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US Senate Examines Offshore 'Blocker' Corporations

by Mike Godfrey,, Washington

28 September 2007

A Senate Finance Committee hearing on Wednesday sought to shed light on the hedge fund investments of tax-exempt entities such as college endowments, and in particular, their use of offshore 'blocker' corporations to avoid Unrelated Business Income Tax (UBIT).

Under US law, tax exempt bodies are subject to UBIT when they exploit their tax-exempt status by acquiring an unrelated operating business and enabling that business to compete with taxable enterprises. However, to avoid UBIT, tax-exempt organizations today can invest in a hedge fund’s foreign fund, which mirrors the US private partnership fund but is not subject to UBIT.

"Foundations and other nonprofits are some of the largest investors in hedge funds," Finance Committee Chairman Max Baucus observed in his opening statement at the hearing. "The law requires nonprofit investors that invest directly in hedge fund partnerships to pay the unrealized business income tax. The policy behind the law is that tax exempt entities should not be able to have an unfair advantage over tax-paying entities doing the same thing."

Baucus revealed that in order to avoid UBIT, nonprofit investors sometimes invest in hedge funds through offshore entities incorporated in low or no tax jurisdictions - entities known as “blockers”.

Committee ranking member, Sen. Charles Grassley, also expressed concern about these transactions.

"This committee should analyze the underlying policy of the debt financing rules," Grassley stated. "I am concerned that tax exempt organizations are so easily able to plan around those rules with offshore structures."

Moves are already afoot in Congress to restrict tax exempt organizations from investing offshore. Earlier this month, Rep Sander Levin (D - Mi) introduced legislation into the House of Representatives designed to encourage tax-exempt entities to invest directly in US-based hedge funds rather than routing their investments offshore.

The bill seeks to amend the Internal Revenue Code of 1986 to provide that indebtedness incurred by a partnership in acquiring securities and commodities is not treated as acquisition indebtedness by organizations which are limited partners for the purposes of the unrelated business income tax.

The Senate hearing also examined the issue of hedge fund manager compensation, and their use of offshore blocker corporations to receive fees from tax-exempt bodies, enabling some to defer their income.

"Deferring income means that you pay taxes later, which is the same as a significant tax savings," Baucus noted, going on to add that on this issue "people can legitimately question whether someone is avoiding paying their taxes".

Under legislation sponsored by Sen. Bryan Dorgan, deferrals would be eliminated for subsidiaries of US companies located in certain jurisdictions if they cannot demonstrate that they have real operations in those locations.

"They have to have a real active business in that area to avoid US taxation," Dorgan testified during the hearing.

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