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Hedge Funds and Taxes
Hedge funds provide a vehicle to pool private capital forinvestment in stocks, securities and financial derivatives. Whilehedge funds take on many different structures-includingmaster-feeder, parallel, or fund-of-funds structures-they sharemany similar tax considerations.
Hedge fund tax issues include entity classification, taxallocations, the taxation of carried interests, swap taxation,withholding, and numerous other issues. In this Insight post, wediscuss the typical hedge fund structure and usual players, as wellas several common tax issues.
Typical Hedge Fund Structures
Most hedge funds use one of the following organizationalstructures: 1) a single entity fund, 2) a master-feeder fund, 3) aparallel fund, or 4) a fund of funds.
A typical hedge fund structure involves an entity formed as apartnership for U.S. federal tax purposes acting as an investmentmanager with a separate entity functioning as a general partner.The investment or fund manager is generally compensated through amanagement fee, typically tied to a percentage of the fund'snet asset value. In addition, the general partner generallyreceives an allocation of partnership profits (net of prior lossesand management fees) that is based on the master fund'sperformance. This is known as a carried interest.
Hedge Funds vs. Private Equity
Hedge funds share some similarities with private equity. Both,for instance, involve partnerships raising capital throughunregistered offerings. Unlike private equity, however, hedge fundsfunction more like an open-ended mutual fund, investing in publicsecurities, rather than private-held operating companies. Manyleverage investments using debt in order to enhance returns oremploy investment vehicles such as straddles and shortpositions.
Hedge funds are privately owned, with investments that aregenerally more liquid than those of private equity funds.
Hedge Fund Regulatory Environment
Unlike mutual funds, hedge funds operate in a largelyunregulated environment. Sponsors generally raise capital throughunregistered Reg. D offerings to "accredited investors"and take measures to avoid registration under the InvestmentCompany Act of 1940, thereby avoiding certain diversification andborrowing restrictions under the act.
The Hedge Fund Players
Master Fund: The Master Fund, often a foreignentity or U.S. LP or LLC, is typically treated as a partnership forU.S. tax purposes. The Master Fund invests capital from any foreignfeeder and domestic feeder.
Investment Manager: The Investment Managermanages the master fund's portfolio for the investors. TheMaster Fund typically enters into an agreement to pay theInvestment Manager a management fee.
General Partner: The General Partner usuallyholds a small interest in the Master Fund and/or feeder funds. Thegeneral partner participates in the master fund's economicperformance through a "carried interest"-a profitsinterest.
Domestic Feeder: The domestic feeder isgenerally a U.S. pass-through entity whose income that is allocatedfrom the Master Fund to DF would be subject to US taxation at thepartner level.
Foreign Feeder: The foreign feeder is typicallya foreign corporation formed in a low or no-tax jurisdiction. ForUS tax purposes, the FF is treated as a corporation. US tax-exemptinvestors (pension funds, 401k funds, governmental entities, etc.)and foreign investors (foreign corporations, non-resident aliens,etc.) make their investments in the Master Fund through the FF. Anydistributions from the FF to its foreign investors are treated asdividends for US tax purposes.1
Carried Interests
Internal Revenue Code section 1061, which was enacted by the Tax Cutsand Jobs Act of 2017, affects certain carried interestarrangements. Generally, under section 1061, certain carriedinterest arrangements (known as "applicable partnershipinterests") must be held for more than three years for therelated capital gains to qualify for long-term capital gaintreatment.
An applicable partnership interest is an interest in apartnership that is transferred to or held by a taxpayer, directlyor indirectly, in connection with the performance of substantialservices by the taxpayer, or any other related person, in anyapplicable trade or business.
Many private equity (PE) funds, hedge funds, andother asset management funds are subject to section 1061'streatment of carried interests. Where it applies, section 1061recharacterizes certain net long-term capital gains of a partnerthat holds one or more applicable partnership interests asshort-term capital gains.
Engaging in a US Trade or Business
The hedge fund's master fund will generally seek to avoidits activities being deemed to be a U.S. trade or business. Forexample, it will seek to avoid U.S. trade or business status due tothe impact on most tax-exempt and foreign investors, as well asavoidance of the net-basis tax regime imposed upon effectivelyconnected income.
Foreign corporations that are deemed to be "engaged in atrade or business" in the United States are, generallyspeaking, subject to U.S.tax on income that is "effectively connected" with that trade orbusiness, as well as a "branch profits" tax on certainincome. The code, however, provides a safe harbor, exempting aforeign corporation that trades in stocks, securities, andderivatives for its own account from being treated as engaged in aU.S. trade or business-an exemption that many states alsoapply.
