The Hedge Fund Law Report

The definitive source of actionable intelligence on hedge fund law and regulation

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By Topic: Tax

  • From Vol. 10 No.9 (Mar. 2, 2017)

    How U.S. Private Fund Managers May Avoid Running Afoul of Proposed U.K. Legislation Criminalizing the Facilitation of Tax Evasion (Part Two of Two)

    In its latest effort to identify and punish those involved in tax evasion, the U.K. has proposed legislation making it a criminal offence for companies and partnerships to fail to prevent their agents from facilitating tax evasion. The proposed regulations – known as the “failure to prevent the facilitation of tax evasion” rules (UKFP rules) – are broad in nature and will affect a range of businesses, including private fund managers and other financial services firms. In this guest article, the second in a two-part series, Sidley Austin partner Will Smith provides an in-depth discussion of how the UKFP rules may apply to private fund managers, including U.S.-based investment managers that have a link to the U.K. The first article provided an overview of the UKFP rules and discussed the two new criminal offences prescribed therein. For insight from Smith’s partner, Leonard Ng, see “E.U. Market Abuse Scenarios Hedge Fund Managers Must Consider” (Dec. 17, 2015); and “Sidley Austin, Ivaldi Capital and Advise Technologies Share Lessons for U.K. Hedge Fund Managers From the January 2015 AIFMD Annex IV Filing” (Mar. 27, 2015).

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  • From Vol. 10 No.9 (Mar. 2, 2017)

    Ways the Trump Administration’s Policies May Affect Private Fund Advisers

    With a Republican president and Republican-controlled Congress, there is the possibility for comprehensive changes in several areas of concern to private fund managers, including taxation, regulation and enforcement. In his first weeks in office, President Trump issued a series of sweeping, yet sometimes confusing, orders directed at fulfilling some of his campaign promises. A recent seminar presented by the Association for Corporate Growth (ACG) provided insight on the impact of the Trump executive orders regarding the pending fiduciary rule and other regulatory matters; developments at the SEC; the future of the Dodd-Frank Act and other laws that may affect the private fund industry; proposed tax reform; cybersecurity; and political contributions. Scott Gluck, special counsel at Duane Morris, moderated the discussion, which featured Langston Emerson, a managing director at advisory firm The Cypress Group; Basil Godellas, a partner at Winston & Strawn; Ronald M. Jacobs, a partner at Venable; and Michael Pappacena, a managing director at ACA Aponix. This article summarizes their insights. For coverage of other ACG webinars, see “SEC Staff Provides Roadmap to Middle-Market Private Fund Adviser Examinations” (May 16, 2014); and “SEC’s David Blass Expands on the Analysis in Recent No-Action Letter Bearing on the Activities of Hedge Fund Marketers” (Mar. 13, 2014). 

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  • From Vol. 10 No.8 (Feb. 23, 2017)

    U.K. Proposes Legislation to Impose Criminal Liability on Companies and Partnerships Whose Employees and Other Agents Facilitate Tax Evasion (Part One of Two)

    The previous three years have generally heralded a new approach to combating tax evasion, with a significant international focus on cross-border cooperation and the extra-territorial application of tax regimes. The U.K. has been at the forefront of such international action, legislating or proposing a series of new rules and regimes in this area. A particular focus of the U.K. authorities has been to implement legislation designed to change the behaviour of individual taxpayers, targeting individuals directly engaged in tax evasion or who indirectly facilitate or enable that tax evasion. For a review of U.S. efforts to combat tax evasion, see “What Impact Will FATCA Have on Offshore Hedge Funds and How Should Such Funds Prepare for FATCA Compliance?” (Feb. 1, 2013); and “U.S. Releases Helpful FATCA Guidance, but the Law Still Remains” (Mar. 8, 2012). The U.K. has proposed a new set of rules that, if enacted, will introduce a new criminal liability for certain companies and partnerships in circumstances where an employee, agent or service provider facilitates tax evasion by other persons. In this guest article, the first in a two-part series, Sidley Austin partner Will Smith provides an overview of these new rules known as the “failure to prevent the facilitation of tax evasion” rules (UKFP rules). The second article will provide an in-depth discussion of how the UKFP rules may apply to private fund managers, including U.S.-based investment managers that have a link to the U.K. For additional insight from Smith, see “Potential Impact on U.S. Hedge Fund Managers of the Reform of the U.K. Tax Regime Relating to Partnerships and Limited Liability Partnerships” (Mar. 13, 2014); and Smith’s two-part series “U.K. Disguised Fee Rules May Result in Increased U.K. Taxation of Investment Fees to Individuals Affiliated With Hedge Fund Managers”: Part One (Apr. 16, 2015); and Part Two (Apr. 23, 2015).

