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January 8, 2008
Offshore Explorations: Caribbean Hedge Funds, Part 1
by Martin A. Sullivan and Lee A. Sheppard

Full Text Published by Tax Analysts®

Document originally published in Tax Notes
on January 7, 2008.

The taxation of hedge fund managers has been in the news, but precious little attention has been paid to the taxation of U.S. individual investors in hedge funds. Those investors are taxable on their worldwide income, but offshore hedge funds offer opportunities for evasion. In 1999 a Treasury working group study on hedge funds briefly alluded to the possibility of evasion by investors in offshore hedge funds:

      In the tax area, the fact that a significant number of hedge funds are established in offshore financial centers that are tax havens has focused attention on whether offshore hedge funds are associated with illegal tax avoidance.

But tax policy questions were deemed beyond the scope of the report and were discussed no further. (The report is available at http://www.treas.gov/press/releases/reports/hedgfund.pdf or from Tax Analysts as Doc 1999-15884.)

In 2005 we examined the world of evasion by investors in offshore hedge funds:


      Some of the rentier class are not paying tax on their hedge fund income. They are avoiding tax because the withholding rules are written so that the IRS cannot find out who is behind some types of investor entities.

We detailed the halfhearted effort that the IRS, cowed by fear of offending U.S. banks and their offshore clients, has put into preventing evasion by U.S. individuals investing in hedge funds through corporations and trusts. To plug the leaks, we proposed that the United States withhold tax on all outbound payments to tax havens. (See "Offshore Investments: Don't Ask, Don't Tell," Tax Notes, July 11, 2005, p. 171, Doc 2005-14577 , or 2005 TNT 132-4; and "Withholding Policy: Don't Ask, Don't Tell, Part 2," Tax Notes, May 8, 2006, p. 635, Doc 2006-8703, or 2006 TNT 89-10 .)

Most recently, it has been reported that noncompliance by hedge fund investors has gotten the attention of the IRS. In a February 7, 2007, article in The Wall Street Journal ("Tax Return Probe Into U.S. Private Equity Firms"), James Quinn wrote:


      The tax returns of American private equity houses and hedge funds are to be examined by the Internal Revenue Service in the latest potential clampdown on the alternative investment industry. . . . In a written statement, the IRS said it sought 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." [Emphasis added.]

The tax liabilities of managers of these funds have undergone a lot of scrutiny lately, but beyond these few mentions we are hard-pressed to find similar scrutiny of the treatment of investors. Given recent revelations by U.S. and U.K. tax authorities concerning widespread evasion by individuals with funds in offshore banks (see, e.g., "Keeping Score on Offshore: U.K. 60,000, U.S. 1,300," Tax Notes, July 2, 2007, p. 23, Doc 2007-15466, or 2007 TNT 128-2), why should we not also believe there is similar evasion in offshore hedge funds?

Tax evasion by means of offshore investment is quite easy for U.S. resident individual investors. U.S. tax, securities, and anti-money-laundering laws, as well as U.S. information agreements, don't do much to stop tax evasion. This article looks at the potential for this type of evasion.

Background

Because hedge funds disclose nothing to the government and very little to the public, nobody knows for sure, but the available data indicate that hedge fund assets have skyrocketed from $50 billion at the end of 1990 to $1.5 trillion in 2006. (Joint Committee on Taxation, "Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interests and Related Issues, Part I" (JCX-62-07), p. 11, Doc 2007-20255 or 2007 TNT 172-12.)

The usual hedge fund setup is a master-feeder arrangement. The "master" hedge fund itself is organized as a partnership in a tax and banking haven, giving it foreign residence according to the code. The leading domiciles for offshore hedge funds are the Cayman Islands, the British Virgin Islands, Bermuda, and the Bahamas.

The fund has two "feeders" that invest as partners: the domestic feeder for U.S. resident taxable investors and the foreign feeder for foreign investors and U.S. tax-exempt investors. The domestic feeder is a limited partnership, so all of its items of income, gain, deduction, or loss pass through to its partners.

The foreign feeder is usually a corporation organized in a no-tax jurisdiction. A corporation, as we shall see, provides anonymity to investors, blocks exempt investors from being considered owners of certain kinds of assets, and avoids putting foreign investors directly in a U.S. trade or business that generates effectively connected income.

In the following sections we review U.S. tax rules for hedge funds, focusing on aspects that relate to potential tax evasion by investors. After that we look at what roles U.S. security and anti-money-laundering laws might play in preventing U.S. tax evasion.

Despite tax, securities, and anti-money-laundering laws, U.S. investors in offshore hedge funds can sail away from their U.S. filing requirements. (BRITISH V.I. PRESS OFFICE)Part 2 of this article will review available data on hedge funds and try to quantify the offshore hedge fund assets owned by individuals who — because of a lack of information reporting to onshore tax authorities — might be evading taxes.

