US Taxation of
Offshore Hedge Funds
by Hannah M.
Terhune, Esq
Capital Management Law Group,
PLLC
www.capitalmanagementlaw.com
The number of
offshore hedge funds has increased due to the ability of these
funds to operate outside the scope of government regulation
and disclosure requirements. Hedge funds are set up as
offshore or onshore funds to allow for different groups of
investors. U.S. based hedge fund managers who have significant
pot ential investors outside the United States and/or U.S.
tax-exempt investors typically create offshore funds. Many
hedge fund managers use offshore hedge funds to provide
privacy to investors. In those cases where complete investor
confidentiality and privacy are necessary, an offshore fund
should not accept U.S. investors and the fund manager should
not be based in the United States.
For a new hedge fund
manager who is a small operator and for whom the extra costs
are a major burden, the best location to launch an offshore
hedge fund or a master feeder fund is the Cayman Islands or
the Bahamas. Both countries have tiered statutory regimes for
hedge funds, allowing hedge funds to start out as unregistered
funds and then later upgrading to registered fund status if
necessary. Hedge fund attorneys in both countries are familiar
with hedge fund start ups and will work with a new hedge fund
manager. Related service providers (accountants,
administrators, etc.) in both countries are good, with the
Cayman Islands offering a greater number of service
providers.
Master/Feeder Fund Structure
Confusing to
some is the use of onshore and offshore funds in a
master/feeder structure. The master/feeder structure allows a
hedge fund manager to manage money for a broad spectrum of
investors. The master fund, structured as an offshore
corporation (but treated as a partnership for U.S. tax
purposes via a check-the-box election), engages in all trading
activity. A hedge fund manager will pool money and feed it in
to a master fund and allocate trading gains and losses back to
the onshore and offshore feeder funds based on the percentage
assets under management in each feeder fund. A master/feeder
structure typically includes (in addition to the master fund
company) a U.S. limited partnership or limited liability
company as the feeder fund for U.S. taxable investors and a
foreign corporation as the offshore feeder for foreign
investors and U.S. tax-exempt investors.
The
master/feeder fund structure allows the investment manager to
collectively manage money for varying types of investors in
different investment vehicles without having to allocate
trades and while producing similar performance returns for the
same strategies. Feeder funds invest fund assets in a master
fund that has the same investment strategy as the feeder fund.
The master fund, structured as a partnership, engages in all
trading activity.
In today's trading environment, a
master/feeder structure will include a U.S. limited
partnership or limited liability company for U.S. investors
and a foreign corporation for foreign investors and U.S.
tax-exempt organizations.
U.S. Tax Exempt
Investors
The typical investors in an offshore hedge fund
structured as a corporation will be foreign investors, U.S.
tax-exempt entities, and offshore funds of funds. U.S.
tax-exempt investors favor investments in offshore hedge funds
because they may have exposure to U.S. taxation if they invest
in U.S. based hedge funds. Under U.S. tax laws, a tax-exempt
investor (such as an IRA, an ERISA-type retirement plan, a
foundation, or an endowment) is liable for income tax on
"unrelated business taxable income" (UBTI), notwithstanding
its tax-exempt status. UBTI exposure exists when a U.S.
tax-exempt investor invests in a hedge fund that uses leverage
(e.g., trades on margin).
The UBTI tax is avoided by
investing in an offshore hedge fund. A U.S. based hedge fund
manager should consider setting up an offshore fund if he or
she manages money for foreign and/or U.S. tax-exempt
investors. Although certain organizations, such as qualified
retirement plans, generally are exempt from federal income
tax, unrelated business taxable income (UBTI) passed through
partnerships to tax-exempt partners is subject to that tax.
UBTI is income from regularly carrying on a trade or business
that is not substantially related to the organization's exempt
purpose. UBTI excludes various types of income such as
dividends, interest, royalties, rents from real property (and
incidental rent from personal property), and gains from the
disposition of capital assets, unless the income is from
"debt-financed property," which is any property that is held
to produce income with respect to which there is acquisition
indebtedness (such as margin debt). As a fund's income
attributable to debt-financed property allocable to tax-exempt
partners may constitute UBTI to them, tax-exempt investors
generally refrain from investing in offshore hedge funds
classified as partnerships that expect to engage in leveraged
trading strategies. As a result, fund sponsors organize
separate offshore hedge funds for tax-exempt investors and
have such corporate funds participate in the master-feeder
fund structure.
