Hedge Funds and Taxes: Tax Planning Strategies for U.S. Investors in Domestic and Offshore Hedge Funds

Aude Thibaut de Maisieres MBA ‘03

CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS FALL 2003 www.gsb.columbia.edu/chazenjournal This paper was written in 2002 while the author was a student at Columbia Business School and recently updated as an alumna in 2003. The opinions and analysis in this paper are solely those of the author and do not reflect the views or opinions of, or constitute advice from, her current employer, Goldman Sachs International.

1. Introduction Until recently, the idea of tax efficiency for a hedge fund would have been laughable, like “seeking fuel economy in the Indianapolis 500”1. Yet, returns on hedge fund investments have traditionally generated huge tax bills because the returns themselves were large, the investments rarely qualified for tax exemption, and the nature of the investment style of hedge funds is short - term. Thus the income generated by hedge funds has been subjected to rates closer to the 40- percent ordinary tax rate than to the long-term 20-percent capital gains tax. In the current environment, following the rise of tax-efficient mutual funds and separate accounts, investor pressure is putting scrutiny on hedge fund tax management. The purpose of this paper is to examine the taxation of U.S. investors in domestic and offshore hedge funds, and to review some tax-planning techniques that were inspired by the current high state of taxation, and have been receiving increased scrutiny from the Internal Revenue Service (IRS).

2. The Nature of Hedge Funds’ Tax Inefficiency What makes hedge funds so tax-inefficient? The nature of hedge fund investment is the capture of short-term returns, so rarely does income generated by the funds qualify for long-term capital gains treatment. But there are other structural reasons why hedge funds cannot qualify for more beneficial tax treatment

2.1 Structure of Domestic Hedge Funds In the United States, hedge funds are generally structured as partnerships or Limited Liability Companies (LLCs). As such, gains and losses—usually short-term—flow through to the hedge fund investors. As of September 2003, before the recent Securities and Exchange Commission (SEC) proposals from their October 2003 report (the impact of which is examined in the next section), limited partnerships were exempt from registration with the SEC under the Investment Advisers Act of 1940 Section 3 (c) (1), if the number of investors was less than 100, their net worth was at least $1 million, and the partnership didn’t make a public offering of its securities. Hedge funds, particularly those that invest in highly risky strategies, including shorting and the use of derivatives, coupled with financial leverage, were happy to avoid registration and its

1 Benjamin, Jeff. 2002. Search for tax savings takes unlikely turns. Investment News, 17 July, 3. stringent requirements. Thus, they remain “unregulated,” since they are reluctant to give too much disclosure on their proprietary investment methods. Hedge funds also try to avoid qualifying for ERISA2 rules to be exempted from its stringent requirements as a fiduciary by limiting benefit-plan investments. This means hedge funds cannot benefit from tax benefits that other investment vehicles such as mutual funds experience. Therefore, their best option is to be structured as pass-throughs, i.e., to pass taxable income through to its beneficiaries who are then liable to taxation to at least avoid a double layer of taxation, even though partners are taxed on their allocable shares of partnership income or loss, whether distributed or not, and taxed at top marginal tax rates for the very wealthy. Fortunately, most U.S. states, including New York and Jersey, do not impose an income tax on the in-state trading activities of non-residents.

2.2 What About the New Registration Rules? The recent scrutiny of the SEC towards hedge funds and its year-long study of the industry resulted in October 2003 in a report “The Implication of the Growth of Hedge Funds.”3 If a majority of the SEC’s five commissioners approve the proposals in the report, they should come into effect by the end of the year. They will require the hedge fund advisers to register as investment advisers under the Investment Advisers Act of 1940 and the 1933 Securities Act. The minimum qualifications for investors in hedge funds will be to have net worth of $1.5 million or $750,000 in a single hedge fund. Registration also comes with a limitation on the number of active investments the partnership can hold. It cannot benefit from a partnership tax regime, i.e., no corporation level taxation, only the partnership level of taxation—unless it derives 90 percent of its income from passive sources. Fortunately, hedge funds usually meet these criteria. In conclusion, even though it imposes certain transparency requirements, and increases requirements on investors’ net worth, mandatory registration for hedge funds doesn’t yet allow for offering general solicitation to non-qualified purchasers and the tax benefits available to mutual funds or other registered investments. Thus the structural impact of the new SEC registration rules is neutral.