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  • From Vol. 10 No.6 (Feb. 9, 2017)

    How Tax Reforms Proposed by the Trump Administration and House Republicans May Affect Private Fund Managers

    Tax reform has been a perennial centerpiece of the Republican Party’s agenda, and with the election of Donald Trump and a Republican majority in both houses of Congress, that reform may be more likely than ever. A recent program presented by the New York Hedge Fund Roundtable provided an overview of both the Trump and the House Republican tax proposals as they relate to individual and entity taxes, comparing and contrasting them with each other and the current tax regime and offering key takeaways for fund managers about each proposal. The program was led by Robert E. Akeson, chief operating officer at Mirae Asset Securities, and featured Vadim Blikshteyn, a senior tax manager at Baker Tilly Virchow Krause. This article summarizes the key insights from the program. For more on tax reform, see our two-part series on the global trend toward tax transparency: Part One (Apr. 7, 2016); and Part Two (Apr. 14, 2016); as well as “Tax Proposals and Tax Reforms May Affect Rates and Impose Liabilities on Hedge Fund Managers” (Apr. 16, 2015). For a comprehensive look at hedge fund taxation, see our four-part series: “Allocations of Gains and Losses, Contributions to and Distributions of Property From a Fund, Expense Pass-Throughs and K-1 Preparation” (Jan. 16, 2014); “Provisions Impacting Foreign Investors in Foreign Hedge Funds” (Jan. 23, 2014); “Taxation of Foreign Investments and Distressed Debt Investments” (Jan. 30, 2014); and “Taxation of Swaps, Wash Sales, Constructive Sales, Short Sales and Straddles” (Feb. 6, 2014).

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  • From Vol. 10 No.4 (Jan. 26, 2017)

    KKWC and EisnerAmper Panel Details Benefits, Tax Considerations, Common Structures and Terms of Seed Deals

    A recent panel hosted by EisnerAmper and Kleinberg, Kaplan, Wolff & Cohen discussed the current seeding landscape, focusing on common seed deal structures and terms, the availability of seed capital and common tax considerations in seed deals. For an overview of seeding and seed deal terms, see “Seward & Kissel Private Funds Forum Analyzes Trends in Hedge Fund Seeding Arrangements and Fee Structures (Part One of Two)” (Jul. 23, 2015). The program was moderated by Kleinberg Kaplan partner Eric S. Wagner, and featured his partners Philip S. Gross and Jason P. Grunfeld, as well as Frank L. Napolitani, director in the financial services group at EisnerAmper. This article highlights their insights. For more from Gross, see “Tax Court Decision Upholding ‘Investor Control’ Doctrine May Nullify Tax Benefits for Some Policyholders Investing in Hedge Funds Through Private Placement Life Insurance” (Jul. 23, 2015); and “The Impact of Revenue Ruling 2014-18 on Compensation of Hedge Fund Managers and Employees” (Jun. 19, 2014). 

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  • From Vol. 9 No.42 (Oct. 27, 2016)

    The Current State of Direct Lending by Hedge Funds: Fund Structures, Tax and Financing Options

    A decrease in bank lending to small- and middle-market companies has created opportunities for private fund managers that wish to engage in direct lending. A recent program presented by Dechert explored the current growth in direct lending, focusing on fund structures and strategies, tax implications and debt financing for direct lending funds. The program featured Dechert partners Matthew K. Kerfoot and Russel G. Perkins. This article summarizes the speakers’ key insights. See our three-part series on hedge fund direct lending: “Tax Considerations for Hedge Funds Pursuing Direct Lending Strategies” (Sep. 22, 2016); “Structures to Manage the U.S. Trade or Business Risk to Foreign Investors” (Sep. 29, 2016); and “Regulatory Considerations of Direct Lending and a Review of Fund Investment Terms” (Oct. 6, 2016). For additional insight from Kerfoot, see “Dechert Panel Discusses Recent Hedge Fund Fee and Liquidity Terms, the Growth of Direct Lending and Demands of Institutional Investors” (Jun. 14, 2016); and “Dechert Webinar Highlights Key Deal Points and Tactics in Negotiations Between Hedge Fund Managers and Futures Commission Merchants Regarding Cleared Derivative Agreements” (Apr. 18, 2013). 

