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Managing Offshore Funds - A View from the Beach

Many offshore hedge funds engage in a variety of activities within the US. To the extent an offshore hedge fund becomes engaged in a US trade or business, all of its income and gains effectively connected to such business are subject to US tax.

At some point, an offshore hedge fund could cross the line between investing, trading, and banking activities. The tax consequences to an offshore hedge fund are substantial. This article explores the extent to which an offshore hedge fund can engage in diversified or entrepreneurial activities within the US without “landing” for tax purposes, e.g., subjecting a portion of their income to tax on ground that it is effectively connected to a US trade or business.

Taxation of Offshore Hedge Funds

Offshore hedge funds generally engage in investment strategies to profit from capital appreciation and daily swings in the price of stocks, securities, or commodities. These profits are generally characterized as gains from the sale of capital assets.

Offshore hedge funds are not taxed on (1) interest from US bank deposits or interest entitled to the portfolio interest exception, and (2) capital gains so long as the gains do not arise from the sale or exchange of a direct or indirect interest in real property located in the US. To the extent an offshore hedge fund becomes engaged in a US trade or business, all of its income and gains effectively connected to such business are subject to US tax without the exceptions referenced above.

Trade or Business

The term "trade or business" is not defined in the Internal Revenue Code or in Treasury regulations. Buying and selling stocks or securities may constitute a trade or business, or such activity may fall within the scope of investing, which is not a trade or business.
Over the years, the IRS broadened the definition of investing activities and narrowed the definition of "trade or business" in order to limit business expense deductions. Investment expense deductions are subject to limitations.

Courts have drawn distinctions between investing, trading and selling goods or services in the US to determine whether a foreign corporation is so engaged. Foreign investors are not engaged in a trade or business even if they perform services to increase or protect the value of their investments. They are simply viewed as engaged in an activity for the production of income. Foreign traders may be engaged in a trade or business but may qualify for an exception applicable to certain trading activities.

US Inbound Investment

With the intent to encourage foreign investment in US financial markets, and realizing that trading in stocks and securities may constitute a trade or business in certain circumstances, Congress provided two safe harbor exceptions within the scope of Section 864 for offshore hedge funds that were engaged in trading activities in US financial markets. Those safe harbors are the dealer safe harbor and the trading safe harbor.

Dealer Safe Harbor

An offshore hedge fund, whether or not a dealer in stocks and securities abroad, may trade in US stocks, securities and commodities (for its own account or for customers), through a resident broker, commission agent, custodian, or other independent agent, provided that it does not maintain an office within the US through which or by the direction of which the transactions in stocks, securities, or commodities are effected.

Trading Safe Harbor

The trading safe harbor applies to an offshore hedge fund that trades in stocks, securities, and commodities for its own account, even if it (1) maintains its principal office within the US for taxable years after 1997, and (2) hires employees or exclusive agents in the US who direct its trading activities using their own discretion. The exception covers trading in stocks, securities, and options to buy or sell stocks or securities, including margin transactions and short sales.

In 1997, Congress revised Section 864 to clarify that the exception from US tax for offshore hedge funds that actively trade US stocks, securities and commodities for their own account applies notwithstanding the fact that such funds maintain their principal office and perform administrative functions in the US. This law change did not expand the trading exception to include activities beyond the scope of trading in stocks, securities and commodities.

Offshore Perspective on Trade or Business

No court has defined the term “trade or business” for purposes of Sections 864 with respect to foreign corporations. The determination is made based on the facts and circumstances of each case. However, once an offshore hedge fund has met an exception set forth in Section 864 with respect to its trading activities, all other activities must be vetted to determine whether those activities result in a US trade or business. Notwithstanding the fact that an offshore hedge fund meets the trading safe harbor, the fund may still be considered carrying on a trade or business for other reasons.

U.S. Tax "Landings"

An offshore hedge fund should not assume that the trading safe harbor always protects trading income or gains. How might an offshore hedge fund end up with effectively connected income?

Some hedge fund management companies offer US investors partnership interests in domestic partnerships while offering foreign investors and U.S. tax-exempt investors shares in the offshore fund. Offshore hedge funds are most often classified as corporations for US tax purposes.

Consider the scenario where a private fund manager has captured the attention of the money manager of offshore hedge fund. The private fund manager is the general partner of a hedge fund named Hot Stuff, LP. Hot Stuff's general partner desires to quickly accommodate the interest of the foreign money manager to put funds under his management (e.g., invest part of the offshore fund into Hot Stuff).