2.3 Frictions Arising from the U.S. Partnership structure The domestic partnership structure is not advantageous to all types of investors in hedge funds. Certain U.S. investors who are generally tax-exempt in the United States are still taxable with respect to Unrelated Business Taxable Income (UBTI). UBTI includes income earned from investments that are financed with indebtedness. Receipt of an allocation of any such income can cause a trust to be taxable on all its income. Yet, the entire strategy of a hedge fund revolves

2 Employee Retirement Income Security Act of 1974, establishing guidelines for the investment and management of private pension plans. 3 www.sec.gov/news/studies/hedgefunds0903.pdf

FALL 2003 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 3 around its leverage, which allows it to increase gains for the shareholders. For that reason, tax- exempt investors, bodies or individuals would generally prefer to invest in a corporation rather than a partnership. Other investors dissatisfied with investing in U.S. hedge funds are non-U.S. investors. Foreign investors would rather avoid paying Uncle Sam taxes, and retain their anonymity. A solution to this problem is to give tax-exempt investors the option of investing through a non-U.S. feeder corporation established primarily for non-U.S. investors, eliminating the flow-through of taxable income to the tax-exempt investor. A foreign feeder corporation also ensures that the non- U.S. investor’s identity will not have to be disclosed to any tax authority. Nevertheless, this may be in conflict with home jurisdiction and may cut off treaty benefits. So, wouldn’t the establishment of an offshore hedge fund even for U.S. investors be the ideal solution?

3. Offshore Hedge Funds and their Investors For all our examples, we will use Cayman as our offshore location.4 Cayman is the world’s fifth biggest financial center, with 3000 mutual funds holding $215 billion in assets.5 Cayman has no corporate taxes and no personal taxes. Funds in offshore locations are usually structured as open- ended investment companies. In this section we will examine what the taxation of U.S. investors in offshore investment companies is, what the taxation of tax-exempt and non-U.S. investors in offshore investments is, and we will make some comments about the incentives created by the U.S. taxation system compared to other countries with respect to tax compliance. We will start our analysis assuming that U.S. citizens do not try to avoid taxation by investing offshore. In December 2001, Cayman signed a tax information exchange agreement with the United States that is enforced by the IRS under the Tax Shelter Act.

3.1 The Taxation of U.S. Investors in Offshore Hedge Funds A U.S. citizen who invests in an offshore fund that is treated for U.S. income tax purposes as a corporation (and not a partnership) is subject to taxation under Sections 1291 through 1298 of the Internal Revenue Code, provisions that apply to so-called "passive foreign investment companies" or PFICs. Under the PFIC rules, the U.S. investor can elect to defer tax or to pay tax currently. If the U.S. investor elects to defer tax, then he or she is taxed only when either he or she is receiving a distribution (if it is an excess distribution) or when he or she sells the shares of the PFIC. In either case the income is subject to significant deferred tax and interest charges that are designed to eliminate the benefits of deferral. If, on the other hand, the investor elects current inclusion, then he or she must include in gross income his or her share of the PFIC's ordinary earnings and

4 www.caymanfinance.gov.ky 5 Fasken, H. 2002. Financial Times, European Intelligence Wire, 1 January.

FALL 2003 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 4 capital gains—whether or not a distribution is received. In that case, the tax treatment approximates the current tax treatment of a partnership, although net losses of the PFIC do not flow through annually, and the deferred tax and interest charges are not applicable. Therefore, U.S. investors are at best indifferent to the domicile of the fund, with a negative bias against it because of the negative reputation of tax havens, the aura of suspicion that surrounds them in the eyes of the IRS, and the headaches they create for fund managers from increased disclosure without tax advantages.