U.S. Investor, Domestic Fund

Although hedge funds themselves can usually avoid the corporate tax, U.S. investors in domestic hedge funds bear the full brunt of the individual income tax. As noted by the alternative investment advisory firm LJH Global Investments (http://www.ljh.com), "The trading strategies employed by the majority of hedge fund managers are generally short-term in nature and, thus, taxable at the 40 percent short-term ordinary income tax rate regardless of how long the fund is held." In other words, as Douglas Rogers writes, "By their very nature, most hedge funds will be notoriously tax inefficient." (Tax-Aware Investment Management: The Essential Guide, Bloomberg Press, 2006, p. 167.)


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SIDEBAR: Basic Hedge Fund Structures


The most common structure is the master-feeder, shown in Figure A. In a master-feeder structure, all the trading activity takes place at the master level. There is one investment vehicle and one portfolio to monitor. Income is allocated between the feeders according to the level of investment in each.


The other basic structure employed by hedge funds is known as side-by-side, shown in Figure B. A side-by-side fund is more costly to operate, but it allows tax planning in the domestic fund (for domestic taxable investors) without interfering with and adding to the cost of trading in the offshore fund (for foreign and domestic tax-exempt investors).


For the level of detail in this article, making a distinction between these two structures is not essential. For tax purposes, the critical distinction is between a foreign feeder corporation and a domestic feeder partnership.

___________________________________________________________________

In a domestic fund that is a limited partnership, the fund manager is the general partner, and investors are limited partners who receive flow-through treatment of hedge fund income. The fund files a Form 1065 and attaches copies of Form K-1 sent to each partner. The Forms K-1 report each investor's share of fund income and expenses. Each investor bears the annual responsibility of filing tax returns and paying taxes irrespective of whether any income is distributed.

Foreign Investor in a Partnership

The threshold question for foreign investors in a hedge fund is whether the fund generates income that is effectively connected with a U.S. trade or business. If it does and that fund is a partnership, the partnership must withhold U.S. tax unless the foreign partner provides the partnership with a completed Form W-8ECI, "Certificate of Foreign Person's Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States." In any case, by virtue of the investment in the partnership that generates ECI, the foreign investor is a U.S. taxpayer who must file a U.S. tax return, even if no tax is due. The investor would receive a Form K-1 from the fund, which it shares with the IRS when the fund files its Form 1065.

In general, whether a partnership (either domestic or foreign) generates ECI is a factual determination. Under current law, most hedge funds seek to qualify for the trading safe harbor under section 864(b)(2)(A). Despite this congressional accommodation to the industry, hedge fund income will not always escape characterization as ECI given the wide range of activities in which a hedge fund may be engaged. (See "Neither a Dealer Nor a Lender Be, Part 2: Hedge Fund Lending," Tax Notes, Aug. 15, 2005, p. 729, Doc 2005-17086, or 2005 TNT 157-3.)

If the partnership does not generate ECI, the foreign partners are still subject to withholding on some types of U.S.-source income. Most interest payments, including interest on bonds and bank accounts, are not subject to withholding. Capital gains (as long as they do not arise from the sale or exchange of a direct or indirect interest in U.S. real estate) are not subject to withholding.

But U.S.-source dividends are subject to withholding, the rate of which is frequently reduced by treaty. There are no treaties with the tax havens in which hedge funds and their foreign feeders organize. A foreign investor is required to file a Form W-8BEN, "Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding," to identify his foreign status and to qualify for treaty benefits if the investor is a resident of a country that has negotiated a tax treaty with the United States.

Foreign Investor in a Corporation

Foreign investors prefer to invest in the United States through corporations because their anonymity is preserved and because they are not required to file a U.S. tax return unless they have something else going on.

When a hedge fund is considered engaged in a U.S. trade or business, its ECI is subject to U.S. tax. As noted above, if the fund is a partnership, all that income will flow through to the foreign partners, who must file a U.S. return. If, however, the foreigner invests through a foreign feeder corporation, the latter must file a Form-1120F and pay U.S. corporate tax on the ECI. Although tax is due whether the feeder is a partnership or corporation, when a foreign individual invests in a foreign corporation, that individual avoids U.S. filing requirements related to that income and avoids direct payment of U.S. withholding tax on that income.

When a foreign corporation invests in a fund that qualifies for the trading safe harbor, it need not file a U.S. tax return. However, withholding tax is due on any U.S. dividends paid to the foreign corporation. The foreign corporation, rather than its investors, files a Form W-8BEN. Because the feeders are domiciled in tax havens, there is no chance for reduced withholding through treaty benefits. The payer of the dividend is permitted to rely on statements made in Form W-8 unless it has knowledge that the statement is incorrect. Otherwise, a foreign corporation is opaque, and its investors remain anonymous.

And so the identity of a foreign investor in a foreign corporation invested in a hedge fund remains totally unknown to the IRS. Article after article by practitioners stresses the importance foreign investors place on avoiding U.S. filing requirements and retaining their anonymity.

U.S. Investor in a Foreign Feeder Corporation

U.S. individual investors who invest in hedge funds through foreign feeder corporations almost always will be subject to the passive foreign investment company rules (IRC sections 1291 through 1298). The PFIC rules would apply regardless of how the U.S. investor invests in the feeder, whether individually (which hedge funds say they do not permit) or through a wholly owned foreign shell corporation (the most likely route for anonymity and plausible deniability). Such a shell corporation would be a controlled foreign corporation, but the PFIC rules would govern the treatment of the investor. PFIC status is self-reported on Form 8621 filed with the investor's tax return.

