Kaiser ABA Hedge Fund Tax


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Building Blocks of Hedge Fund Taxation

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Kaiser ABA Hedge Fund Tax

  1. 1. Building Blocks of Hedge FundTaxationKevin W. KaiserSeptember 27, 2006 1
  2. 2. Hedge Funds - Topics Hedge funds defined Investments and strategies Formation and structural issues Investors Operational issues Tax reporting 2
  3. 3. Hedge Funds Defined Privately organized investment vehicle Term of art May be domestic or foreign May be pass through or corporate entity Generally, not registered under the Investment Company Act of 1940 Benefits of not being registered in the U.S. Distinguish from mutual fund 3
  4. 4. Hedge Funds DefinedOne possible definitionA privately organized investment vehicle thatmanages a concentrated portfolio of publicsecurities and derivative instruments on publicsecurities, that can invest both long and short,and can apply leverage.Mark J.P. Anson, The Handbook of Financial Instruments 605 (Frank J. Fabozzi ed., 2002). 4
  5. 5. Hedge Funds – Distinguish from MutualFunds (selected items) Distribution requirements Mutual funds must make annual distributions of investment income Diversification requirements Hedge funds tend to have concentrated portfolios Mutual funds must diversify Qualifying income requirement Mutual funds must earn income from certain qualifying sources No such requirement for hedge funds Minimum Investment Hedge fund minimum investments are typically large Mutual funds typically have small or no minimum investment 5
  6. 6. Hedge Fund Investments There is no requirement to “hedge” Securities may be actively traded or held long term for investment Hedge fund investments may include Debt Equity Currency Commodities (distinguish from mutual funds) Derivatives 6
  7. 7. Hedge Fund StrategiesHedge funds use a variety of strategies, including: Equity long/short Short selling Convertible bond arbitrage Merger arbitrage Fixed income arbitrage Mortgage-Backed Securities Arbitrage Distressed debt Event driven Market timing Relative value 7
  8. 8. Hedge Fund StrategiesHedge funds use a variety of strategies, including: Single-strategy funds Funds that focus on one investment technique Multi-strategy funds Use various strategies simultaneously Fund of funds Generally used to increase diversification Invests solely in other funds 8
  9. 9. Hedge Fund Formation and StructuringEntity types Corporate Fund Generally used for offshore funds Pass through entity Generally used for onshore funds Usually classified as a partnership for U.S. tax purposesDecision driver – Tax consequences to investors Corporations – accumulate income and losses at the corporate level Partnerships – pass-through income and losses 9
  10. 10. Hedge Fund Formation and StructuringInvestor classifications Non-U.S. Investors U.S. Taxable Investors U.S. Tax-Exempt Investors 10
  11. 11. Hedge Fund Formation and StructuringOnshore Funds Limited Liability Companies (classified as partnerships for tax purposes) or partnerships Pass-through tax treatment 11
  12. 12. Hedge Fund Formation and StructuringOffshore Funds Corporations No pass-through Formed in low-tax or no-tax jurisdictions U.S. tax-exempts and foreign investors Generally, not subject to U.S. income tax 12
  13. 13. Hedge Fund Formation and StructuringTypes of fund structures Single manager funds (stand alone) Foreign structure Domestic structure Parallel funds Multi-manager funds (umbrella fund) Master-feeder structures Fund of funds 13
  14. 14. Single-Manager (Stand alone) Non U.S. Investors Tax-Exempts (shareholders) Administrator Offshore Corporate Fund Prime Broker Investment Manager 14
  15. 15. Single-Manager (Stand alone) U.S. Taxable Investors General Partner (limited partners) Administrator Limited Partnership Prime Broker (U.S.) Investment Manager 15
  16. 16. Parallel Fund U.S. Principals Individuals U.S. Tax-ExemptsU.S. Limited Partners (Taxable) U.S. GP Foreign Investors (U.S. LP or LLC) Investment Manager (U.S. LP) Offshore Investment Vehicle U.S. Investment Vehicle (Foreign Corp) (U.S. LP) 16
  17. 17. Multi-Manager Fund (umbrella fund) U.S. Investors (Taxable) Fund A shares B shares C shares D shares E shares Sub Fund Sub Fund Sub Fund Sub Fund Sub Fund Investment Investment Investment Investment Investment Manager Manager Manager Manager Manager 17
  18. 18. Master-Feeder Structure U.S. Principal(s) IndividualsU.S. Limited Partners Foreign Investors (Taxable) U.S. GP U.S. Tax-Exempts (U.S. LP or LLC) Investment Manager (U.S. LP) Domestic Master Fund Partnership – CTB Foreign Feeder Feeder (Foreign Corp) (U.S. LP) (Offshore) 18
