Hedge Funds and Taxes
Hedge funds provide a vehicle to pool private capital for investment in stocks, securities and financial derivatives. While hedge funds take on many different structures-including master-feeder, parallel, or fund-of-funds structures-they share many similar tax considerations.
Hedge fund tax issues include entity classification, tax allocations, the taxation of carried interests, swap taxation, withholding, and numerous other issues. In this Insight post, we discuss the typical hedge fund structure and usual players, as well as several common tax issues.
Typical Hedge Fund Structures
Most hedge funds use one of the following organizational structures: 1) a single entity fund, 2) a master-feeder fund, 3) a parallel fund, or 4) a fund of funds.
A typical hedge fund structure involves an entity formed as a partnership for U.S. federal tax purposes acting as an investment manager with a separate entity functioning as a general partner. The investment or fund manager is generally compensated through a management fee, typically tied to a percentage of the fund's net asset value. In addition, the general partner generally receives an allocation of partnership profits (net of prior losses and management fees) that is based on the master fund's performance. 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 through unregistered offerings. Unlike private equity, however, hedge funds function more like an open-ended mutual fund, investing in public securities, rather than private-held operating companies. Many leverage investments using debt in order to enhance returns or employ investment vehicles such as straddles and short positions.
Hedge funds are privately owned, with investments that are generally more liquid than those of private equity funds.
Hedge Fund Regulatory Environment
Unlike mutual funds, hedge funds operate in a largely unregulated environment. Sponsors generally raise capital through unregistered Reg. D offerings to "accredited investors" and take measures to avoid registration under the Investment Company Act of 1940, thereby avoiding certain diversification and borrowing restrictions under the act.
The Hedge Fund Players
Master Fund: The Master Fund, often a foreign entity or U.S. LP or LLC, is typically treated as a partnership for U.S. tax purposes. The Master Fund invests capital from any foreign feeder and domestic feeder.
Investment Manager: The Investment Manager manages the master fund's portfolio for the investors. The Master Fund typically enters into an agreement to pay the Investment Manager a management fee.
General Partner: The General Partner usually holds a small interest in the Master Fund and/or feeder funds. The general partner participates in the master fund's economic performance through a "carried interest"-a profits interest.
Domestic Feeder: The domestic feeder is generally a U.S. pass-through entity whose income that is allocated from the Master Fund to DF would be subject to US taxation at the partner level.
Foreign Feeder: The foreign feeder is typically a foreign corporation formed in a low or no-tax jurisdiction. For US tax purposes, the FF is treated as a corporation. US tax-exempt investors (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. Any distributions from the FF to its foreign investors are treated as dividends for US tax purposes.1
Internal Revenue Code section 1061, which was enacted by the Tax Cuts and Jobs Act of 2017, affects certain carried interest arrangements. Generally, under section 1061, certain carried interest arrangements (known as "applicable partnership interests") must be held for more than three years for the related capital gains to qualify for long-term capital gain treatment.
An applicable partnership interest is an interest in a partnership that is transferred to or held by a taxpayer, directly or indirectly, in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business.
Many private equity (PE) funds, hedge funds, and other asset management funds are subject to section 1061's treatment of carried interests. Where it applies, section 1061 recharacterizes certain net long-term capital gains of a partner that holds one or more applicable partnership interests as short-term capital gains.
Engaging in a US Trade or Business
The hedge fund's master fund will generally seek to avoid its activities being deemed to be a U.S. trade or business. For example, it will seek to avoid U.S. trade or business status due to the impact on most tax-exempt and foreign investors, as well as avoidance of the net-basis tax regime imposed upon effectively connected income.
Foreign corporations that are deemed to be "engaged in a trade or business" in the United States are, generally speaking, subject to U.S.tax on income that is "effectively connected" with that trade or business, as well as a "branch profits" tax on certain income. The code, however, provides a safe harbor, exempting a foreign corporation that trades in stocks, securities, and derivatives for its own account from being treated as engaged in a U.S. trade or business-an exemption that many states also apply.
A foreign person who invests in a partnership that is engaged in a U.S. trade or business is deemed to be engaged in a U.S. trade or business itself, regardless of the number of partnership tiers between the initial partnership and the foreign partner.
Effectively Connected Income
If a master fund is engaged in a US trade or business, certain foreign-source income earned by the master fund may be effectively connected income (ECI). Certain income, gain, or loss from foreign sources is treated as effectively connected with the conduct of a U.S. trade or business if the nonresident alien individual or foreign corporation has an office or other fixed place of business within the United States to which such income, gain, or loss is attributable and such income, gain, or loss.2
Similar results may arise if the master fund is investing in U.S. real estate. Under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), a foreign person's gain or loss from the disposition of a United States real property interest is treated as if it is effectively connected with a U.S. trade or business. A United States real property interest includes a) an interest in real property (including an interest in a mine, well, or other natural deposit) located in the United States or the Virgin Islands, and b) any interest (other than an interest solely as a creditor) in any domestic corporation unless the taxpayer establishes that such corporation was at no time a United States real property holding corporation.
What is a Trade or Business?
The Internal Revenue Code does not define the phrase "trade or business within the United States." However, the Code provides that the term "trade or business within the United States" includes the performance of personal services within the United States at any time within the taxable year, but does not include" certain personal service activity, and does not generally include "trading in stocks or securities" or trading in commodities. The IRS has adopted a facts-and-circumstances test to determine whether a foreign person's activities result in a trade or business within the United States.
Trading Safe Harbors
The Trading Safe Harbors provides two statutory safe harbors under which certain trading activities conducted by or for a foreign person that might otherwise constitute a trade or business within the United States are deemed not to give rise to a trade or business within the United States.
The first trading safe harbor provides that the term "trade or 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 not apply, however, if the foreign person maintains an office or other fixed place of business in the United States at any time during the taxable year through which the transactions in stocks or securities are effected.
The second Trading Safe Harbor provides that the term "trade or business within the United States" does not include "[t]rading in stocks or securities for the taxpayer's own account, whether by the taxpayer or his employees or through a resident broker, commission agent, custodian, or other agent, and whether or not any such employee or agent has discretionary authority to make decisions in effecting the transactions.5" This safe harbor is not available to a dealer in stocks, securities, or commodities. On the other hand, it may apply to a foreign person who has an office or other fixed place of business in the United States.
1. The choice of the corporate form may also lead to the FF being classified as a passive foreign investment company" ("PFIC") under IRC §1297. A foreign corporation is a PFIC if either a) 75 percent or more of its gross income for the tax year is passive income (passive income test), or b) on average 50 percent or more of its assets produce passive income or are held for the production of passive income (passive asset test). An asset is generally characterized as passive if it generates, or is reasonably expected to generate in the reasonably foreseeable future, passive income as defined in IRC §1297(b). The FF is commonly referred to as a blocker entity because it prevents income flow through treatment to the investors in the FF.
2. The term "securities" means any note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing; and the effecting of transactions in stocks or securities including buying, selling (whether or not by entering into short sales), or trading in stocks, securities, or contracts or options to buy or sell stocks or securities, on margin or otherwise, for the account and risk of the taxpayer.
3. If a foreign person is not a dealer, the term engaged in trade or business within the United States does not include effecting transactions in derivatives for the taxpayer's own account, including hedging transactions.
4. The phrase "effecting of transactions in stocks or securities" includes buying, selling, shorting or trading stocks, securities, or options or contracts to buy or sell stocks or securities for the account and risk of the taxpayer, and any other activities closely related to those activities, such as obtaining credit.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.