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
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
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
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
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
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
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
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
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
Not engaged in a US trade or business,
Not classified as "a withholding
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