  19. 19. Fund-of-Funds U.S. Investors (Taxable) Fund of Fundsmanager Fund Fund Fund Fund Fund (LP) (LP) (LP) (LP) (LP) Investments Investments Investments Investments Investments 19
  20. 20. Operational Issues Asset based: X percent of committed capital Incentive based: X percent of profits aka, “carry” or “carried interest” Other features High water mark Incentive compensation only derived from net positive performance measured cumulatively Hurdle rate Incentive compensation earned when fund performance exceeds specified market index or rate for a given time period 20
  21. 21. Operation IssuesFund Manager Compensation Arrangements Asset based compensation is typically structured as a fee Incentive based compensation Partnership interest transferred to a partner as compensation Typically, structured as a profits interest – Rev. Proc. 93-27 and Rev. Proc. 2001-43 Proposed regulations on compensatory partnership interests - Proposed Treas. Reg. § 1.721-1(b)(2); Proposed Treas. Reg. § 1.83-3(e); IRS Notice 2005-43 21
  22. 22. Operational IssuesFund Manager Compensation Arrangements Deferred compensation New rules provided in section 409A that address payment of deferred compensation Proposed Treas. Reg. § 1.409A-1; IRS Notice 2005-1 Proposed rules provide a number of anti-deferral provisions 22
  23. 23. Operational Issues“Trader” vs. “Investor” Classification The trader vs. investor classifications is an important distinction that is relevant to the treatment of the fund expenses and the opportunity to use the mark-to- market method of accounting. Taxpayers who buy and sell securities can be “dealers,” “traders,” or “investors” Dealers maintain inventory and sell to customers Hedge funds generally do not have “customers” and so cannot be considered dealers 23
  24. 24. Operational Issues“Trader “ vs. “Investor” Classification Accounting for management fees “Traders” deduct as section 162 business expenses “Investors” treat as production of investment income expense under section 212 and deduct as miscellaneous itemized deduction The standards that determine “trader in securities” for purposes of the section 475(f) mark-to-market election are related to the determination of whether a trader is engaged in a trade or business 24
  25. 25. Operational Investors“Trader” vs. “Investor” Classification No definition of “trader” or “investor” Facts and circumstances test Taxpayer must be engaged in trade or buinsess Must be regular and continuous. Comm’r v. Groetzinger, 480 U.S. 23 (1987) Traders are in and out of the market seeking profit from movement in prices. Higgins v. Comm’r, 312 U.S. 212 (1941); Liang v. Comm’r, 23 T.C. 1040 (1955) 25
  26. 26. Operational Issues“Trader” vs. “Investor” Classification Recent Developments Chen v. Comm’r, T.C. Memo 2004-132: Case involved day trader that failed to qualify for mark-to-market method of accounting under section 475(f). Failure to properly elect MTM. Failure to qualify as trader in securities IRS Tech. Adv. Mem. 200423015 and 200429011: Taxpayers failed to properly elect section 475(f) MTM method of accounting. IRS rejected late elections Vines v. Comm’r, 126 T.C. No. 15 (2006): Taxpayer was entitled to "section 9100" relief to permit late election of mark-to-market method 26
  27. 27. Operational IssuesTax Allocations for U.S. Onshore partnerships Subchapter K rules control Under section 704(b), allocations of partners’ distributive shares are generally determined in accordance with the partnership agreement, provided: Allocations have substantial economic effect, or Allocations are made in accordance with partner’s interest in the partnership Allocations of partnership items are generally required to be taken into account by the partners for their tax year in which the tax year of the partnership ends 27
  28. 28. Operational Issues Partnership may revalue its assets as a result of certain events Revaluations generally must reflect unrealized gains and losses on a property by property basis Special rules for “securities partnerships” 28
  29. 29. Operational Issues Special rules for “securities partnerships” Special aggregation rules under section 704(c) for securities partnerships Treas. Reg. § 1.704-3(e)(3) Rules permit securities partnerships to make section 704(c) allocations on a net basis Partnership may aggregate gains and losses from “qualified financial assets” to determine partners reverse section 704(c) allocations. 29
  30. 30. Operational Issues Special rules for “securities partnerships” Defined Terms Securities partnership Qualified financial asset 30
  31. 31. Operational Issues Tax Allocations for U.S. Onshore partnerships Special Hedge Fund Allocations Issues Fill-up and Fill-down Lot layering Side Pockets Hot Issues Mandatory basis adjustments (sections 734 and 743) Return disclosure issues Opportunity to elect out 31