3.2 Tax Advantages of Offshore Hedge Funds for Other Non-U.S. Investors U.S. tax-exempt American institutions certainly prefer to invest in a hedge fund structured as an offshore open-ended investment companies because the offshore structure allows them to avoid not submitting their earnings to the UBTI rules despite the leverage of the hedge fund. By investing offshore, non-U.S. investors avoid the scrutiny of the IRS altogether. They might not, however, escape the scrutiny of their home jurisdiction. Non-U.S. investors could have the obligation of investing in a registered fund to receive beneficial tax treatment at home. Different countries have different responses to offshore investing by their citizens. The United Kingdom is currently undergoing a move to tax offshore funds annually because so far U.K. residents are subject to tax only at repatriation of funds, what is called “roll-up” of funds, and of course tend to find better uses for their funds than to repatriate them. Germany does not tax capital gains after a one-year investment period. It does tax dividends. But for non-registered funds, the government assumes that any increase in the value of the fund is dividend income and taxes it as such.6 For the French, offshore funds are taxed like French funds. Ireland only taxes 10 percent for financial services companies, and as a consequence many funds have established themselves in Dublin away from other European countries.

3.3 The IRS and Its Worldwide Taxation System Has It Right The purpose of this analysis is not to look into foreign treatment of offshore funds taxation but to have the means to assess the efficiency of IRS policy to both tax their citizens and retain the activity of hedge funds onshore. We conclude that IRS policy with regard to taxation of investors in hedge funds proves very successful. The rules on tax deferral approximate the U.S. worldwide taxation system by making the income abroad taxable in the same way as in the United States for its citizen. As a result, as of the end of 2002, according to industry estimates, 90 percent of hedge funds management companies were located in the United States. and only 10 percent offshore, since U.S. investors are the most active seekers of that investment class. This is not to say that

6 Reier, Sharon. 2001. A wealth of choice for Europeans. International Herald Tribune, 4 April, 19.

FALL 2003 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 5 U.S. investors have not tried to pursue tax-planning strategies within the IRS rules to limit taxes paid. In comparison, the United Kingdom is moving towards ending the deferred taxation—at repatriation, of offshore income to increase the competitiveness of U.K domestic funds relative to offshore funds. The French tax offshore funds in the same way as domestic funds to avoid the moral hazard that it might generate for repatriation, i.e., creating no incentive for repatriation as it would come with a tax punishment. This is not to say that U.S. investors have not tried to pursue tax-planning strategies within the U.S. IRS rules to limit taxes paid.

4. Tax Planning Strategies for U.S. Investors in Hedge Funds The following strategies try to take advantage of other investment instruments’ tax benefits, through ‘income- type shifting’ (i.e., shifting income from one taxable type to another taxable type) and ‘deferral of income’ (i.e., shifting taxable income from one period to another). They are based on the special tax treatment that life insurance and annuity contracts receive, allowing investors to defer taxes on investments held in those contracts as long as the investor isn’t deemed to have sufficient control over the investment to be considered the owner and if the investment offered through the policy isn’t something that is available to the general public, thus seeming to qualify hedge funds.

4.1 Three Variations on a Tax Planning Strategy Strategy A: Invest in a hedge fund through variable annuities offered by insurance companies. Variable annuities provide a retirement annuity. They are not tax-deductible and distribution is taxed, but they are tax-deferred, much like an Individual Retirement Account (IRA). Variable annuities also guarantee capital gains treatment in the long run. That way, your investment in hedge funds grows tax deferred. By “income-type shifting” from a taxable income to deferred distribution, the investor gets deferral treatment. Strategy B: An investor buys an insurance policy that promises to invest the premiums in a hedge fund. The investment grows tax-free because insurance policy gains aren’t taxable. The gains are distributed in the form of a death benefit. This strategy is pocket-shifting from a high tax into a tax-free instrument. Strategy C: The hedge fund is wrapped inside a private insurance company established in an offshore location. The insurance company invests in the hedge fund itself. Investors buy the shares in the insurance company to get the benefit of the hedge fund gains. In a word, the insurance company invests all of its money in hedge funds and is not taxed, and the benefits flow to its shareholders in lower taxes on shares held long-term. This strategy combines pocket-shifting with income-type shifting: the insurance company offshore is tax-free, whereas the investor is highly

FALL 2003 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 6 taxed, and the short-term gains of the hedge fund becomes long-term capital gains in the shares of the insurance company held by the investor. One danger of this strategy is that investors take on the risk of the insurance company, not just of the hedge fund.