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  • From Vol. 9 No.41 (Oct. 20, 2016)

    Seward & Kissel Private Funds Forum Offers Practical Steps for Fund Managers to Address HSR Act Enforcement, Tax Reforms, Brexit Uncertainty, MiFID II, Cybersecurity and Side Letters

    Years after the financial crisis, private funds in the U.S. and Europe continue to be affected by factors as varied as the trends in enforcement of the Hart-Scott-Rodino Antitrust Improvements Act of 1976; reforms to the U.S. tax code; ongoing uncertainty over Brexit, including whether the U.K. will make a “hard” or “soft” departure from the E.U.; cybersecurity risks; and selective disclosure concerns. These issues were the focus of a segment of the second annual Private Funds Forum co-produced by Bloomberg BNA and Seward & Kissel (S&K) on September 15, 2016. The panel was moderated by S&K partner Robert Van Grover and featured James E. Cofer and David R. Mulle, also partners at S&K; Richard Perry, a partner at Simmons & Simmons; Matthew B. Siano, managing director and general counsel of Two Sigma Investments; and Mark Strefling, general counsel and chief operating officer of Whitebox Advisors. This article highlights the salient points made by the panel. For coverage of the first segment of this forum, see our two-part series: “How Managers Can Mitigate Improper Dissemination of Sensitive Information” (Sep. 22, 2016); and “How Managers Can Prevent Conflicts of Interest and Foster an Environment of Compliance to Reduce Whistleblowing and Avoid Insider Trading” (Sep. 29, 2016). On Tuesday, November 1, 2016, at 10:00 a.m. EDT, Mulle and fellow S&K partner Steve Nadel will expand on issues relating to side letters in a complimentary webinar co-produced by The Hedge Fund Law Report and S&K. For more information or to register for the webinar, please send an email to rsvp@hflawreport.com.

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  • From Vol. 9 No.39 (Oct. 6, 2016)

    Hedge Funds As Direct Lenders: Regulatory Considerations of Direct Lending and a Review of Fund Investment Terms (Part Three of Three)

    As lending to U.S. companies has increased in popularity as an investment strategy among hedge and private equity funds, some have voiced concerns about the lack of regulation of these alternative corporate lenders as compared to the capital requirements imposed on traditional lenders. This is in stark contrast to the European alternative lending market, where substantial and varied barriers imposed by some jurisdictions create challenges for alternative lenders originating loans on a cross-border basis. Whether U.S. regulators will adopt a European-style regulatory model of alternative lending to U.S. companies remains to be seen. This final article in a three-part series provides an overview of the current regulatory environment surrounding direct lending by alternative lenders and outlines common fee and liquidity terms of direct lending funds. The first article discussed the prevalence of hedge fund lending to U.S. companies and the primary tax considerations to hedge fund investors associated with this strategy. The second article examined how direct lending can constitute engaging in a “U.S. trade or business” and explored structures and strategies available to minimize this risk to investors in an offshore fund. See also “Permanent Capital Structures Offer Managers Funding Stability and Access to Capital While Granting Investors Liquidity and Access to Managers” (Apr. 9, 2015).

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  • From Vol. 9 No.38 (Sep. 29, 2016)

    Hedge Funds As Direct Lenders: Structures to Manage the U.S. Trade or Business Risk to Foreign Investors (Part Two of Three)

    Investor demand for exposure to lending strategies continues unabated, as allocators seek investment strategies with attractive yields and lower correlation to the broader markets. Much of the demand comes from pension plans and foreign institutions, which often seek to invest through offshore funds. However, an offshore fund originating loans to U.S. companies runs the risk of being deemed to be engaged in a trade or business in the U.S., thus potentially subjecting its investors to an effective tax rate of more than 50 percent. See “IRS Memo Analyzes Whether Offshore Fund That Engaged in Underwriting and Lending Activities in the U.S. Through an Investment Manager Was Engaged in a ‘Trade or Business’ in the U.S. and Subject to U.S. Income Tax” (Jan. 29, 2015). To mitigate this risk, hedge fund managers have taken advantage of various strategies and structures. This article, the second in a three-part series, examines how direct lending can constitute engaging in a “U.S. trade or business” and explores options available to minimize this risk to investors in an offshore fund. The first article discussed the prevalence of hedge fund lending to U.S. companies and the primary tax considerations for hedge fund investors associated with direct lending. The third article will provide an overview of the regulatory environment surrounding direct lending and a discussion of the common terms applicable to direct lending funds. See also “Key Tax Issues Facing Offshore Hedge Funds: FDAPI, ECI, FIRPTA, the Portfolio Interest Exemption and ‘Season and Sell’ Techniques” (Jan. 22, 2015).