A foreign person who invests in a partnership that is engaged ina U.S. trade or business is deemed to be engaged in a U.S. trade orbusiness itself, regardless of the number of partnership tiersbetween the initial partnership and the foreign partner.
Effectively Connected Income
If a master fund is engaged in a US trade or business, certainforeign-source income earned by the masterfund may be effectively connected income (ECI). Certainincome, gain, or loss from foreign sources is treated aseffectively connected with the conduct of a U.S. trade or businessif the nonresident alien individual or foreign corporation has anoffice or other fixed place of business within the United States towhich such income, gain, or loss is attributable and such income,gain, or loss.2
Similar results may arise if the master fund is investing inU.S. real estate. Under the Foreign Investment in Real Property Tax Act of1980 (FIRPTA), a foreign person's gain or loss from thedisposition of a United States real property interest istreated as if it is effectively connected with a U.S. trade orbusiness. A United States real property interest includes a) aninterest in real property (including an interest in a mine, well,or other natural deposit) located in the United States or theVirgin Islands, and b) any interest (other than an interest solelyas a creditor) in any domestic corporation unless the taxpayerestablishes that such corporation was at no time a United Statesreal property holding corporation.
What is a Trade or Business?
The Internal Revenue Code does not define the phrase "tradeor business within the United States." However, the Codeprovides that the term "trade or business within the UnitedStates" includes the performance of personal services withinthe United States at any time within the taxable year, but does notinclude" certain personal service activity, and does notgenerally include "trading in stocks or securities" ortrading in commodities. The IRS has adopted afacts-and-circ*mstances test to determine whether a foreignperson's activities result in a trade or business within theUnited States.
Trading Safe Harbors
The Trading Safe Harbors provides two statutory safe harborsunder which certain trading activities conducted by or for aforeign person that might otherwise constitute a trade or businesswithin the United States are deemed not to give rise to a trade orbusiness within the United States.
The first trading safe harbor provides that the term "tradeor business within the United States" does not include"[t]rading in stocks or securities3 through a resident broker,commission agent, custodian, or other independent agent."§ 864(b)(2)(A)(i).4 The trading safe harbor does notapply, however, if the foreign person maintains an office or otherfixed place of business in the United States at any time during thetaxable year through which the transactions in stocks or securitiesare effected.
The second Trading Safe Harbor provides that the term"trade or business within the United States" does notinclude "[t]rading in stocks or securities for thetaxpayer's own account, whether by the taxpayer or hisemployees or through a resident broker, commission agent,custodian, or other agent, and whether or not any such employee oragent has discretionary authority to make decisions in effectingthe transactions.5" This safe harbor is notavailable to a dealer in stocks, securities, or commodities. On theother hand, it may apply to a foreign person who has an office orother fixed place of business in the United States.
Footnotes
1. The choice of the corporate form may also leadto the FF being classified as a passive foreign investmentcompany" ("PFIC") under IRC §1297. A foreigncorporation is a PFIC if either a) 75 percent or more of its grossincome for the tax year is passive income (passive income test), orb) on average 50 percent or more of its assets produce passiveincome or are held for the production of passive income (passiveasset test). An asset is generally characterized as passive if itgenerates, or is reasonably expected to generate in the reasonablyforeseeable future, passive income as defined in IRC §1297(b).The FF is commonly referred to as a blocker entity because itprevents income flow through treatment to the investors in theFF.
2. The term "securities" means anynote, bond, debenture, or other evidence of indebtedness, or anyevidence of an interest in or right to subscribe to or purchase anyof the foregoing; and the effecting of transactions in stocks orsecurities including buying, selling (whether or not by enteringinto short sales), or trading in stocks, securities, or contractsor options to buy or sell stocks or securities, on margin orotherwise, for the account and risk of the taxpayer.
3. If a foreign person is not a dealer, the termengaged in trade or business within the United States does notinclude effecting transactions in derivatives for thetaxpayer's own account, including hedgingtransactions.
4. The phrase "effecting of transactions instocks or securities" includes buying, selling, shorting ortrading stocks, securities, or options or contracts to buy or sellstocks or securities for the account and risk of the taxpayer, andany other activities closely related to those activities, such asobtaining credit.
The content of this article is intended to provide ageneral guide to the subject matter. Specialist advice should besought about your specific circ*mstances.
