IRS Attacks Hedge Fund Managers' Offshore Tax Deferral Technique

by Mike Godfrey, Tax-News.com, New York

18 February 2003

According to the Wall Street Journal, the Internal Revenue Service is actively targeting the methods used by hedge fund managers to defer tax on their own, often very substantial, earnings. Fund managers make use of offshore fund subsidiaries, exchanging their onshore entitlement to fees for future-dated holdings in the offshore funds, which allow deferral of tax since they are dependent on the performance of the fund.

The Journal says that the IRS is attacking III Offshore Advisors, which manages a Florida-based bond fund, as a test case. The IRS claims it failed to report $192m of income which was exchanged for shares in in III's offshore fund, which can only be redeemed in 2005.

To take advantage of this form of deferral, hedge funds must choose to account for their income on a "cash" rather than an "accrual" basis. The IRS points to the fact that, while III's offshore company uses a cash basis of accounting, its onshore company uses accrual accounting. The IRS also says that III was erratic in its use of deferral, indicating that the practice was being used solely for tax planning.

If the IRS is successful with III, it is sure to follow up with other hedge funds, and it is said to be preparing a number of dossiers.

The regulatory and fiscal pressure on US hedge funds is now reaching a point at which many of the funds must be thinking about moving offshore, lock, stock and barrel. Apart from the SEC's ongoing study of the hedge fund sector, which is widely expected to lead to a more extensive program of registration than the current voluntary system, the Treasury issued a proposed rule requiring investment companies not registered with the Securities and Exchange Commission to establish an anti-money laundering program as specified under section 352 of the Patriot Act.

In addition there is a likelihood that Congress will worsen the tax position of US companies with offshore subsidiaries and assets in the course of legislating to comply with the WTO ruling which strikes down the ETI (Extra-Territorial Income) regime, although the shape of eventual legislation is still hazy in the extreme.

There are already significant concentrations of hedge fund activity and expertise in various offshore jurisdictions, with Hong Kong being a leading example. The problem for a US hedge fund manager however is that a move offshore will quite probably increase the tax difficulties of his US clients, not to mention worsening his own tax position (if he is a US national).

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