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  • From Vol. 9 No.37 (Sep. 22, 2016)

    Hedge Funds As Shadow Banks: Tax Considerations for Hedge Funds Pursuing Direct Lending Strategies (Part One of Three)

    Since the 2008 financial crisis, a tangle of regulations has forced banks to step back from providing credit to companies and individuals. Recognizing a market opportunity, other financial intermediaries – including hedge and private equity funds – have stepped in to fill this void. These new lenders are often referred to as “shadow banks” because, although they are not regulated like banks, they perform bank-like activities such as making loans to companies. As asset managers continuously search for yield, the investment strategy of direct lending – generally characterized as “non-bank finance” – has risen in popularity, with alternative lenders typically charging higher interest rates than traditional lenders. However, engaging in these direct lending practices can pose a number of challenges from a tax perspective, particularly for non-U.S. investors, that impact hedge fund managers undertaking these efforts. This article, the first in a three-part series, discusses the prevalence of hedge fund lending to U.S. companies and the primary tax considerations for hedge fund investors associated with direct lending. The second article will explore structures available to hedge fund managers to mitigate the tax consequences of pursuing a direct lending strategy. The third article will provide an overview of the regulatory environment surrounding direct lending and a discussion of the common terms applicable to direct lending funds. For additional insight on the prevalence of direct lending in the hedge fund industry, see “Dechert Panel Discusses Recent Hedge Fund Fee and Liquidity Terms, the Growth of Direct Lending and Demands of Institutional Investors” (Jul. 14, 2016).

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  • From Vol. 9 No.22 (Jun. 2, 2016)

    OTC Options on Major Currencies May Be Marked-to-Market for Tax Purposes

    In Wright v. Commissioner, a recent court decision that came as a surprise to many, the Sixth Circuit held that over-the-counter (OTC) options on so-called “major” currencies should be marked-to-market for U.S. federal income tax purposes. This could have significant consequences for investment funds that take positions in options of this type. In a guest article, John Kaufmann of Greenberg Traurig discusses the Wright case; the applicable regulations and legislative history; and the decision’s potential implications for hedge fund managers who take positions in OTC options on major currencies. For additional insight from Kaufmann, see our two-part series on “The New Section 871(m) Regulations: Withholding Law Applicable to Non-U.S. Hedge Funds”: Part One (Jan. 21, 2016); and Part Two (Jan. 28, 2016). For more on mark-to-market accounting, see “Tax Practitioners Discuss Taxation of Options and Swaps and Impact of Proposed IRS Regulations” (Feb. 19, 2015).

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  • From Vol. 9 No.18 (May 5, 2016)

    Hedge Fund Managers Must Act Now to Determine Potential Exposure to U.K. Transfer Pricing, “Google Tax” and Disguised Investment Management Fee Regimes

    The transfer-pricing policies adopted by multinationals has been subject to increased scrutiny for a number of years, a trend that promises greater tax transparency and revisions to the international tax framework. However, U.K.-based investment managers are subject to additional layers of regulation that pose a significantly greater risk, not only at a corporate level but also at an investor and personal level. Since April 2015, U.K.-based hedge fund managers have fallen within the scope of the Diverted Profits Tax and the Disguised Investment Management Fee regimes, two pieces of anti-avoidance legislation that pose their own unique set of challenges but also have themes in common with transfer pricing. In a guest article, Michael Beart, a director at Duff & Phelps, focuses on the legislation and its practical implications for hedge fund managers operating in the U.K. For more from Duff & Phelps practitioners, see “What Should Hedge Fund Managers Understand About Transfer Pricing and How to Manage the Related Risks?” (Nov. 1, 2013); and “Duff & Phelps Roundtable Focuses on Hedge Fund-Specific Valuation, Accounting and Regulatory Issues” (Feb. 4, 2010). 

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  • From Vol. 9 No.17 (Apr. 28, 2016)

    A Bipartisan Problem for Private Funds: How Revised Regulations Facilitate IRS Audits of Partnerships (Part Two of Two)

    The Bipartisan Budget Act of 2015 (2015 Budget Act) repealed the long-standing “TEFRA” (Tax Equity and Fiscal Responsibility Act of 1982) rules, small partnership exception and electing large partnership rules. In their place, the 2015 Budget Act streamlines the rules governing federal income audits and judicial proceedings involving partnerships into a single set of rules that generally apply at the partnership level, subject to a limited electable exception. This new “streamlined audit approach” is expected to facilitate IRS audits of large partnerships, including hedge funds and other private funds, starting in 2018. In a two-part guest series, David A. Roby, Jr., a partner at Sutherland Asbill & Brennan, explores the streamlined audit approach and its implications for hedge fund and other private fund managers. This second part examines how the revised partnership audit rules will impact hedge funds and other private funds. The first part discussed current partnership tax principles and audit procedures and explored the reasons for revising the applicable rules. For insight from Roby’s colleague Yasho Lahiri, see our two-part series “How Can Hedge Fund Managers Market Their Funds Using Case Studies Without Violating the Cherry Picking Rule?”: Part One (Dec. 5, 2013); and Part Two (Dec. 12, 2013).