A master/feeder arrangement, though it works, does not yet exist. The offshore fund may invest in the domestic partnership as a type of modified master/feeder structure.

The Hot Stuff's Private Placement Memoranda (PPM) indicates that it is in its first year of operation. The PPM, read fairly against the backdrop of US case law, could tend to suggest that Hot Stuff's proposed trading strategy could give rise to either “trader” or “investor” tax status, e.g., that it is an investment hedge fund opposed to a trading hedge fund.

To date, the offshore hedge fund has traded US financial markets free of US tax by relying on the trading safe harbor. In addition to investing in the offshore hedge fund will continue to directly trade US financial markets.

The tax consequences to the offshore fund of an investment in Hot Stuff are risky. Notwithstanding the fact that an offshore hedge fund meets the trading safe harbor, the fund may still be considered carrying on a trade or business for other reasons.

In a 1998 field service advice, the IRS advised that a US limited partnership's investment activity was not a trade or business and as such a foreign corporation's distributive share of the partnership income was not taxable in the US as effectively connected income.

In that advice, a foreign corporation held an interest in a domestic limited partnership, which primarily invested in stocks. The limited partnership's offering documents indicated that its objective was to invest its committed capital in a diversified portfolio of leveraged equity investments and that it expected s to hold the investments for two to six years. The investments produced interest, dividend, and capital gain income.

The field service advice clearly left the door open to concluding that an offshore investor in an actively traded domestic hedge fund structured as a partnership (or a limited liability company electing to be taxed as a partnership) would “land” in the US for tax purposes by operation of law pursuant to Section 875.

In short, an offshore hedge fund that is a partner in a partnership or a beneficiary of a trust that is engaged in a US trade or business is treated and taxed as so engaged. However, an ownership interest in a US investment partnership or an investment trust should not, by itself, cause an offshore investment fund to be engaged in a US trade or business.

Avoiding US Trade or Business Status

How might the offshore fund manager have avoided “landing” for US tax purposes? Instead of investing directly in Hot Stuff, LP, through purchase of a limited partnership interest, the offshore hedge fund could have loaned funds to Hot Stuff.

Domestic hedge funds, such as Hot Stuff, LP, typically trade on “margin” and borrow funds to leverage investment capacity. With respect to this loan, the interest charge and offsets could have been structured as a type of “tracking” investment with the goal of establishing a rate of return with an economic yield (net of performance and management fees) equivalent to the yield expected by a typical limited partner in Hot Stuff.

The question arises whether this loan would give create a US banking business for the offshore hedge fund? Statistics indicate that more than half of the total receipts of effectively connected income reported by offshore entities arise from the provision of thebanking, insurance and other financial services.

According to US Treasury regulations, a banking business includes any one of the following activities: receiving deposits of funds from the public; making personal, mortgage, industrial, or other loans to the public; purchasing, selling, discounting, or negotiating for the public on a regular basis, notes, drafts, checks, bills of exchange, acceptances, or other evidences of indebtedness; issuing letters of credit to the public and negotiating drafts drawn hereunder; providing trust services for the public; and financing foreign exchange transactions for the public.

Generally, limited venture capital activities should not cause an offshore hedge fund to be engaged in a US trade or business. According to US Treasury regulations, such activities may include searching for companies in need of financing, negotiating an investment structure with the companies' existing management, occasionally making bridge loans to the companies, participating in the management of the companies, and holding the investments in order to profit from capital appreciation.

In the debenture investment proposed above, it would be ideal to structure the interest yield as one qualifying for the portfolio interest exception in situations where a reduced treaty rate is not available to reduce the default statutory withholding taxes rates applicable to outbound interest payments.

Foreign partners are subject to US withholding tax on dividend income and non-portfolio interest income. This is especially critical if the offshore hedge fund is not a corporation but rather a partnership.

An offshore hedge fund, structured as a partnership, that only trades for its own account and does not otherwise engage in a US trade or business is not required to file Schedule K-1's on behalf of its foreign partners. However, a foreign partnership that generates effectively connected income must file a complete US partnership return, with Schedule K-1's for all partners, including the foreign partners. Compliance with the withholding regulations applicable to a tiered inbound investment is difficult and detracting to manage.

The IRS will not issue a private letter ruling to a foreign corporation determining whether or not it is engaged in a US trade or business. Despite the wealth of US inbound investment, the IRS has issued little guidance in this area, other than to state that each determination will be based on all of the facts and circumstances. Given the magnitude of the consequences, it is important to vet proposed US inbound investments to be certain of the tax consequences.

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Last updated 2787 days ago by Capital Management Services Group