4.2 The IRS’s Response The danger of the above strategies is that the IRS is not blind to them. Having started to realize over the last year that taxes on huge hedge fund profits were being deferred in this way, in July 2003 the IRS came up with two rulings against the use of annuities as wrappers to shield current income from taxation. Ruling 2003-91 curtails the amount of control a variable contract a policyholder has over the investment in annuity sub-accounts. Ruling 2003-92 prevents non- insurance assets from being included in an annuity that is the financing vehicle for a partnership. Life insurance companies may only offer hedge funds as an investment choice for variable annuity contracts if the fund manager agrees to establish a new fund available exclusively through insurance products (Colter 2003). Yet, through its rulings, the IRS actually endorses hedge funds as investment options in variable life and annuity contracts under certain conditions. Hedge fund managers have immediately reacted by setting up separate accounts to maintain the tax-free status. Contract holders should make payments to the insurer, the net proceeds of which are allocated to the separate account and then in turn to the hedge funds. The contract must provide a death benefit that is a multiple of the investment values. The IRS rules still seem to allow the use of insurance-dedicated hedge funds as investment options in variable life and annuities. They also appear to allow investment funds that invest in hedge funds along with other funds available to taxable investors. All are observing the next move of the IRS.

5. Conclusion Hedge funds have started to try and offer solutions for their embedded tax inefficiency. The creativity deployed in tax planning strategies is, however, rapidly matched by the IRS’s reactivity to them. The tax planning strategies described above and the IRS’s response to them are a typical example of the interactive process through which tax legislation is created in the United States. If the IRS insists on the spirit of the law being observed as well as the letter in those tax planning strategies, the only tax planning strategy left for hedge fund investors might be tax planning at the portfolio level—i.e., holding investments over 12 months to benefit from long-term capital gains treatment. Yet this strategy seems to defy the investment style of most existing hedge funds.

FALL 2003 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 7 References Bennett, Allison. 2003. IRS proposes limits on use of insurance, annuity contracts to avoid investment taxes. BNA’s Banking Report 81, 4 August. Blockinger, J. and P. Modhera. 2002. Selecting the appropriate type of hedge fund. Review of Securities and Commodities Regulation 35, 25 September. Breslow, Stephanie R. and Andrew B. Mensh. 2002. Hedge funds as investment vehicles for variable life insurance. Banking and Financial Services Policy Report 21, 1 October. Collinson, Dale and Patrick Carmody. 1998. U.S. position raises new questions. International Tax Review 9, 1 March. Colter, Allison Bisbey. 2003 Some hedge funds see silver lining in IRS rules in insurance. Dow Jones News Service, 25 July. Earle, Julie. 2002. Thousands of U.S. hedge fund investors may face big back-tax demands. Financial Times, 6 November. Economist. 2003. The SEC and Hedge Funds: Rules for the unregulated, 4 October, 85. Fenn, Patrick and David Goldstein. 2002. Tax considerations in structuring U.S.-based private equity funds. International Financial Law Review, 1 January. (ISSN: 0262-6969) Gallo, Pete. 1999. Charity and taxes. Institutions. January: 8. ______1999. Money laundering. Offshore Funds. November: 16. ______. 2001. Agreement could pierce privacy of Caymans hedge funds. HedgeWorld Daily News. 3 December. Hargreaves, Deborah. 2002. Hedge funds may face big penalties. Financial Times (U.S. edition), 23 April, 21. Huggard, John P. 2001. VA’s victorious at tax time. Financial Planning, 1 October. McKinnon, John. 2002. U.S. threatens crackdown on insurance arrangements. Wall Street Journal, 12 September. ______2002. U.S. Treasury readies new rules related to offshore hedge funds. Wall Street Journal, 25 September. Monaco, Stephanie M. and Jeffrey C. Blockinger. 2002. Operating a hedge fund in a regulated environment. Review of Securities and Commodities Regulation 35, 13 February 13. Pillsbury Winthrop LLP. 2002. USA regulations–Crackdown on tax shelters. EIU Viewswire, 25 September. Postal, Arthur D. 2003. IRS acts against hedge funds use of annuities. Insurance Accounting 14, 28 July.

FALL 2003 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 8 Power, Edward. 2002. Cayman on brink of major policy shift to diminish anonymity guaranteed to foreign investors Irish Times, 21 November.Smith, Henry and Theresa Pitcairn. 2002. The Cayman Islands. International Financial Law Review, January 1. (ISSN: 0262-6969) Sullivan, Aline. 2002. Recent storms shed new light on tax havens. Financial Times, 19 February.

FALL 2003 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 9