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  • From Vol. 9 No.17 (Apr. 28, 2016)

    New Luxembourg RAIF Structure Offers Marketing Options and Tax Benefits for Non-E.U. Hedge Fund Managers (Part Two of Two)

    The new Reserved Alternative Investment Fund (RAIF) structure unveiled by Luxembourg offers U.S. managers a flexible new option for marketing in the E.U. In addition, the structure allows U.S. managers to take advantage of certain tax benefits. Thus, the RAIF is a game changer for hedge fund managers and can also be a useful vehicle for real estate and private equity funds. At a recent presentation, the Association of the Luxembourg Fund Industry (ALFI) provided a comprehensive overview of the business, tax and regulatory ramifications of the RAIF. This second article in our two-part series explores opportunities presented by RAIFs for U.S. managers – including hedge fund, real estate and private equity managers – as well as tax considerations of the new fund structure. The first article summarized the panel’s discussion of the Luxembourg funds landscape and the key features of RAIFs. For more on the marketing options presented by Luxembourg fund structures, see “Luxembourg Financial Regulator Issues Guidance on AIFMD Marketing and Reverse Solicitation” (Sep. 3, 2015); and “How Can Hedge Fund Managers Use Luxembourg Funds to Access Investors and Investments in Europe, Asia and Latin America?” (Jul. 12, 2012).

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  • From Vol. 9 No.16 (Apr. 21, 2016)

    A Bipartisan Problem for Private Funds: How Current Regulations Complicate IRS Audits of Partnerships (Part One of Two)

    The procedural rules governing federal income tax audits and judicial proceedings of partnerships and other entities classified as partnerships for federal income tax purposes were amended last November under the Bipartisan Budget Act of 2015 (2015 Budget Act). Scheduled to take effect in 2018, this new “streamlined audit approach” is expected to make it easier for the Internal Revenue Service to audit large partnerships, including hedge funds and other private funds. In a two-part guest series, David A. Roby, Jr., a partner at Sutherland Asbill & Brennan, explores the new approach and its implications for hedge fund and other private fund managers. This first part discusses current partnership tax principles and audit procedures and explores the reasons for revising the applicable rules. The second article will examine the revised partnership audit rules under the 2015 Budget Act and their impact on hedge funds and other private funds. For more on the streamlined audit approach, see “How to Draft Key Hedge Fund Documents to Take New Partnership Rules Into Account” (Feb. 11, 2016). For insight from Roby’s colleague John Walsh, see “Current and Former Regulators Advise Hedge Fund Managers on How to Prepare for SEC Exams” (Feb. 18, 2016); “Insights on SEC Priorities for 2015” (Apr. 23, 2015); and “Three Steps in Responding to an SEC Examination Deficiency Letter and Other Practical Guidance for Hedge Fund Managers” (Feb. 13, 2014).

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  • From Vol. 9 No.15 (Apr. 14, 2016)

    Steps That Alternative Investment Fund Managers Need to Consider to Comply With the Global Trend Toward Tax Transparency (Part Two of Two)

    In response to increased demand for transparency and reporting, alternative investment funds (AIFs) and other financial institutions can improve their positions in a competitive market by proactively addressing reporting and planning issues arising from recent global initiatives. In a two-part guest series, Dmitri Semenov, Jun Li, Lucas Rachuba and Carter Vinson of Ernst & Young (EY) highlight challenges and steps that AIFs should consider taking to address the global planning and reporting issues associated with increased transparency demands arising from global initiatives. This second article discusses the planning considerations and other long-term issues for hedge funds and other AIFs to consider. The first article addressed global reporting considerations and areas on which AIFs should immediately focus. For more on tax transparency, see “A Checklist for Updating Hedge Fund and Service Provider Documents for FATCA Compliance” (Feb. 21, 2014). For analysis from other EY professionals, see “Eight Key Elements of an Integrated, Efficient and Accurate Hedge Fund Reporting Solution” (Nov. 13, 2014); and “Daniel New, Executive Director of EY’s Asset Management Advisory Practice, Discusses Best Practices on ‘Hot Button’ Hedge Fund Compliance Issues” (Oct. 17, 2013).