U.S. Individual Investors
Offshore
hedge funds are generally organized as corporations for
marketing, tax, and legal reasons. Less frequently, offshore
hedge funds will elect to be treated as a partnership for U.S.
tax purposes to attract U.S. individual investors as well as
participate in master/feeder fund arrangements. If U.S.
taxable investors invest in or effectively control an offshore
hedge fund, some complex U.S. tax rules applicable to
controlled foreign corporations, foreign personal holding
companies, or passive foreign investment companies (PFIC) need
to be addressed. However, these rules are manageable when
knowledgeable tax advisors are on board. If US individual
investors participate in an offshore hedge fund structured as
a corporation, they may be exposed to onerous tax rules
applicable to con trolled foreign corporations, foreign
personal holding companies, or a passive foreign investment
company (PFIC). To attract U.S. individual investors, fund
sponsors organize separate hedge funds that elect to be
treated as partnerships for US tax purposes so that these
investors receive favorable tax treatment. These funds
participate in the master/feeder structure. Under the U.S.
entity classification (i.e., check-the-box) rules, an offshore
hedge fund can elect to be treated as a partnership for U.S.
tax purposes by filing Form 8832, "Entity Classification
Election," so long as the fund is not one of several
enumerated entities that are required to be treated as
corporations.
U.S. Reporting Requirements
An
interesting issue that has arisen in the context of the
master/feeder fund structure concerns the nature of U.S.
reporting requirements. Section 6031(a) requires every
partnership to file a partnership return, Form 1065. However,
section 6031(e) provides that a foreign partnership is not
required to file a return for a taxable year unless during
that year it derives gross income from sources within the
United States (US-source income) or has gross income that is
effectively connected with the conduct of a trade or business
within the US (ECI). Regulations issued pursuant to Section
6031 generally provide that a foreign partnership is not
required to file a Form 1065, if the following two conditions
are met:
1. The foreign partnership does not have gross
income that is (or is treated as) effectively connected with
the conduct of a trade or business in the U.S. (i.e., no
effectively connected income or ECI).
2. The foreign
partnership does not have gross income (including gains)
derived from sources within the United States (i.e., no U.S.-
source income).
With respect to a foreign partnership
that is not a withholding foreign partnership (i.e., a foreign
partnership that has entered into an agreement with the IRS
whereby the foreign partnership agrees to be subject to the
withholding and reporting provisions applicable to withholding
agents and payors), the critical inquiry in determining
whether a US filing requirement exists is ECI. To the extent
that a foreign partnership generates ECI, it is required to
file Form 1065.
The test for determining whether a US
partnership filing requirement exists in this context (i.e.,
whether the partnership generates ECI) is dictated Section 864
and its regulations. In general, an offshore hedge fund is not
considered to be conducting a trade or business within the
United States merely by investing in the stocks or securities
of U.S. issuers or by trading in such stocks or securities in
the United States for its own account. In addition, an
offshore hedge fund may retain the services of United States
investment advisers and brokers and may grant them discretion
to engage in securities transactions without causing the fund
to be deemed to be conducting such a trade or business. A fund
that is considered a "dealer" in stocks or securities of U.S.
issuers, however, is considered to be conducting a trade or
business within the United States. The determination of whethe
r a fund's activities rise to the level of dealer activities
depends on the facts and circumstances of each
case.
Prior to the repeal of the statutory basis for
the "Ten Commandments" by the Taxpayer Relief Act of 1997, an
offshore hedge fund that traded in stocks or securities of
U.S. issuers for its own account was considered to be
conducting a trade or business within the United States if it
maintained its principal office in the United States.
Regulations under Section 864 set forth a "safe harbor" list
of ten administrative functions (Ten Commandments) that, if
conducted substantially outside the United States, would tend
to cause a fund to be treated as if its principal office were
outside the United States. Although it is no longer necessary
to comply with this safe harbor to avoid being treated as
conducting a U.S. trade or business, many offshore hedge funds
continue to maintain their books and records and perform
certain other administrative functions offshore for privacy
reasons and t o avoid taxation in a handful of states that, in
effect, have not adopted the repeal.
As for offshore
hedge funds trading stocks and securities for their own
account and not otherwise engaging in the conduct of a U.S.
trade or business, foreign partners are subject to U.S.
withholding taxes only on dividend income and nonportfolio
interest income.
Reporting Rules for Foreign
Partnerships Having No ECI
Regulations also contain three
rules that modify the reporting requirements of offshore hedge
funds that do not generate ECI. Except for the de minimis
rule, the modified reporting requirements apply only when the
following occurs:
1. The foreign partnership or one or
more withholding agents files the required Form 1042, "Annual
Withholding Tax Return for U.S. Source Income of Foreign
Persons," (Form 1042 reports fixed or determinable annual or
periodic (FDAP) income that a U.S. withholding agent receives,
controls, has custody of, disposes of, or pays) and Form
1042-S, "Foreign Person's U.S. Source Income Subject to
Withholding," (Form 1042-S reports the income paid and taxes
withheld with respect to a foreign person as well as the
withholding agent's identification information) for
U.S.-source income allocable to foreign partners of the
foreign partnership.
2. The tax liability of foreign
partners with respect to that income must be fully satisfied
by withholding of tax at source.