The foreign feeder corporation would be a PFIC for the U.S. investor for the same reason it would be an effective blocker for an exempt investor: It produces passive investment income. The PFIC rules, which have asset and income tests for PFIC status, are antideferral rules that largely eliminate any deferral benefit from passive offshore investment. The funds that the PFIC rules were drafted to attack were not unlike hedge funds in that investors bought and held for eventual capital gain, receiving no current distributions.

Under PFIC rules, the U.S. investor has three options. The first allows the investor to make a mark-to-market election, but that requires that fund shares be traded on an organized exchange. The second option imposes an interest charge on fund gains in addition to the deferred tax liability.

The third and most widely used option is for the U.S. investor to elect qualified electing fund (QEF) status. Under that method, the investor is taxed on current income essentially as if the corporation were a flow-through entity whether or not the income is actually distributed. For a U.S. investor to elect QEF status, the fund must be willing to provide annual information statements to the investor. There is no U.S. requirement that an offshore fund provide those statements. And a QEF election requires a lot of identifying information from the U.S. investor.

Some practitioners point out that under limited circumstances, a U.S. investor may find it advantageous from a tax perspective to make hedge fund investments in an offshore corporation rather than in a domestic partnership. (See Philip S. Gross, "Tax Planning for Offshore Hedge Funds — The Potential Benefits of Investing in a PFIC," Journal of Taxation of Investments, Winter 2004; and Andrew W. Needham and Christian Brause, Hedge Funds, BNA Tax Management Portfolio 736.) In general, however, because of the PFIC rules, there is little or no tax benefit for compliant U.S. investors in offshore funds.

Is there any tax advantage to incurring the expense of setting up an offshore shell corporation and investing in the fund in the name of that corporation? For U.S. resident investors who comply with the law, the answer is no. An offshore shell corporation beneficially owned by a U.S. citizen is a CFC. The owner (U.S. shareholder) of a CFC is currently taxable on its passive income, whether that income is repatriated or not. The owner must annually file a Form 5471 information return and include the CFC's passive investment income in adjusted gross income reported on Form 1040.

U.S. Tax Evader Investing in an Offshore Fund

The evidence that exists indicates that compliance with U.S. tax laws by U.S. resident investors holding offshore bank accounts is low. (For the latest compliance data, see "Offshore Account Reports Rising, but Compliance Remains Low," Tax Notes, June 18, 2007, p. 1099, Doc 2007-14435 , or 2007 TNT 118-7.) Is it unreasonable to suspect that U.S. investors use offshore hedge funds to evade taxes? Apparently, author Daniel Strachman does not think so. In his 2007 book The Fundamentals of Hedge Fund Management (Wiley & Sons 2007, p. 48), he writes:


      Most offshore investors do not care where the fund is domiciled as long as the location is deemed a tax-haven jurisdiction. If you want to grow your offshore operation, you will need to please U.S.-based investors who seek anonymity and who wish to avoid the U.S. government seeing their investments. [Emphasis added.]

Of course, it would be an empty victory if a U.S. investor successfully evaded individual income tax only to have a comparable level of tax imposed at the corporate level. If fund income was effectively connected with a U.S. trade or business, then the foreign feeder corporation would have to file a U.S. tax return and pay tax.

 Hedge Fund: Offshore Evasion vs. Investment in Domestic Partnership
 ---------------------------------------------------------------------------
                                             
U.S. Investor
 
                           U.S. Partner      Not Reporting
 
                           in Domestic       Offshore Fund
 
                           Partnership —    Income — U.S.
 
                           U.S. Income       Withholding      Difference:
 
                           Tax Rate on       Tax Rate on      Tax Reduction
 
Type of Income             Individual        Corporation      From Evasion
 ---------------------------------------------------------------------------

 Qualified Dividend             15%               30%             -15%
 Portfolio Interest             35%                0%             +35%
 Long-Term Capital Gain         15%                0%             +15%
 Short-Term Capital Gain        35%                0%             +35%

However, when there is no ECI, the foreign feeder does not have to file a corporate tax return or report to the IRS any payments made to investors. And there is no foreign corporate tax because the feeder and the fund are domiciled in a tax haven.

In that case (that is, when hedge fund income is not ECI), the major fly in the ointment for the would-be evader is U.S. withholding tax on U.S.-source dividends. The foreign corporation will be subject to the full 30 percent withholding tax rate on U.S.-source dividends because tax havens do not have tax treaties with the United States. This assumes, of course, that the brokers who paid over the U.S.-source dividends would comply with the law, which — as the 2004 U.S. amnesty for withholding agents of payments to foreigners demonstrated — many did not. (Rev. Proc. 2004-59, 2004-2 C.B. 678, Doc 2004-19238, 2004 TNT 190-13.)

The benefit to be derived from evading income tax on income from an offshore fund depends on the composition of fund income. If a hedge fund generated a lot of qualified dividends, the benefits could be small or even nonexistent. However, it is probably true that for most hedge funds the bulk of income comes in the form of capital gains. If most hedge fund income is short-term capital gain, the financial benefits from evasion can be large.

