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Building Blocks of Hedge Fund

TaxationKevin W. KaiserSeptember 27, 2006

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Hedge Funds - Topics

Hedge funds defined

Investments and strategies

Formation and structural issues

Investors

Operational issues

Tax reporting

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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

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Hedge Funds Defined

One possible definition

A privately organized investment vehicle that manages a concentrated portfolio of public securities and derivative instruments on public securities, 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).

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Hedge Funds – Distinguish from Mutual

Funds (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

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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

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Hedge Fund Strategies

Hedge 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

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Hedge Fund Strategies

Hedge 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

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Hedge Fund Formation and Structuring

Entity 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 purposes

Decision driver – Tax consequences to investors

Corporations – accumulate income and losses at the corporate level

Partnerships – pass-through income and losses

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Hedge Fund Formation and Structuring

Investor classifications

Non-U.S. Investors

U.S. Taxable Investors

U.S. Tax-Exempt Investors

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Hedge Fund Formation and Structuring

Onshore Funds

Limited Liability Companies (classified as partnerships for tax purposes) or partnerships

Pass-through tax treatment

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Hedge Fund Formation and Structuring

Offshore 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

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Hedge Fund Formation and Structuring

Types 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

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Single-Manager (Stand alone)

Offshore Corporate Fund Prime Broker

Non U.S. Investors

Tax-Exempts

(shareholders)

Administrator

Investment Manager

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Single-Manager (Stand alone)

Limited Partnership

(U.S.)

Prime Broker

U.S. Taxable Investors

(limited partners)

Administrator

Investment Manager

General Partner

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Parallel Fund

Investment Manager

(U.S. LP)

Offshore

Investment Vehicle

(Foreign Corp)

U.S. GP

(U.S. LP or LLC)

U.S. Limited Partners

(Taxable)

U.S. Principals

Individuals

Foreign Investors

U.S. Tax-Exempts

U.S. Investment Vehicle

(U.S. LP)

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Multi-Manager Fund (umbrella fund)

U.S. Investors

(Taxable)

Fund

Sub Fund Sub Fund Sub Fund Sub Fund Sub Fund

Investment

Manager

Investment

ManagerInvestment

Manager

Investment

ManagerInvestment

Manager

A shares B shares C shares D shares E shares

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Master-Feeder Structure

Investment Manager

(U.S. LP)

Foreign Feeder

(Foreign Corp)

U.S. GP

(U.S. LP or LLC)

U.S. Limited Partners

(Taxable)

U.S. Principal(s)

Individuals

Foreign Investors

U.S. Tax-Exempts

Master Fund

Partnership – CTB

(Offshore)

Domestic

Feeder

(U.S. LP)

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Fund-of-Funds

U.S. Investors

(Taxable)

Fund of Funds

Fund

(LP)

Fund

(LP)

Fund

(LP)

Fund

(LP)

Fund

(LP)

InvestmentsInvestments Investments Investments Investments

manager

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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

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Operation Issues

Fund 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

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Operational Issues

Fund 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

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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

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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

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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)

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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

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Operational Issues

Tax 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

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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”

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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.

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Operational Issues

Special rules for “securities partnerships”

Defined Terms

Securities partnership

Qualified financial asset

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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

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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

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Operational Issues

Investment 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

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Operational Issues

Investment 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

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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)

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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

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Tax Reporting

Domestic

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

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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

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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

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Tax Reporting – Other Issues

Dividend Received Deduction (DRD)

Foreign dividends do not qualify for DRD

Stock held less than 45 days

Diminished risk (hedged)

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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.

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Tax Reporting – Other Issues

Other 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

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Tax Reporting – Other Issues

Other 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

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Building Blocks of Hedge Fund Taxation

Q & A

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