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  • From Vol. 9 No.14 (Apr. 7, 2016)

    Steps That Alternative Investment Fund Managers Need to Take Today to Comply With the Global Trend Toward Tax Transparency (Part One of Two)

    If one word can describe the focus of international tax policy today, that word is transparency. Taxing authorities around the world continue to demand increased levels of transparency and reporting from alternative investment funds (AIFs) and other financial institutions with respect to their investors, business operations and transactions. This increased focus on transparency will affect planning and compliance for AIFs, their management companies and investors. Despite the obvious challenges, taking a proactive approach to reporting and planning issues could enhance an AIF’s position in a competitive market. In a two-part guest series, Dmitri Semenov, Jun Li, Lucas Rachuba and Carter Vinson of Ernst & Young (EY) highlight challenges and recommend steps for AIFs to meet these global planning and reporting challenges. This first article addresses global reporting and areas on which AIFs should immediately focus. The second article will discuss planning and other long-term considerations for hedge funds and other AIFs to consider. For more on tax transparency, see “Understanding the Intricacies for Private Funds of Becoming and Remaining FATCA-Compliant” (Sep. 12, 2013). For commentary from other EY professionals, see “Critical Components of a Hedge Fund Manager Cybersecurity Program: Resources, Preparation, Coordination, Response and Mitigation” (Jan. 15, 2015); and “Considerations for Hedge Fund Managers Evaluating Forming Reinsurance Vehicles in the Cayman Islands” (Sep. 4, 2014).

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  • From Vol. 9 No.13 (Mar. 31, 2016)

    How Hedge Funds Can Mitigate FIN 48 Exposure in Australia and Mexico (Part Three of Three)

    Exposure to withholding taxes and exposure under FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48), are growing concerns for hedge funds investing in foreign securities. Australia and Mexico, along with other countries, have issued pronouncements on taxation of capital gains for non-residents. However, certain methods can be useful for funds to avoid or reduce exposure to withholding taxes. In this guest three-part series, Harold Adrion of EisnerAmper discusses hedge fund exposure to foreign withholding taxes and FIN 48. This third article explores developments in Australia and Mexico, as well as how hedge funds can minimize exposure to withholding taxes. The first article explained Fin 48 and considered E.U. developments regarding free movement of capital and its impact on funds. The second article addressed the limited exemption to capital gains taxation of non-residents announced by China and other issues for non-resident investors. For more on Australian tax issues, see “What Hedge Funds Need to Know About Tax Relief Under the New Australian Investment Manager Regime” (Jun. 11, 2015). For further insight from EisnerAmper professionals, see our two-part series on “How Can Hedge Fund Managers Structure, Negotiate and Implement Expense Caps to Amplify Capital Raising Efforts?”: Part One (Jun. 20, 2013); and Part Two (Jun. 27, 2013).

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  • From Vol. 9 No.12 (Mar. 24, 2016)

    How Hedge Funds Can Mitigate FIN 48 Exposure in China (Part Two of Three)

    In an increasingly global market, hedge funds must keep up with numerous tax issues when investing in non-U.S. securities, including withholding on interest, dividends and capital gains, as well as the fund’s exposure under FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). In addition to regimes developing in the E.U., China has taken positions that are helpful to hedge funds, although significant issues remain for foreign hedge funds investing in Chinese securities. In this guest three-part series, Harold Adrion of EisnerAmper discusses foreign withholding taxes and FIN 48 exposure applicable to hedge funds. This second article focuses on the limited exemption from capital gains taxation for non-Chinese residents and other issues faced by non-resident investors. The first article explained FIN 48 and explored E.U. developments regarding free movement of capital and its impact on funds. The third article will address developments in Australia and Mexico, and how hedge funds can minimize exposure to withholding taxes in those jurisdictions. For more on investing in Chinese securities, see “China Launches Landmark Reforms Impacting Hedge Fund Capital Raising, Investments and Operations” (Aug. 2, 2012); and “Questions Hedge Fund Managers Need to Consider Prior to Making Investments in Chinese Companies” (Jun. 23, 2011). For further insight from EisnerAmper professionals, see “Legal and Accounting Considerations in Connection With Hedge Fund General Redemption Provisions, Lock-Up Periods, Side Pockets, Gates, Redemption Suspensions and Special Purpose Vehicles” (Nov. 5, 2010).

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  • From Vol. 9 No.11 (Mar. 17, 2016)

    How Hedge Funds Can Mitigate FIN 48 Exposure in Europe (Part One of Three)

    Funds that invest in foreign securities face a host of tax issues ranging from withholding on interest, dividends and capital gains to evaluating the fund’s exposure under FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). In the last several years, there have been significant developments in the treatment of interest, dividends and capital gains derived by funds in non-U.S. securities. In this guest three-part series, Harold Adrion of EisnerAmper discusses issues relating to foreign withholding taxes and FIN 48 exposure applicable to hedge funds. This first article explains FIN 48 and explores E.U. developments regarding free movement of capital and its impact on funds. The second article will address the limited exemption from capital gains taxation of non-residents announced by China, and other issues faced by non-resident investors. The third article will discuss developments in Australia and Mexico, and how hedge funds can minimize exposure to withholding taxes. For additional coverage of withholding tax issues pertaining to hedge funds, see our two-part series on the new Section 871(m) regulations: Part One (Jan. 21, 2016); and Part Two (Jan. 28, 2016). For further insight from EisnerAmper professionals, see “Accounting for Uncertain Income Tax Positions for Investment Funds” (Jan. 14, 2011).