The table on the previous page shows the benefits of evasion for different types of offshore hedge fund income.

Further, when there is potential for 30 percent withholding on dividends, many foreign investors avoid withholding by engaging in stock swaps instead of owning the shares directly. According to recent Wall Street Journal articles by Anita Raghavan ("How Lehman Sold Plan to Sidestep Tax Man: Hedge Funds Use Swaps to Avoid Dividend Hit; IRS Seeks Information," Sept. 17, 2007; and "Hedge Funds Could Lose Offshore Shelter; Senate Panel Eyes Targeting Derivatives by Change in Tax Rules," Oct. 1, 2007), hedge funds have avoided an estimated $1 billion in withholding taxes by engaging in stock swaps with domestic investment banks (exempt from withholding taxes) that received the dividends on behalf of their hedge fund clients.

The Honor System

If the IRS is going to collect any income tax from U.S. resident individuals investing in foreign feeders, it is almost entirely dependent on voluntary disclosure by those investors. Withholding and reporting rules are designed to ascertain whether a payee claiming foreign residence is eligible for treaty benefits — not to ensure tax compliance. So it is relatively easy for U.S. resident individuals who want to evade U.S. income tax to do so by means of offshore hedge fund investments and tax haven bank accounts.

How? The U.S. resident individual puts money in a wholly owned foreign shell corporation, formed in a tax haven, which immediately invests the money in a hedge fund, which likely claims residence in another tax haven. The corporation gives the hedge fund a Form W-8 listing itself as the beneficial owner. The hedge fund passes that on to withholding agents along with its own Form W-8IMY for passthrough entities. Form W-8 does not require further identification of the ownership of a corporation because the corporation is considered a separate legal person.

Does the foreign feeder know who its investors are? Hedge funds maintain that they do not allow U.S. resident individuals to invest directly in foreign feeders. But if a U.S. resident individual is allowed to purchase shares of a foreign feeder by means of a foreign shell corporation, there is no requirement for the feeder to report any information about that investment to the IRS. U.S. tax laws do not even require the feeder to collect any information from the investor. Again, the corporation is opaque.

In summary, because hedge funds are generally tax-unfriendly and because withholding burdens are manageable, there are significant gains for successful evasion. Further, because the IRS has no method of routinely checking the identity of investors in most offshore hedge funds, the chances of detection in the absence of voluntary disclosure are slim.

The following two sections examine the effect of other areas of U.S. law beyond tax law on the potential use of offshore hedge funds for tax evasion. First we look at U.S. securities law, where, in many instances, the Securities and Exchange Commission requires funds to differentiate between domestic and foreign investors. Second, we look at anti-money-laundering rules.

SEC Rules for Private Placements

Does a hedge fund collect information from investors and other sources to verify their residence? Does the SEC collect this information? Can the SEC share it with the IRS? In the following section, we try to assess the extent to which the SEC regulations could deter tax evasion by U.S. investors in offshore funds.

From a securities law perspective, the overarching concern of a hedge fund manager is to avoid SEC regulation. Regulation could be required by virtue of characterization of the sale of fund shares as a public offering, or from classification of the fund itself as an investment company under the Investment Company Act of 1940. Because of the broad jurisdictional scope of U.S. securities laws, qualifying for exemptions from both of those requirements is a fundamental issue for hedge funds.

Hedge funds always want to qualify for the private placement exemption to the public offering registration rules. The statutory requirements for exemption under section (4)(2) of the Securities Act of 1933 are not precise, so SEC regulations are the principal interpretation. Among the criteria used in determining whether hedge fund shares qualify as private offerings are investors' sophistication and ability to assume risk, investors' relationship with the fund and with each other, the number of investors, and the size of the offering. (SEC v. Ralston Purina Co., 346 U.S. 119 (1953).)

Most hedge funds opt for the safe harbors provided by SEC Regulation D and Regulation S for offerings outside the United States. (The regulations are available at http://www.sec.gov/investor/pubs/securitieslaws.htm, under "17 CFR, part 230 — Securities Act of 1933," sections 230.501-508 and sections 230.901-905.)

Promulgated in 1982, section 506 of Regulation D allows a company to sell an unlimited dollar amount of securities to an unlimited number of "accredited investors" and to up to 35 nonaccredited investors. Accredited investors include individuals with a minimum annual income of $200,000 ($300,000 with spouse) or $1 million in net worth; a trust with $5 million in assets; most types of financial institutions and companies; pension plans; and tax-exempt organizations. An accredited investor is also any entity entirely owned by accredited investors.

Nonaccredited investors must be "sophisticated investors" (that is, individuals with experience in financial matters, capable of evaluating risks of investment in the fund). In practice, most funds accept only accredited investors.

On December 27, 2006, the SEC proposed significantly tightening the accredited investor rules by adding a new requirement that a natural person own (individually or jointly with a spouse) at least $2.5 million of assets available for investment, which would exclude a personal residence. The SEC received more than 600 comment letters on the proposed regulation, most from commentators who opposed the change. The SEC proposed additional changes to the definition on August 7, 2007.

