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ğRISERLAW.COM
BRIEFING CENTER
Offshore Mutual Funds
and Offshore Hedge Funds
"Invest in our high-flying offshore
investment funds tax-free! Pay no
tax until you take your profits back to the U.S.!!" Each
year, many
U.S. investors fall for similar pitches and invest in offshore investment funds,
usually filtering the invested funds through an offshore company, typically an
IBC or LLC, specifically established for the purpose of investing in foreign
mutual funds. Other U.S. investors simply are attracted to the potential
returns of privately offered offshore hedge funds. Offshore funds are
usually formed offshore for regulatory reasons, or for the advantages they can
offer to U.S. tax-exempt investors, such as pension funds.
While it may be true in most cases that no tax
is payable in the jurisdiction where the fund is established, U.S. taxes are
payable if the owner of the fund is:
- a U.S. citizen or resident;
- an foreign entity (corporation, LLC, IBC,
foundation, etc.) owned by a U.S. citizen or resident;
- a foreign trust established by a U.S. citizen or resident; or
- any other structure, the underlying owner of
which is a U.S. citizen or resident, and which is not otherwise legally able to
avoid or defer taxation
(e.g., where the fund shares are owned within a tax-compliant
variable annuity or variable life insurance policy).
U.S. expatriates who simply buy shares from a local
foreign broker and U.S. resident aliens who have moved to the U.S. and own the
portfolio of foreign fund shares they owned abroad also will find themselves
subject to the complex U.S. tax rules applied to foreign investment fund shares.
Taxation of Offshore Invesment Fund Shares
Foreign investment funds are treated under the Internal Revenue Code as
"passive foreign investment companies" (PFICs). While foreign
mutual funds used to offer certain tax deferral benefits to U.S. investors, that has not
been the case since 1986. Offshore funds offer no direct tax benefits to
U.S. investors. Technically speaking, a PFIC is any foreign company that
derives at least 75% of its gross income from passive activities or that derives
passive income from at least 50% of its assets. Nearly all of the income
of an investment fund is passive income. So, nearly all offshore funds are PFICs
with respect to any U.S. shareholders.
If the fund shares are owned by an intermediary
offshore holding company, the PFIC rules generally require that the
shareholder(s) of the holding company treat the fund shares as PFIC shares owned
by the shareholder(s) for U.S. tax purposes. So, that Cayman Islands company you
established to own your offshore hedge fund shares? It does nothing to
help you from a U.S. tax perspective. All of the fund shares owned by that
company will be treated as PFIC shares owned by you.
Often, the reason given for using a foreign
entity as the owner is that the
use of a foreign entity is necessary to avoid U.S. securities laws regarding the sale of securities which are not registered in the U.S.
It is generally true that a foreign entity is not a 'U.S. person' under U.S.
securities laws. However, if a foreign entity is owned by U.S. persons and if the
foreign entity was formed principally for the purpose of investing in
unregistered securities, SEC rules treat the foreign entity as a U.S. person,
thus subjecting advisers who market and sell unregistered securities to SEC
sanctions if any activity related to the marketing and sale of such securities
takes place in the U.S. Failure to meet SEC muster in this regard will not
cause problems for the investor, although the fund will likely redeem any
shares deemed to be held by U.S. persons.
So, how are PFICs taxed? There are three alternatives from which a taxpayer may choose.
Section 1291 Fund Excess Distributions Method. First, the default method (i.e., the method used unless one of the
alternatives is affirmatively elected) is the excess distributions method.
A fund taxed under the excess distributions method is referred to as a "Section
1291 fund."
At first glance, treatment as a 1291 fund seems good because the basic premise is that you pay no tax
until you cash out. The devil is in the details. First, when tax is
paid, all income and gains are taxed at the highest ordinary income rate
(presently 39.6%). There is no long-term capital gains treatment.