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  • From Vol. 9 No.8 (Feb. 25, 2016)

    Insurance Products Provide Tax-Efficient Means for Investors to Access Hedge Funds

    Certain life insurance products permit policyholders to invest the cash values of their policies in various investment products, including hedge funds. A key benefit of those policies is that such investments can grow on an income tax-deferred or tax-free basis. Katten Muchin Rosenman recently hosted a panel discussion on the use of private placement life insurance (PPLI) and private placement variable annuities (PPVA) as tax-efficient investment vehicles for high net worth individuals. The program, entitled “Tax-Efficient New Products for Sophisticated Investors, Family Offices and Alternative Asset Managers,” featured Katten partners as well as representatives from insurance brokers, investment firms and a Big Four accounting firm. This article examines the key takeaways from the discussion. For more on PPLI and PPVA, see “Insurance Dedicated Funds Offer Hedge Fund Exposure Plus Tax, Underwriting and Asset Protection Advantages for Investors” (Jul. 18, 2013).

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  • From Vol. 9 No.6 (Feb. 11, 2016)

    How to Draft Key Hedge Fund Documents to Take New Partnership Rules Into Account

    On November 2, 2015, new partnership audit rules were enacted as part of The Bipartisan Budget Act of 2015. The new audit rules could significantly impact partnerships generally and investment partnerships in particular. Although the new rules will only become effective for audits of taxable years beginning after December 31, 2017, existing partnership operating agreements, offering memoranda, subscription agreements and side letters should be revised before then to reflect the new audit rules, and new fund documents should be drafted to comport with these new rules. In a guest article, Philip S. Gross and Matthew Tominey, partner and associate, respectively, at Kleinberg, Kaplan, Wolff & Cohen, compare existing partnership audit rules with the new rules under the Bipartisan Budget Act of 2015; explore election options that the new rules allow; and address issues and questions that the new rules present. They also provide strategies for drafting or updating key fund documents so as to take the new rules into account. For additional insight from Gross, see “Tax Court Decision Upholding ‘Investor Control’ Doctrine May Nullify Tax Benefits for Some Policyholders Investing in Hedge Funds Through Private Placement Life Insurance” (Jul. 23, 2015); and “The Impact of Revenue Ruling 2014-18 on Compensation of Hedge Fund Managers and Employees” (Jun. 19, 2014). For more from KKWC, see “Recent Cases Reduce the Impact of Newman on Insider Trading Enforcement” (May 7, 2015).

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  • From Vol. 9 No.4 (Jan. 28, 2016)

    The New Section 871(m) Regulations: Issues With the Expanding Scope of Withholding Law Applicable to Non-U.S. Hedge Funds (Part Two of Two)

    Most non-U.S. hedge funds take precautions to avoid engaging in a U.S. trade or business; otherwise, they are subject to U.S. federal income tax on net income that is effectively connected with that U.S. trade or business. However, all funds that invest in U.S. debt and equity – as well as in derivatives that reference U.S. debt and equity – may be subject to a 30% withholding tax on gross payments of U.S.-sourced fixed, determinable, annual or periodic income (FDAP). In this two-part series, John Kaufmann of Greenberg Traurig discusses certain ways in which final and temporary regulations recently promulgated under Internal Revenue Code Section 871(m) increase the scope of FDAP withholding, and lists traps for the unwary created by these regulations. This second article explains the scope of the new regulations and the potential complications that they have created. The first article discussed the current law and the issues that the new regulations are intended to address. For additional commentary from the firm, see our series on “Investment Opt-Out Rights for Hedge Fund Investors”: Part One (Nov. 8, 2013); Part Two (Nov. 14, 2013); and Part Three (Nov. 21, 2013).