Rule 502(c) of Regulation D prohibits any form of general solicitation or general advertising. All selling efforts must be low-key and are subject to several restrictions. One requirement is for the seller to have a preexisting relationship with prospective customers. For solicitation on the Internet, investors must be prescreened for accreditation, and then they may later be offered privately placed securities.

As Regulation D was intended to clarify rules for small, nonpublic offerings, Regulation S similarly provides an exemption from registration under the Securities Act for offerings and sales of securities occurring outside the United States. For Regulation S status, two basic conditions must be satisfied. First, the offer or sale of securities must take place in an "offshore transaction." To meet that requirement, there must be no sale to a U.S. person. Second, no "directed selling efforts" may be made in the United States. So, for example, if information about a fund using Regulation S is posted on the fund's Web site, there must be a prominent disclaimer stating that the offer of securities is made only to persons in countries other than the United States.

At first blush, the above rules would seem to shut out U.S. investors from hedge funds issuing securities under Regulation S. But there are important exceptions to the rules for qualifying investors. For example, a trust formed in a foreign jurisdiction with a foreign trustee — the typical setup for an offshore asset protection trust - - can invest in a Regulation S fund.

Also, a foreign corporation controlled by a U.S. investor can invest in a foreign fund. A 1990 decision by the U.S. Court of Appeals for the Fifth Circuit describes how an issuer, wishing to avoid SEC registration requirements, offered stock "exclusively to investors who were neither citizens, residents, nationals, nor chartered residents of the United States." Further, to "ensure compliance with these restrictions, every purchaser of the securities was required to sign a declaration attesting to compliance therewith, and the stock certificates bore a legend informing of the restrictions."

Nevertheless, the plaintiff in the case was legally able to attain status as a foreign purchaser by purchasing shares through a Hong Kong corporation, "a mere 'shell' created to avoid the obligations of the securities laws." (MCG Inc. v. Great Western Energy Corp., 896 F.2d 170 (5th Cir. 1990).)

Under current SEC rules, a foreign corporation owned by accredited U.S. investors can buy into the fund as long as the corporation was not formed principally for the purpose of investing in exempt securities. It would seem, therefore, that a foreign corporation that had a business purpose before investing in the fund or that has significant other investments can invest in a fund that relies on Regulation S to avoid private placement requirements.

Attorneys Mark Barth and Marco Blanco suggest that some practitioners assume that a company is not formed for the purpose of circumventing requirements if investment in the fund does not constitute more than 40 percent of the company's assets. ("U.S. Regulatory and Tax Considerations for Offshore Funds," first published in The Capital Guide to Offshore Funds 2001, pp. 15-61, ISI Publications, eds. Sarah Barham and Ian Hallsworth, 2001, p. 38, n. 122, available at http://www.cm-p.com/pdf/offshore_funds_2001.pdf.)

Hedge fund feeders can issue shares under both Regulation D and Regulation S concurrently. In other words, an offshore fund can simultaneously make a public offering outside the United States and a private placement in the United States. When that is the case, a fund using Regulation S may have up to 100 U.S. investors.

A foreign investor who is a natural person may qualify under either Regulation D or Regulation S. The advantage of qualifying under the Regulation S exemption is that an investor need not be accredited and is not included in the investor count for the 100-investor limitation. Although a U.S. accredited investor operating through a foreign shell corporation may qualify as a non-U.S. person under Regulation S, the shell corporation will be disregarded if the fund is using non-U.S. status to circumvent restrictions on the number of U.S. investors.

SEC Rules for Investment Companies

In addition to avoiding the requirements of a public offering, hedge funds also want to avoid classification as investment companies (aka mutual funds) under the Investment Company Act of 1940. It would be nearly impossible for any hedge fund to operate under the activity restrictions of that law. For example, a hedge fund classified as an investment company could not use debt financing to leverage its portfolio.

For hedge funds there are two statutory exceptions. The first — the section 3(c)(1) exception — is the most commonly used. It restricts the number of investors to no more than 100. In a 2003 report, the SEC points out that a hedge fund that is incorporated offshore that relies on section 3(c)(1) may exclude non-U.S. investors in determining whether it is in compliance with the 100-investor limitation. Therefore, the study notes, "in practice, many offshore hedge funds relying on section 3(c)(1) have more than 100 investors." ("Implications of the Growth of Hedge Funds, Staff Report to the United States Securities and Exchange Commission," Sept. 2003, p. 11, available at http://www.sec.gov/news/studies/hedgefunds0903.pdf.) Because a fund relying on section 3(c)(1) of the 1940 act must also meet the private placement requirements of the 1933 act, no more than 35 investors counted under the 100-investor limitation may be nonaccredited.

Section 3(c)(7) of the 1940 act exempts a hedge fund from investment company rules if all of its investors are "qualified purchasers," defined as an individual or family business with $5 million in investments or an institutional investor with more than $25 million in investments. There is no limitation in section 3(c)(7) on the number of investors, but as a practical matter most funds will remain below 500 investors to avoid the separate registration requirements of section 12 of the Securities Exchange Act of 1934.

