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The IRS Takes Aim At The Hedgies

by Mike Godfrey,, New York

05 November 2007

The Internal Revenue Service announced last week that it is targeting seven areas for possible tax abuse at hedge funds and private-equity firms, explaining that: "The service seeks to identify any areas of possible non-compliance in the income tax reporting of hedge fund and private equity fund investors and managers, as well as possible non-compliance in the reporting of withholding obligations."

The IRS listed the seven areas:

  • Compliance with filing requirements;

  • Issues related to investor, trader, dealer and business activities, including loan origination;

  • Income recognition;

  • Characterization of income as ordinary or capital gains;
  • The flow of funds between onshore and offshore entities;
  • The allocation and timing of incentive payments and other income;
  • The accounting methods used to reflect income.

IRS officials have reportedly said that the enquiry was particularly focused on the use of derivatives to avoid withholding taxes.

Much discussion in Congress over the perceived need to rein back the high incomes being achieved by hedge fund managers culminated last week in the launch of Representative Charles Rangel's Tax Reduction and Reform Act of 2007, which seeks to pay for populist tax cuts by cutting back a numnber of corporate tax breaks, including a change in the tax treatment of "carried interest" for fund managers, so that they will no longer receive the lower 15% capital gains tax rate for what is, according to Rangel, "essentially a management fee or payment for services, which generally are taxed as ordinary income". The bill would, however, continue to tax carried interest at capital gains tax rates to the extent that carried interest reflects a "reasonable return" on invested capital.

These is also more bad news for hedge fund managers in the legislation, in the shape of curbs on the the use of offshore corporations and other structures to defer taxes on compensation received for providing investment services. The measure is also designed to eliminate the incentive for exempt entities to invest in hedge funds and other investment funds through so-called offshore “blocker” corporations.

Rangel's bill may stand no chance of success, despite its focus on the AMT, but faced with a probable eight years of Democrat Congressional savaging, many hedge fund managers are probably already packing their bags for the friendlier climes of Switzerland, Luxembourg, London and Dublin, in what may turn out to be a re-run of the suicidal Eurobond fiasco of the 1960s.

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