Deferred tax in a blocker corporation is a proportion of the gain, not a fixed deduction. It cushions a fall until the asset reaches its tax base, and then stops.
A blocker's deferred tax liability is the tax rate times the built-in gain, so it reduces net asset value by a proportion of the gain, not a fixed amount, and it moves when values move. On an illustrative blocker holding an asset worth 180.0 with a tax base of 84.0, the liability at 25 per cent is 24.0; a 10 per cent fall in the asset cuts the liability to 19.5, so the fund loses 13.5, three quarters of the 18.0 gross fall, until the gain is gone after a fall of 53.3 per cent.
Worked in full in How to Read a Private Fund's Financial Statements by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Funds put a corporate blocker between certain investments and investors who must not receive the underlying income directly, typically tax-exempt or non-resident limited partners. The blocker is a taxpayer. When the fund reports its investment in the blocker at fair value, the tax the blocker would pay on selling its asset at that value is deducted, either inside the blocker's own valuation or as a deferred tax liability in the consolidated ladder below the fund. Readers of the schedule of investments often treat that line as a fixed deduction. It is not.
| Input | Value |
|---|---|
| Fair value of the asset held by the blocker | 180.0 |
| Blocker's tax base in the asset | 84.0 |
| Tax rate on the blocker's gain (illustrative) | 25% |
| Fund net asset value, all positions | 400.0 |
| One investor's share of the fund | 5.0% |
1. The liability today. The built-in gain is fair value less tax base; the liability is that gain times the rate.
Built-in gain = 180.0 − 84.0 = 96.0
Deferred tax liability = 96.0 × 25% = 24.0, which is 13.3% of the asset's value
Blocker net of tax = 180.0 − 24.0 = 156.0, 39.0% of the fund's net assets
Excel: =MAX(0,Value-Base)*Rate
2. Stress the asset. Take 10 per cent off: the asset is 162.0, the gain 78.0, the liability 19.50 and the net position 142.50.
Gross fall = 180.0 − 162.0 = 18.0
Fall in the liability = 24.0 − 19.50 = 4.50
Loss to the fund = 156.0 − 142.50 = 13.50, which is 75.0% of the gross fall
Fund net assets = 400.0 − 13.50 = 386.50, down 3.375%
The investor's 20.0 becomes 19.325: a loss of 0.675, not the 0.90 that a fixed deduction would imply.
While there is a gain, the liability absorbs the tax rate's share of every movement, up or down. Once the asset falls to its tax base, the liability is zero and the fund takes every further unit of loss. Unless the blocker can recognise a deferred tax asset on losses, and auditors usually require evidence of future taxable profit before it does, there is nothing below the base.
| Change in asset | Asset | Gain | Deferred tax | Blocker net | Fund NAV | NAV change | Share of gross move borne |
|---|---|---|---|---|---|---|---|
| +10.0% | 198.0 | 114.0 | 28.50 | 169.50 | 413.50 | +3.38% | 75.0% |
| Today | 180.0 | 96.0 | 24.00 | 156.00 | 400.00 | 0.00% | |
| −10.0% | 162.0 | 78.0 | 19.50 | 142.50 | 386.50 | −3.38% | 75.0% |
| −25.0% | 135.0 | 51.0 | 12.75 | 122.25 | 366.25 | −8.44% | 75.0% |
| −40.0% | 108.0 | 24.0 | 6.00 | 102.00 | 346.00 | −13.50% | 75.0% |
| −53.3%, at the tax base | 84.0 | 0.0 | 0.00 | 84.00 | 328.00 | −18.00% | 75.0% |
| −60.0% | 72.0 | 0.0 | 0.00 | 72.00 | 316.00 | −21.00% | 77.8% |
Between 84.0 and 72.0 the fund bears 100 per cent of the 12.0 fall: the cushion is spent. A 60 per cent fall costs the fund 84.0 of the 108.0 gross, and the 24.0 the liability absorbed is all it ever could.
The cushion is largest where the gains are largest. A blocker holding a position near its tax base has no cushion at all, so the positions that look most protected in a stress are the ones that have done best, and the ones at risk of a deep fall are often the ones with the least gain left to absorb it.
The 24.0 assumes the blocker sells the asset and pays the tax. If the fund instead sells the blocker's shares, the buyer inherits the low tax base and prices part of the liability into the price. A buyer that deducts the full liability pays 156.0; one that deducts half of it pays 168.0; only a buyer who ignores the tax entirely pays 180.0. Some valuation policies discount the liability for that reason, which is a judgement to find in the valuation note, not in the arithmetic. Ignoring the liability altogether would overstate this fund's net assets by 6.0 per cent, at 424.0. The present-value approach to the same question is worked in how to deduct deferred tax in a real estate fund's NAV.
Holding the tax at today's amount when stressing the portfolio. On a 10 per cent fall that charges the fund 18.0 instead of 13.5, a 4.50 per cent fall in net assets instead of 3.375, and it overstates the investor's loss by a third. The reverse mistake is worse: applying the 75 per cent cushion to a deep fall, beyond the 53.3 per cent at which the gain runs out, understates the loss. Rerun the liability at each stressed value, the same way an accrued carry has to be rerun through the waterfall; the parallel is in why a fund's investments add up to more than 100 per cent of net assets, where the carry accrual is the largest liability.
The ladder below the fund, with the deferred tax and a joint venture promote rerun as functions of value, is in the free workbook for this case.
Because the blocker is a corporate taxpayer and would pay tax on selling its asset at the reported fair value. On the illustrative case, an asset worth 180.0 with a tax base of 84.0 carries a built-in gain of 96.0 and, at 25 per cent, a liability of 24.0, so the fund's position is worth 156.0 net, not 180.0.
Partly, and only down to the tax base. With a 25 per cent rate the liability absorbs a quarter of each fall while a gain remains: a 25 per cent fall in the illustrative asset costs the fund 33.75 rather than 45.0. Beyond a 53.3 per cent fall the gain is gone and the fund bears every further loss.
Not necessarily: a buyer of the blocker's shares inherits the low tax base and prices only part of the tax. On the illustrative case the seller receives 156.0 if the buyer deducts the full liability and 168.0 if it deducts half. Ignoring the 24.0 entirely would overstate the fund's NAV by 6.0 per cent.
Chapter 16 of How to Read a Private Fund's Financial Statements includes a blocker whose tax is a function of value; the companion files take it to a number. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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