Putting this all together, we can see that there are considerable opportunities for offshore hedge funds to include U.S. investors among purchasers of their shares without running afoul of U.S. securities laws. Perhaps the most significant obstacle to U.S. investor involvement in offshore hedge funds is the strict prohibition on marketing shares of hedge funds relying on a Regulation S exemption to U.S. investors. But that does not prohibit indirect ownership of shares through trusts and properly structured corporations. As for offshore hedge funds relying on Regulation D exemption, neither foreigners nor U.S. investors investing through foreign entities pose any special concerns — just as long as they, like most domestic investors, are accredited.

Verifying Residency

Before leaving the topic of SEC regulation of offshore hedge funds, we should note how those funds determine whether investors meet the various requirements under different exemptions.

The burden of proof for establishing whether a hedge fund offering is a private placement falls on the hedge fund. Attorneys advise hedge funds to maintain records establishing the qualifications for each person to whom hedge fund shares are offered. For example, according to information found on the Web site of the law firm Dechert LLP, a fund should be able to identify each prospective investor and should "keep detailed records of the prospective offeree which support the conclusion that the offeree is an accredited investor" (http://www.dechert.com/library/chapter_6_new.pdf).

In general, investors complete questionnaires and subscription agreements attesting to their qualifications as investors. Those documents are the basis for hedge funds being able to "reasonably believe" (as the regulations say) that requirements for accredited investor status (under Regulation D) and requirements that the buyer is outside the United States (under Regulation S) have been met. Although an issuer of securities may ask for evidence of accreditation standards, such as bank statements or tax returns, that evidence is not required.

There is no automatic information reporting of investor information to the SEC. The only SEC filing requirement for issuers claiming a Regulation D exemption is Form D (http://www.sec.gov/about/forms/formd.pdf), due 15 days after the first sale of the offering. The relatively brief nine-page form requests mostly identification information about the issuer. Without detailed information, the SEC staff cannot even begin scrutinizing hedge funds or their investors the way they do issuers of registered securities. And when the SEC does investigate an unregistered filing, its focus is on protecting the investor from false information provided by the issuer, not the other way around.

Given all the information above, we conclude that even though there are restrictions on marketing privately placed hedge funds to nonaccredited investors and on marketing offshore funds to U.S. investors, SEC rules present only minor impediments to high-net-worth individuals seeking to invest in the offshore hedge. Further, there is no routine method by which the SEC may determine the identity of investors in offshore hedge funds.

(Lack of) Anti-Money-Laundering Rules

Since the 2001 terrorist attacks in the United States, concerns about money laundering and terrorist financing have moved to the forefront of U.S. law enforcement efforts. Do hedge funds managed from the United States have to establish the identity of their investors? Do the funds have to share that information with the U.S. government or with the IRS?

Section 352 of the USA PATRIOT Act (signed into law on Oct. 26, 2001) amended the Bank Secrecy Act to require that every financial institution establish an anti-money-laundering (AML) program containing four elements: (1) minimum policies, procedures, and controls; (2) a designated AML compliance officer; (3) ongoing employee AML training; and (4) an independent AML audit function.

There are Treasury AML regulations in effect for banks; savings and loans; credit unions; broker-dealers; money service businesses; mutual funds; insurance companies; credit card operators; casinos; and dealers in precious metals, precious stones, or jewels. ("Codified Bank Secrecy Act Regulations," Chapter I — Monetary Offices, Department of the Treasury, 31 CFR, Part 103 — Financial Recordkeeping and Reporting of Currency and Foreign Transactions, sections 103.110-103.170, available at http://www.fincen.gov/reg_statutes.html.)

Amazingly, however, there are no Treasury AML regulations for hedge funds. Treasury proposed regulations for hedge funds on September 18, 2002, but they have not yet been finalized. The proposed regulations would require hedge funds — both domestic funds and offshore funds with any connection to the United States — to implement within 90 days of finalization of the regulations a written AML program meeting the four statutory requirements described above as well as provide some basic identifying information about the hedge fund. If a fund prohibited withdrawals for two years or more, it would be exempt from the proposed rules.

A June 19, 2006, article in BusinessWeek ("Where's the Heat on Hedge Funds?") put the spotlight on this absence of AML requirements. "When drug runners and terrorists want to park illicit cash, there may be no better haven than hedge funds," wrote Mara Der Hovanesian and Dawn Kopecki. The article went on to quote an industry expert who said that "there's no indication of who is behind these accounts," as well as a former Financial Crimes Enforcement Network (FinCEN) official who said, "The lack of controls is conspicuous."

