Section of Taxation Publications

VOL. 61
NO. 3

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Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.

Taxation of United States Tax-Exempt Entities’ Offshore Hedge Fund Investments:
Application of the Section 514 Debt-Financed Rules to Leveraged Hedge Funds and
Derivatives and the Case for Equalization

Summer A. LePree*

* Associate, Holland & Knight LLP, Miami, Florida;
University of Florida College of Law, J.D., 2006, LL.M., 2007


Several tax issues involving hedge funds have been receiving substantial attention, both in the media and in Congress. One of these issues involves the immense amounts being invested in offshore hedge funds by tax-exempt entities, such as university endowments and pension trusts. These investments are made offshore, in sunny spots like the Cayman Islands, to enable these tax-exempt investors to avoid tax liability. If the same investments were made domestically, the tax-exempt investors would be subject to tax at a rate of 35% on some portion of their investment income. This Article examines this disparate tax treatment and the history and policy behind the rules that give rise to it, and then considers several potential means of equalization.

Background on the Proliferation of Offshore Hedge Funds

As hedge funds in general continue to grow in size and number, so do hedge fund investments by tax-exempt entities. In particular, university endowments and pension funds are allocating increasingly substantial sums to hedge funds and have attracted the attention of a Congress in search of additional sources of revenue. The potential revenue raiser stems from an inconsistency arising under United States tax law, between the treatment of offshore hedge funds (which are generally corporations for United States tax purposes) and domestic hedge funds (generally pass-through entities for United States tax purposes).

Tax-exempt entities are generally subject to tax on their “unrelated business taxable income” (UBTI). UBTI consists of income from the active conduct of a trade or business unrelated to an organization’s exempt purposes, but generally does not include passive investment income, such as dividends and income from most derivatives. However, the unrelated business income tax (UBIT) does apply to income from most “debt-financed” property. Where debt-financed property is involved, UBTI includes the income from the property multiplied by its “debt/basis percentage” (a percentage equal to “average acquisition indebtedness” divided by “average adjusted basis”). UBTI is taxed under the usual rules and rates governing corporations or trusts, depending on the structure of the particular entity. In either case, a 35% federal tax rate is generally applicable.

Hedge funds are unregulated pools of capital that invest in financial markets on behalf of wealthy individuals and institutions, often utilizing some combination of non-traditional portfolio management strategies, such as short sales and leveraged long positions. Hedge funds in general attempt to earn absolute returns as opposed to relative returns, meaning that positive returns are sought “in both declining and rising securities markets,” rather than performance being measured against market benchmarks. Many hedge funds are highly leveraged, which allows them to compound the benefits of the successful investments they make. This works both ways though; leverage also magnifies losses. For example, if a fund makes an investment with a debt-to-equity ratio of two-to-one, meaning that $2 of borrowed money is invested for every $1 of equity invested, the effects of changes in value of the investment will be magnified by three times, as compared to an all-equity investment. In this scenario, if the underlying assets increase in value by 20%, the fund gains 60% on the capital it has invested, triple what it would gain if no borrowed funds had been used. Conversely, if the assets fall in value by 20%, the fund’s loss on the investment is tripled. According to most industry estimates, the average leverage ratio of hedge funds is between two-to-one and three-to-one, though some sources estimate much higher ratios.

Domestic hedge funds are organized as pass-through entities—typically limited partnerships, and less frequently, limited liability companies, which are usually treated the same as partnerships under United States tax laws. This structure prevents hedge fund income from being subject to two levels of tax, which would be the case if the funds were organized as United States corporations. Under United States tax laws, indebtedness of a partnership is attributed to its partners in proportion to their partnership interests. This rule, coupled with the debt-financed rules, causes tax-exempt investors in domestic hedge funds to realize UBTI on leveraged investments made by the hedge funds.

This debt attribution rule is peculiar to pass-through taxation though, so it is easily avoided using a C corporation. Since a domestic C corporation is subject to United States taxation at the 35% rate on its taxable income, this is not an appealing option in terms of escaping the UBIT without otherwise eroding investor returns. Instead, the fund’s organizers locate the corporate entity overseas in a tax haven jurisdiction ( i.e., a country that imposes little or no corporate income tax). When this is done, the corporation is not a United States person since it is incorporated in and governed by the laws of a foreign country. Foreign corporations are not required to file United States tax returns unless they are engaged in a United States trade or business and have income effectively connected with that business. Even if a hedge fund has an office in the United States, it meets a statutory exception providing that income earned from trading for one’s own account is not considered to be part of a United States trade or business. If an offshore hedge fund buys and sells United States securities or commodities, even if the fund sells them on a United States exchange, any resulting capital gain (or loss) is classified as foreign source income of a non-resident and is not subject to United States tax. While the United States collects withholding taxes from many periodic payments made from United States sources to foreign entities, such as interest, dividends, and rents, exceptions to this rule exist for interest from bank deposits and portfolio interest. Since capital gains and portfolio interest are the primary sources of income for offshore hedge funds, the funds “pay little or no United States income tax.” The funds are not subject to taxation at “home” either, because they are generally legal residents of countries with zero percent corporate tax rates. This inconsistent result is technically correct under current law. Yet, it elevates form over substance in a way that is undesirable from a policy standpoint, particularly on horizontal equity grounds. The issue has faced much recent media and public attention and has prompted an examination by Congress.


Published by the
American Bar Association Section of Taxation
in Collaboration with the
Georgetown University Law Center


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