  32. 32. Operational Issues and Reporting Mandatory basis adjustments and disclosures IRS Notice 2005-32; Treas. Reg. § 1.734-1(d) and Treas. Reg. § 1.743-1(k). Partnership distributions Transfers of partnership interests Rules for Electing Investment Partnership (EIP) Required Disclosures and Statements 32
  33. 33. Operational IssuesInvestment Activities Tax Issues The normal rules that govern the tax treatment of financial instruments and products applies to hedge funds. These rules control the amount, timing, character, and source of the funds portfolio income. Debt Securities Equity Securities Commodities 33
  34. 34. Operational IssuesInvestment Activities Tax Issues Special rules governing the taxation of financial instrument transactions. (Potential book/tax differences – selected issues) Short sales – section 1233 Wash sales – section 1091 Straddles – section 1092 Constructive sales – section 1259 Constructive ownership – section 1260 Notional Principal Contracts (aka, swaps) – Treas. Reg. § 1.446-3 Futures and Forwards – section 1256 Options – section 1234 Hedging – section 1221 and Treas. Reg. § 1.446-4 34
  35. 35. Hedge Fund Activities Offshore Hedge funds activities offshore can generate income that is effectively connected with the conduct of a trade or business within the U.S. Effectively connected income (“ECI”) may be earned: By the fund itself, if a corporation By foreign investors, if a partnership If a foreign investor or corporation has ECI, a U.S. tax return is generally required under section 6012 If return is not filed, the taxpayer will not be allowed any deductions. Sections 874(a) and 882(c)(2) 35
  36. 36. Hedge Fund Activities Offshore Hedge funds and the “trade or business” concept for purposes of ECI. Facts and circumstances test Profit oriented Regular and continuous activity Financing activities Debt funds 36
  37. 37. Tax ReportingDomestic U.S. Federal Partnership Tax Return Form 1065 Partner Schedule K-1s State Partnership Tax Returns Withholding on Non-U.S. Partners State tax withholding 37
  38. 38. Tax Reporting – Other Issues Passive Foreign Investment Company (“PFIC”) Statements 75 percent gross income test or 50 percent asset test Interest in Foreign Partnership Form 8865 38
  39. 39. Tax Reporting – Other Issues Unrelated Business Taxable Income (UBTI) Income defined for IRAs, pensions, other tax-exempt entities Investment and portfolio type income generally excluded from UBTI definition Leveraged or debt financed income usually creates UBTI 39
  40. 40. Tax Reporting – Other Issues Dividend Received Deduction (DRD) Foreign dividends do not qualify for DRD Stock held less than 45 days Diminished risk (hedged) 40
  41. 41. Tax Reporting – Other Issues Tax Shelter Reporting – Reportable transactions under Treas. Reg. § 1.6011-4(b). Form 8826. Confidential transactions Transactions with contractual protection Loss transactions Transactions involving a brief asset holding period Listed transactions Protective disclosures IRS Notice 2006-16 safe harbor relief regarding protective disclosures for IRS Notice 2002-35 contingent deferred swaps. 41
  42. 42. Tax Reporting – Other IssuesOther elections and considerations Section 475(f) election to adopt mark-to-market method of accounting. Timing - Election under section 475(f) must be filed no later than the original due date (without extensions) of the federal income tax return for the prior year Treat income and losses as ordinary 42
  43. 43. Tax Reporting – Other IssuesOther elections and considerations Proposed swap regulations for contingent nonperiodic payments. Treas. Reg. § 1.446-3 Requires noncontingent swap method (NCSM) Mark-to-market election available Wait-and-see method not permitted 43
  44. 44. Building Blocks of Hedge Fund Taxation Q&A 44
  45. 45. ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED TO BE USED,AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FORTHE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANYTAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHERPARTY ANY MATTERS ADDRESSED HEREIN.The information contained herein is of a general nature and is not intended to address the circumstances of anyparticular individual or entity. Although we endeavor to provide accurate and timely information, there can be noguarantee that such information is accurate as of the date it is received or that it will continue to be accurate in thefuture. No one should act on such information without appropriate professional advice after a thorough examinationof the particular situation. 45