Second, losses are disallowed. Third, you have to assume that all of the gains are earned ratably over the
time the investment was held -- even if the fund lost money the first few years
and only made its gains in the last year when you cashed out. Why is
that bad? Because of the final part of the quadruple whammy - interest
charges, compounded annually. Annually compounded interest at the
underpayment interest rate (which is set by the Treasury Department each quarter
and has been anywhere from 5%
to 10% over the last several years) is charged on deferred tax. Consider
this example:
$100,000 is invested in offshore fund shares on 1/1/1995. The fund
performs poorly
from 1995 to 2001, but does phenomenally well from 2002 to 2004, growing to
$500,000 by the time the shares are redeemed on 12/31/2004. The rule
requiring the assumption of ratable returns will force you to assume that the
$400,000 gain was earned one-tenth in 1995, one-tenth in 1996, etc. For
each year, tax is calculated at the highest tax rate with interest
calculated on the deferred tax and compounded
annually. The result would be an effective tax rate of about 69% on
redemption after 10 years. 69% of the $400,000 gain -- about $277,000 -- would be lost to
tax. The much-touted power of compounding obviously works in the
government's favor here.
On the other hand, a low underpayment interest
rate and a high fund performance can produce an arbitrage benefit for the
taxpayer.
$100,000 is invested in offshore fund shares on
1/1/2002. The fund
performs exceptionally well from
from 2002 through 2005, with an average 19% annual return over the period,
growing to $200,000 by the time the shares are redeemed on 12/31/2005. The rule
requiring the assumption of ratable returns require you to assume that the
$100,000 gain was earned one-fourth in 2002, one-fourth in 2003 etc. For
each year, tax is calculated at the highest tax rate with interest
calculated on the deferred tax and compounded
annually. At the relatively low underpayment interest rates in effect from
2003 to 2005, the interest charge on the tax of $35,000 would be about
$2,500. However, because the investor was able to invest funds that
otherwise would have been used to pay taxes on gains each year, which, for
most high-performing hedge funds, are usually short-term gains taxed at
ordinary rates, the investor makes an arbitrage gain, assuming that $35,000
was invested in a way that produced a return better than the $2,500 interest
charge.
Mark-to-Market Method. The
mark-to-market method allows an owner of PFIC shares to mark gains to
market at each year end. In other words, you pay tax on the difference between
the fair market value of the shares at the beginning of the year and the fair
market value of the shares at the end of the year, and you start fresh each
January 1st. Gains and losses are all ordinary, not capital. This
method is blissfully simple, compared to the other two methods. However, there are requirements that must
be met by the fund in order for a shareholder to make the mark-to-market election,
two of the most important of which are that the fund must be listed on an
exchange with fund prices readily
available (e.g., from the Financial Times, etc.) and that the fund cannot
require a minimum investment of more than $10,000. Because most offshore
hedge funds are not listed on an exchange and/or require large minimum
investments, the mark-to-market method is not available for many hedge funds.
Qualified Electing Fund Method. If
a fund meets certain
accounting and reporting requirements, a shareholder can elect to treat the
fund as a Qualified Electing Fund (QEF). The effect is that the offshore
fund shares are taxed like U.S. shares. In addition, a QEF
shareholder can elect to defer tax on undistributed fund income, paying the tax
(plus interest at the underpayment rate) when the income is actually
distributed. Sounds like a good deal. Why
doesn't everyone make a QEF election for offshore fund shares?
Few U.S. investors make QEF elections for
offshore fund shares because it is impossible to do so in most cases. Offshore funds,
even those that are essentially offshore clones of U.S. funds, simply do not keep U.S.
books and tax records and provide U.S. tax information to their shareholders, which is a requirement for making the QEF election.
Only a very small handful of publicly traded foreign funds keep records that
allow shareholders to make a QEF election for U.S. tax purposes.
Whichever of the foregoing three methods is chosen, an IRS Form
8621, Return by a Shareholder of a Passive Foreign Investment Company or
Qualified Electing Fund, must be filed. A separate Form 8821 must be filed
each year for each foreign fund owned. If you are a do-it-yourself filer,
be prepared to spend a good deal of time working through the Form
8621 instructions to learn how to complete it properly, and be prepared to
invest in underpayment interest calculation software. If you use an
accountant, be prepared to spend a good deal of money while your accountant learns how to
complete it properly. Whatever you do, be sure it is filed. Failure
to file the 8621 when required to do so can result in substantial penalties.
The bottom line? Don't believe any foreign investment adviser regarding
the U.S. tax consequences of any investment. Know the consequences of
investing in offshore funds before you invest by getting tax advice from a U.S. tax practitioner
with experience in PFIC taxation.
Our firm has considerable experience in
advising investors and fund managers on PFIC tax issues, as well as in preparing
Form 8621 and the necessary attachments. For more information, contact
Chris
Riser at
criser@riserlaw.com or schedule an initial telephone consultation by calling
404-634-0750.
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