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. US-based hedge fund managers who have significant potential investors outside the United States and/or US 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 US 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 US 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 US limited partnership or limited liability company as the feeder fund for US taxable investors and a foreign corporation as the offshore feeder for foreign investors and US 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 US limited partnership or limited liability company for US investors and a foreign corporation for foreign investors and US tax-exempt organisations.
US Tax Exempt Investors
The typical investors in an offshore hedge fund structured as a corporation will be foreign investors, US tax-exempt entities and offshore funds of funds. US tax-exempt investors favour investments in offshore hedge funds because they may have exposure to US taxation if they invest in US-based hedge funds. Under US 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 US tax-exempt investor invests in a hedge fund that uses leverage (eg, trades on margin).
The UBTI tax is avoided by investing in an offshore hedge fund. A US-based hedge fund manager should consider setting up an offshore fund if he or she manages money for foreign and/or US tax-exempt investors. Although certain organisations, such as qualified retirement plans, generally are exempt from federal income tax, (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 organisation'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 organise separate offshore hedge funds for tax-exempt investors and have such corporate funds participate in the master/feeder fund structure.
US Individual Investors
Offshore hedge funds are generally organised as corporations for marketing, tax and legal reasons. Less frequently, offshore hedge funds will elect to be treated as a partnership for US tax purposes to attract US individual investors as well as participate in master/feeder fund arrangements. If US taxable investors invest in or effectively control an offshore hedge fund, some complex US 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 controlled foreign corporations, foreign personal holding companies or a passive PFIC. To attract US individual investors, fund sponsors organise separate hedge funds that elect to be treated as partnerships for US tax purposes so that these investors receive favourable tax treatment. These funds participate in the master/feeder structure. Under the US entity classification (ie, check-the-box) rules, an offshore hedge fund can elect to be treated as a partnership for US 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.
US Reporting Requirements
An interesting issue that has arisen in the context of the master/feeder fund structure concerns the nature of US 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 United States (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:
- 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 United States (ie, no effectively connected income or ECI).
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