is a blocker generating an NOL. It would create a deferred tax asset (DTA), which can be carried forward to offset future taxable income. The blocker is required to record the DTA at the time it is generated, as it will be a future tax benefit. This is one area where domestic blockers have a leg up on foreign subsidiaries, as they have the ability to carry forward NOLs, which can reduce future taxable income.
For funds with blockers, deferred taxes are generally accrued at NAV/pricing intervals. The process generally looks as follows:
Current tax is the amount the blocker owes for the current tax year based on its taxable income. A corporation is generally taxed at the federal, state and local levels. While accruing deferred taxes impacts NAV, the current cash payments of tax are not generally NAV impacting, as they should have been accrued through the deferred tax process.
Generally, blockers are required to pay federal tax estimates quarterly. There should be a process built around these quarterly estimates, in addition to the deferred tax accrual. Depending on the location and type of assets held in the blocker, state income, state franchise or local tax considerations may apply as well. These taxes are current obligations, and accounting for them is paramount to avoiding cash shortfalls, especially during times when distributions are planned. As such, ensuring sufficient cash is on hand to make payments is important. If not, the blocker could incur penalties or interest.
Scenario A: Consider a domestic blocker that holds a real estate asset valued at $200,000 at fiscal year-end with unrealized appreciation of $30,000. For tax purposes, the unrealized gain is generally not recognized until the asset is disposed. Therefore, the blocker records a DTL based on the future tax liability of $30,000 unrealized gain. Assuming a 21% federal tax rate, the DTL is equal to $6,300. No cash has been paid yet, and the DTL will be used to pay the future tax liability when the asset is sold.
| Unrealized Appreciation | $ | 30,000 |
| Tax Rate | 21% | |
| DTL | $ | 6,300 |
Impact to the RIC: When the blocker eventually distributes the sale proceeds, the RIC will receive dividend income, which is considered qualified income for purposes of the gross income test at the RIC level.
Scenario B: In year one, a blocker invests in a startup fund that generates a $500,000 loss and has no other taxable income. The $500,000 NOL creates a DTA because this loss can offset future taxable income. Assuming the same 21% federal tax rate, the DTA is equal to $105,000. The blocker must assess realizability (the need for valuation allowance) under ASC 740 for each DTA.
| Net Operating Loss | $ | 500,000 |
| Tax Rate | 21% | |
| DTA | $ | 105,000 |
Impact to the RIC: If the blocker strategically uses NOLs, it can mitigate tax drag before distributing dividends to the RIC, which ultimately benefits shareholder returns.
When structured and monitored appropriately, domestic blockers allow RICs to access alternative investments while maintaining compliance with the gross income and asset diversification requirements under Subchapter M. However, the associated deferred and current tax considerations must be carefully monitored, particularly as they affect NAV reporting and cash planning at the blocker level.
Please consult your tax adviser and legal counsel when evaluating these structures.
Contact Eric Lemmon or a member of your service team to discuss this topic further.
In this blog Cohen & Co is not rendering legal, accounting, investment, tax or other professional advice. Rather, the information contained in this blog is for general informational purposes only. Any decisions or actions based on the general information contained in this blog should be made or taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.