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Hedge Funds Are Anxiously Eyeing IRS Rules On Insurance Wrappers

by Leroy James, for Investors Offshore, New York

11 December 2002

A hedge fund conference in New York this week was slated to discuss insurance-based hedge funds, but it was their taxation that took over the discussion, after the US Treasury made it clear recently that it was unhappy with many of the structures that purport to offer investors tax-free funds by 'wrapping' the fund units as insurance products such as variable life and annuity contracts.

A recent Internal Revenue Service ruling in a response to a private enquiry by Keyport Life Insurance was negative, saying that only dedicated hedge funds set up by insurers would allow the products sold to investors keep their insured character, rather than being treated as mutual funds, whose income and capital gains are taxed annually in the US, whether distributed or not.

In a plain vanilla version of the 'wrapping' technique, an investor buys an insurance policy that invests the premiums in a hedge fund or funds the investor chooses from a list. Growth in the insurance policy is tax-free, and if the policy is structured correctly it also escapes inheritance tax.

A more complex version of the structure employes an offshore insurance company to make the hedge fund investments and investors buy shares in the insurance company in order to share in the growth of the hedge fund.

Although many of these arrangements are legal under current rules, those involving offshore companies may be abusive, says the Treasury. Rosemary Gilchrist, an executive of Tremont Advisers Inc., says that one likely issue for the Treasury Department is whether some insurers are giving investors too much control over their investments. The Treasury also might be exploring whether offshore companies are taking enough real insurance risk in order to justify their special tax treatment, or whether they are simple 'put-through' shells. An insurance company is of course entitled to make investments with its retained capital and reserves, but only as an ancillary activity to its insurance business.

Some speakers at the conference wanted to dispute the IRS's position that wrapping hedge funds in tax-free products fails to make them tax-free, but others said that the government is likely to require hedge fund managers to set up separate funds for insurance investors, as is already the case for conventional mutual funds, so that any other technique is already too risky.

Most insurers are expected to take a cautious approach, either asking hedge fund managers to set up separate funds for insurance investors or setting up separate funds that invest in a variety of existing hedge funds, arguing that the fund of funds is a unique product. The IRS may disapprove of any type of hedge fund wrapping, but Sandra Manske, co-chairman and co-chief executive of Tremont Advisers, said she thought that it would be possible to defend the fund of funds approach against an IRS attack, saying: "I think that's an argument we could win."

Even if the IRS applies the same treatment to wrapped hedge funds as it does to wrapped mutual funds, there is still an advantage for the insurance companies in being able to market hedge funds direct to small investors in this way, which would otherwise have to register with the SEC and acceptonerous reporting requirements to achieve the same goal.

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