Tax Compliance Issues Affecting Offshore Funds

While tax administrators play a key role in economies that are progressively becoming more globalised, they also face numerous challenges that come with sectors that are not easy to tax, sophisticated communication technologies and intense tax competition. Below are some answers to questions you might have about hedge funds categorised as foreign corporations.

Foreign funds can be organised as corporations or partnerships under US tax principles, and hedge funds organised as corporations should heed Passive Foreign Investment Company (PFIC) Rules. Reasons for these rules are as follows:

  • US citizens could make an investment in a corporation organised in an offshore jurisdiction that has no corporate tax.
  • The corporation's only asset would be an investment portfolio of marketable securities.
  • The US investor would trade the portfolio, allow it to appreciate, take no distributions and not recognise and taxable income.
  • Upon eventual liquidation of the offshore corporation, the US investor would recognise a long-term capital gain with a deferral of income.

Two tests can determine if a foreign corporation is a PFIC: asset tests and income tests. An asset test establishes that if at least 50% of a foreign corporation's assets produce or are held for the production of a passive income (eg interest, dividends, capital gains) it is a PFIC. An income test ascertains that a foreign corporation is a PFIC if at least 75% of the corporation's gross income for the tax year is passive income. Most offshore hedge funds organised as corporations will meet both test and be considered a PFIC, and due to PFIC Rules, US individuals generally do not invest in offshore corporations that hold investments in securities.

Direct and indirect US shareholders of a PFIC are all subject to PFIC rules and are taxed in on of four methods: Qualifying Electing Fund (QEF), Mark to Market rules, Excess Distribution rules or Sale of the PFIC.

Qualified Electing Funds
Direct US investors can make a QEF election and report currently the realised income attributable to PFIC shares, which most US investors do. The fund must provide an annual statement to shareholders, reporting their share of income (in US dollars) based up on their ownership of shares of stock.

Income from a QEF is classified as ordinary or long-term capital gain. While losses may not be deducted currently, short-term gains are included in ordinary income. QEF election is made on Form 8621 and is binding for subsequent tax years.

Mark to Market
US shareholders may elect to mark to market PFIC shares that qualify as "marketable stock" to be taxed as ordinary income. Gain recognised to the extent that fair market value of PFIC as year end exceeds its adjusted basis. Losses can be recognised only to the extent that adjusted basis exceeds the fair market value and is limited to previously recognised gains.

Excess Distributions or Dispositions of PFIC Shares
Excess distribution is a distribution from a PFIC that exceeds 125% of the average distributions made during the previous three years. If US investors do not make a QEF or mark to market election, the following assessments will be made:

  • Taxes and interest charge. Interest charge is based upon the value of the tax deferral with the investor disposes of the stock or receives excess distribution. The income is currently taxed as ordinary subject to shareholders' effective tax rate.
  • Rules do not apply to tax exempt investors holding shares in a PFIC.
  • Once a PFIC, always a PFIC.
  • Most foreign countries do not have tax rules similar to US rules, so there are no negative tax consequences for foreign investors.

Reporting Requirements

US taxpayers with ownership in offshore corporations are subject to reporting requirements. These include tax return requirements, which dictate that offshore hedge funds treated as foreign corporations for US tax purposes do no have to file a US corporate tax return as long as their US tax liability is satisfied through withholding.

To report a transfer of a property to a foreign corporation, US taxpayers should use Form 926. Immediately after the transfer, the taxpayer holds directly or indirectly 10% of the voting power or value of the foreign corporation. If the transferor is a Partnership, the domestic partners of the Partnership are required to file.

Form 5471 ("Information Return of US Persons with Respect to Certain Foreign Corporation") must be filed by US persons (which include an individual, Partnership, corporation, estate and trust) who are officers, directors or shareholders in offshore corporate hedge funds, US persons that acquire a 10% or greater interest in an offshore corporate hedge fund or US persons who own more than a 50% interest in the offshore corporate hedge fund. This form requires a balance sheet and income statement of the foreign corporation and the shareholder's ownership percentage.

Benefits of Setting up an Offshore Partnership

An offshore partnership may provide the manager with certain tax advantages, and the incentive fee may include qualified dividends, long-term capital gains and unrealised income. Furthermore, the incentive fee may not be subjected to New York City Unincorporated Business Tax (UBT) or self-employment tax. A foreign partnership is, however, required to file a partnership return for a taxable year if the partnership is engaged in a US trade or business (trading securities for your own account is not considered to be a US trade or business).

What are the tax return filing requirements for an offshore hedge fund structures as a partnership meeting the following three conditions?

  • Not engaged in a US trade or business,
  • Not classified as "a withholding foreign partnership,"
  • US Federal tax liability (if any) of the foreign partners has fully satisfied y the withholding of tax at source.

If there are no US partners, no US return is required, but if there are US partners, investors must file a US partnership tax return and attach only Schedules K-1 reporting income allocable to US partners.

Transfers to a Foreign Partnership

Information reporting of investments in foreign partnerships should be disclosed on Form 8865. These include acquisitions, dispositions ad changes in interest by a US person in a foreign partnership, transfers by a US person to a foreign partnership, and interests in a controlled foreign partnership.

Several tax return requirements for foreign partnerships exist. A foreign partnership that has not income that is effectively connected with the conduct of a trade or business within the US but has gross income derived from US sources will be exempt from filing a US tax return if:

  • No US person has a direct or indirect interest in the partnership.
  • The gross US source income is a Fixed, Determinable, Annual Periodic tenure (FDAP) is and subject to withholding.
  • Forms 1042 and 1042-S are filled with respect to such withholding.
  • The tax liability of the partnership with respect to such gross income is fully satisfied by the withholding of tax at source.