In August 2006 the staff of the Senate Homeland Security and Governmental Affairs Permanent Subcommittee on Investigations issued a 400-page report, "Tax Haven Abuses: the Enablers, the Tools and Secrecy" (Doc 2006-14405, 2006 TNT 147-18). Among their many observations, the staff found fault with the lack of hedge fund regulation:


      In addition to minimal SEC regulation, hedge funds are currently exempt from U.S. anti-money laundering laws. They are not required to institute an anti-money laundering program, know who their customers are, or report suspicious activity to law enforcement, despite significant money laundering vulnerabilities. In 2002, the Treasury Department proposed a rule that would require hedge funds, among other types of unregistered investment funds, to institute anti-money laundering procedures, but four years later it has yet to finalize that rule. [p. 243]

Among their recommendations, the subcommittee staff included finalization of the proposed AML regulations. Following this recommendation, subcommittee Chair Carl Levin, D-Mich., and ranking minority member Norm Coleman, R-Minn., introduced S. 681, the Stop Tax Haven Abuse Act, on Feb. 17, 2007. The bill includes a provision that would require Treasury to finalize the AML rules and to make it clear that unregistered investment companies must use due diligence to evaluate investors supplying offshore funds and must comply with the same requirements for producing records as other financial institutions. Presidential candidate Sen. Barack Obama, D-Ill., is a cosponsor.

Whenever the new regulations are finalized, they are likely to include "know-your-customer" rules, officially known as customer identification programs. As outlined in the Managed Fund Association's AML guide (Sound Practices for Hedge Fund Managers, Nov. 2007, available at http://www.managedfunds.org/mfas-isound-practicesi.asp), the rules would require hedge funds to verify and document the identity of all investors, including the beneficial owners of investing corporations, trusts, and other entities. Details would include investors' names, addresses, and Social Security numbers or tax identification numbers.

IRS to the Rescue?

Collection of detailed customer identification information could be a powerful deterrent to offshore tax evasion for any U.S. citizens investing in offshore hedge funds. One intriguing possibility is that Treasury may assign the responsibility of inspecting hedge fund AML documentation to the IRS. That prospect is not far-fetched, given that FinCEN is not staffed to carry out those types of field activities. (See Susan L. Barreto, "The AML Waiting Game Continues," June 5, 2006, http://www.hedgeworld.com/news/read_news.cgi?section=legl&story=legl1844.html (user name and password required at no charge).)

The possibility of the IRS having access to information about hedge fund investors has not been warmly received by the industry. All comment letters on the proposed regulations that touch on this topic are firmly opposed to giving the IRS inspection authority. Here's how one industry publication viewed the prospect of IRS AML audits:


      For some managers, this will be the worst possible outcome: While looking around for anti-laundering compliance, the tax men and women are likely to also notice and take action on violations in their original bailiwick.

      Hedge funds that are not registered with the U.S. Securities and Exchange Commission get the honor to be examined by the IRS, said Ross Delston, a lawyer and managing director at Kalorama Partners LLC, a Washington consulting firm headed by Harvey Pitt, former chairman of the SEC.

      What will it be like to have an IRS inspector scrutinizing fund operations? If a tax code violation is found, the examiner will refer it to the criminal division, Mr. Delston said. There is no Chinese wall between IRS anti-money laundering enforcement and tax collection, he said. ("IRS May Step In as Hedge Fund Examiner," Lipper HedgeWorld News, Aug. 2, 2006, available at http://www.hedgeworld.com/news/premium/read_news.cgi?section=legl&story=legl1881.html.)


But even if the IRS becomes the enforcer of AML rules, the agency still may not have ready access to information about investors in offshore funds. The hedge fund industry wants the regulations to be consistent with international norms. Those norms don't require the funds themselves to verify a customer's identity if they are introduced to the fund from a financial institution in a jurisdiction that meets internationally accepted AML standards. If that was the final outcome, a Cayman-domiciled hedge fund with a U.S. manager and U.S. investors could satisfy U.S. AML requirements by complying with Cayman AML rules and not providing automatic access of that information to the U.S. manager and Treasury.

Offshore AML Rules

Cayman Island AML rules are rigorous. Financial businesses there must know the identity of all their customers, including the beneficial owners of corporations and trusts that invest in Cayman institutions. That information would be invaluable to IRS antievasion efforts, but even though the official Treasury line is that the Caymans are the model of a cooperating offshore jurisdiction, IRS access to that information is extremely limited.

The governments of the Cayman Islands and the United States signed a tax information exchange agreement on November 27, 2001 (http://www.ustreas.gov/press/releases/docs/agree.pdf, Doc 2001-29147, 2001 TNT 229-14). There are two types of tax information exchange. The first is automatic exchange (sometimes also known as "proactive" exchange), in which governments regularly provide large amounts of information about investors without conditions or a showing of probable cause. The second type is exchange "on demand" (sometimes known as "reactive" exchange), in which information is provided only on a case-by-case basis after some cumbersome bureaucratic wrangling has occurred and some significant legal requirements have been satisfied. The November 2001 agreement falls squarely in the category of on-demand information exchange.

Among many other requirements, the agreement requires that before the Cayman government provides information, the U.S. government must provide the identity of the taxpayer under investigation; the nature of the information requested; the tax purpose for which the information is sought; reasonable grounds for believing that the information requested is in the Cayman Islands; the name and address of any person believed to be in possession or control of the information requested, to the extent known; and a declaration that the request conforms to the law and administrative practices of the United States. Given that the IRS must already have the specified taxpayer under investigation and have reasonable grounds for believing an investment in a Cayman entity exists, it appears the value of information exchange is primarily limited to confirmation rather than discovery of tax evasion.