De Minimis
Rule
The first modified rule for foreign partnerships that
do not generate ECI is the de minimis exception. A foreign
partnership with $20,000 or less of U.S.-source income and no
ECI is required to file a U.S. partnership return only if 1%
or more of any item of partnership income, gain, loss,
deduction, or credit is allocable in the aggregate to direct
U.S. partners.
U.S.-source income but no U.S. Partners
The second modified reporting rule specifies that a
foreign partnership with U.S.-source income but no ECI and no
U.S. partners will not be required to file a U.S. partnership
return.
U.S.-Source Income and U.S. Partners
The
third modified reporting rule requires that a foreign
partnership that has U.S.-source income and one or more U.S.
partners but does not have ECI must file a U.S. partnership
return. The partnership, however, will be required to file
Schedules K-1 only for its direct U.S. partners and for its
pass-through partners through whom U.S. partners hold an
interest in the foreign partnership. Thus, for foreign
partnerships that generate only U.S.-source income but no ECI,
the regulations do not require those partnerships to furnish
Schedules K-1 for foreign partners, because the foreign
partners are subject to information-reporting requirements on
Form 1042-S under Treas. Regs. Secs. 1.1441-5(c) and 1.1461-1.
These regulations subject the foreign partners (and not the
partnership) to information-reporting requirements for
U.S.-source income paid to a foreign partnership that is not
ECI.
Reporting Rules for Foreign Partnerships
Generating ECI
Unlike the rules in the regulations for
foreign partnerships that generate only US-source income but
no ECI, the exception to Schedule K-1 reporting for foreign
partners does not apply to a foreign partnership that
generates ECI. Specifically, a foreign partnership that
generates ECI must file a complete U.S. partnership return of
income, with Schedules K-1 for all partners, including foreign
partners. Furthermore, that partnership must report to all
foreign partners their allocable shares of ECI, as well as
their allocable shares of all items of partnership income,
gain, loss, deduction, and credit.
Partnership-Level
Elections
The regulations provide simplified reporting
rules for foreign partnerships that file U.S. partnership
returns only for the purpose of making partnership-level
elections. Generally, a partnership return filed only to make
a partnership-level election need contain only a written
statement referring to Reg. 1.6031(a)-1(b)(5)(ii), stating the
name and address of the partnership making the election, as
well as the specific election being made. For example, a
foreign partnership that is not otherwise required to file a
U.S. partnership return may choose to file a partnership
return if the partnership has incurred organizational costs
and seeks to elect to amortize these expenses over 60
months.
State Tax Concerns
Although offshore hedge
funds generally will not have nexus to the states, many states
still require partnerships to file state partnership tax
returns if they have partners that are residents of their
jurisdiction. This could result in an offshore hedge fund with
U.S. partnership tax status being required to file a state tax
return even though it arguably may not be required to file a
Form 1065, since the partnership has no U.S.-source income and
no ECI. For example, every partnership that has income or loss
from sources in New Jersey or has a New Jersey resident
partner must file Form NJ-1065. Thus, an offshore hedge fund
with New Jersey resident partners will be required to file a
New Jersey partnership tax return, regardless of whether the
partnership has New Jersey-source income. Partne rships that
have "resident" partners or have income from New York sources
are required to file a New York State partnership return (Form
IT-204). In accordance with these rules, an offshore hedge
fund that has New York resident individual partners will be
required to file a New York partnership return, regardless of
whether the entity has a federal filing requirement. A
partnership is required to file Form CT-1065, "Connecticut
Partnership Income Tax Return," if it is required to file Form
1065 and it has any income, gain, loss, or deduction derived
from or connected with Connecticut sources. Therefore, an
offshore hedge fund will not be required to file Form CT-1065
simply because it has a partner who is a resident of
Connecticut.
Conclusion
An offshore hedge fund that
only trades for its own account and does not otherwise engage
in a trade or business is not required to file Schedules K-1
on behalf of foreign partners. As a result, the offshore hedge
fund can file a U.S. partnership tax return to preserve the
advantages of filing for U.S. partners (i.e., the benefits of
a partnership-level election such as the amortization of
organizational costs over 60 months) without compromising the
anonymity of foreign partners. While an offshore hedge fund
that has U.S. partners but no ECI and no U.S.-source income
does not have a federal filing requirement, the partnership
may be required to file state and local tax returns if its
U.S. partners are residents of certain states. Such state and
local partnership returns may require the identity of all
partners (including foreign partners) to be included as part
of the return. An offshore hedge fund electing partnership
status should carefully analyze the connection of its
activities to the U.S. and the residencies of its U.S.
partners to properly ascertain its federal and state filing
obligations, as well as provide proper disclosure as to the
filing obligations to foreign partners.
“This article was republised with
permission from Hannah Terhune, Esq. and IBCF and originally
published May 1, 2007 on the IBCF.com
Newsletter."
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