The agreement applies only to federal income taxes, and it came into effect in two stages. The first effective date, for criminal tax matters, was January 1, 2004, for matters pertaining to tax years beginning in 2004. The second effective date, for all other tax matters, including "information that may be relevant to the determination, assessment, verification, enforcement or collection of tax claims," was January 1, 2006.

Cayman Islands officials and financial leaders have emphasized the limited nature of the Cayman-U.S. tax information exchange agreement. Shortly after the agreement was signed, Cayman government officials held a press conference and issued a statement to quell fears of Cayman citizens and the financial industry. The officials explained that under the agreement, "information is to be provided on an 'on request' basis, and not automatically or spontaneously." Further, "a valid reason will have to be demonstrated prior to any information being provided." (See "C.I. Government Statement on U.S. Tax Agreement," Nov. 29, 2001.)

On March 27, 2002, the Cayman Islands Government Information Service issued a press release describing a briefing by the Caymans' U.S. legal adviser, Joseph Thomkins Jr., a partner in the Washington office of Sidley Austin Brown & Wood LLP, for a group of 20 representatives of the Cayman financial services industry. Thomkins reiterated the agreement's limitations. He explained that "due to their less serious nature, civil matters are not expected to form a significant part of requests under the TIEA."

Recap

Among the larger concerns for the offshore investor contemplating evasion of U.S. filing requirements are:


      (1) Withholding tax. If an offshore hedge fund has income effectively connected with a U.S. trade or business, even though the U.S. investor may be able to remain unknown to the IRS, the investor's share of the profits is fully subject to corporate tax at the entity level. If there is no ECI, the only entity-level tax is U.S. withholding tax on dividends. Even though this cannot be reduced by treaty, this potential burden is usually small given the composition of hedge fund income and currently available avoidance techniques.

      (2) Disclosure from foreign governments. Even though there are currently no comprehensive U.S. AML rules in place for hedge funds, foreign governments — including those in offshore jurisdictions favored as hedge fund domiciles — have significant know-your-customer rules. It is unlikely, however, that a U.S. investor's identity would be shared with the IRS unless the U.S. investor in question was already under investigation by U.S. law enforcement.

      (3) Potential IRS enforcement of U.S. AML rules. IRS agents would be like kids in a candy shop if they could get access to detailed information about offshore hedge fund investors. This is trouble waiting to happen for tax evaders. But as of now, there are still considerable political and operational difficulties to be overcome before that scenario becomes reality.


Our overall conclusion: Current U.S. tax rules, current SEC rules for determining "accredited investors," and current Treasury AML rules do not present significant hurdles to the moderately sophisticated tax evader wishing to invest in an offshore hedge fund. If the investor does not meet his legal obligation to voluntarily disclose information about investments in offshore hedge funds, there is no alternative way for the IRS to routinely access that information.

It is commonly written that offshore investment is motivated by the need to protect assets from unreasonable creditors, litigators, and soon-to-be-divorced spouses. The primary method of offshore asset protection is formation of offshore trusts by onshore investors. However, as explained by attorneys Jay Adkisson and Chris Riser in their 2004 book Asset Protection: Concepts and Strategies for Protecting Your Wealth, this feature of foreign trusts is oversold. Comparable and often superior asset protection can be achieved through the use of domestic trusts.

In fact, in some cases, fear of discovery by a spouse, rather than being an excuse for going offshore, may be a motivation for tax evasion. Prior years' tax returns are a primary tool of discovery for divorce lawyers. If a Wall Street investment manager, separated from his wife, wants to keep the existence of an offshore bank account from his spouse, he cannot report it on his Form 1040. That's the first thing her Manhattan divorce attorney will be combing through in the search for hidden assets. In a 1994 paper ("Discovery and Treatment of Hidden Assets in Divorce Cases," available at http://www.zermanmogerman.com/articles/Discovery%20of%20Hidden%20Assets%20in%20Divorce.pdf), divorce attorneys Allan Zerman and Cary Mogerman advise:


      In a substantial case, counsel should inquire directly as to the existence of such a trust with specificity, and should follow-up diligently upon any indication of foreign income appearing on Schedule B to the Form 1040. Otherwise, the existence of such a Foreign Asset Protection Trust will most likely never be discovered, absent voluntary disclosure.

So even if tax evasion is not a primary motivation for stashing cash offshore, it may be a necessary step to the lavish life with the trophy wife.

By no means are we implying that all U.S. or non-U.S. individuals investing in hedge funds are tax evaders. However, we must ask, why do wealthy U.S. investors put their money in foreign feeders when the same funds offer domestic feeders (in a master-feeder structure) or near-clones (in a side-by-side structure)? The ability to evade U.S. taxes must be placed high on the list of possible answers.

Part 2 of this article will try to quantify offshore hedge fund assets that are owned by individuals and that — because there is little chance the IRS or any tax authority can learn of their existence short of voluntary disclosure — are potentially involved in tax evasion. By "involved" we mean that the income from those assets goes unreported, or the assets themselves were purchased with funds that were unreported taxable income, or both. Please stay tuned.

Please send your comments to offshoreproject@tax.org.


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