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  • From Vol. 9 No.3 (Jan. 21, 2016)

    The New Section 871(m) Regulations: Withholding Law Applicable to Non-U.S. Hedge Funds (Part One of Two)

    Non-U.S. hedge funds may be subject to two kinds of United States federal income taxes. Funds that are engaged in a U.S. trade or business are subject to U.S. federal income tax on their net income that is effectively connected with their U.S. trade or business. Funds that are not engaged in a U.S. trade or business are generally subject to a 30% tax imposed on gross payments of U.S.-source fixed, determinable, annual or periodic income (FDAP). Most offshore funds take precautions to ensure that they are not engaged in a U.S. trade or business. However, all funds that invest in U.S. debt and equity – as well as in derivatives that reference U.S. debt and equity – may be subject to withholding tax on FDAP. In this two-part series, John Kaufmann of Greenberg Traurig discusses certain ways in which final and temporary regulations recently promulgated under Internal Revenue Code Section 871(m) increase the scope of FDAP withholding, and lists traps for the unwary created by these regulations. This article addresses the current law and the issues that the new Section 871(m) regulations are intended to address. The second article will explain the scope of the new regulations and the potential complications that they have created. For insight from Kaufmann’s colleague, Scott MacLeod, see “Tax, Structuring, Compliance and Operating Challenges Raised by Hedge Funds Offered Exclusively to Insurance Companies” (Oct. 30, 2014).

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  • From Vol. 8 No.34 (Sep. 3, 2015)

    How Hedge Fund Managers Should Respond to Tax Regulator Attacks on “Disguised Management Fees” (Part Two of Two)

    In an effort to limit arrangements in which hedge fund managers and other private fund managers receive interests in funds in exchange for waiving management fees (thereby deferring recognition of income and changing its character), tax regulators in the United States recently proposed regulations to treat some investment fund management fee waivers and other payments in lieu of management fees as “disguised payments for services,” with immediate income tax consequences.  The U.S. tax authorities are not the only ones trying to strip the disguises from management fees.  In the United Kingdom, the Finance Act 2015 introduced disguised management fee rules to combat creative strategies to convert what is in economic substance a management fee – calculated by reference to funds under management and taxed as income at the rate of 45% – to capital gains taxable at 28%.  A new bill will also change the taxation of “good carry.”  In a guest article, the second in a two-part series, George J. Schutzer and Timothy Jarvis of Squire Patton Boggs outline proposed actions in the U.K. and suggest steps for hedge fund managers and others to take in response to the rules in place and the proposed new rules in the U.S. and the U.K.  The first article described common management fee waiver provisions and explained how the U.S. proposals would limit fee waivers that would be respected for tax purposes.  For more on proposals that could affect the taxation of hedge fund managers and their employees, see “U.K. Disguised Fee Rules May Result in Increased U.K. Taxation of Investment Fees to Individuals Affiliated with Hedge Fund Managers (Part Two of Two),” The Hedge Fund Law Report, Vol. 8, No. 16 (Apr. 23, 2015); and “Potential Impact on U.S. Hedge Fund Managers of the Reform of the U.K. Tax Regime Relating to Partnerships and Limited Liability Partnerships,” The Hedge Fund Law Report, Vol. 7, No. 10 (Mar. 13, 2014).

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  • From Vol. 8 No.33 (Aug. 27, 2015)

    Tax Regulators Attack Hedge Fund Manager Efforts to Disguise Management Fees (Part One of Two)

    Tax regulators in the United States and United Kingdom are attacking arrangements in which hedge fund managers and other private investment fund managers receive interests in funds in exchange for waiving management fees – or otherwise disguise fixed management fees – thereby deferring recognition of income and changing its character.  The IRS recently issued a notice of proposed rulemaking (Notice) that will treat such arrangements as “disguised payments for services,” resulting in immediate ordinary income for the manager or general partner that waives the fee.  Some fund sponsors will need to alter their current and future fee waivers to avoid this outcome, and they may need to act quickly because the Notice indicates that the IRS believes this reflects current law.  In a guest article, the first in a two-part series, George J. Schutzer and Timothy Jarvis of Squire Patton Boggs describe common management fee waiver provisions and explain how the U.S. proposals would limit fee waivers that would be respected for tax purposes.  The second article in the series will describe similar proposed actions in the U.K. and suggest steps for hedge fund managers and others to take in response to the rules in place and the proposed new rules in the U.S. and the U.K.  For more on tax proposals that could affect hedge fund managers and their employees, see “Tax Proposals and Tax Reforms May Affect Rates and Impose Liabilities on Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 8, No. 15 (Apr. 16, 2015); and “U.K. Disguised Fee Rules May Result in Increased U.K. Taxation of Investment Fees to Individuals Affiliated with Hedge Fund Managers (Part One of Two),” The Hedge Fund Law Report, Vol. 8, No. 15 (Apr. 16, 2015).

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  • From Vol. 8 No.32 (Aug. 13, 2015)

    Tax, Legal and Operational Advantages of the Irish Collective Asset-Management Vehicle Structure for Hedge Funds

    The Irish Collective Asset-management Vehicles Act came into operation in March 2015 and allows for the creation of an innovative, tax-efficient corporate structure for Irish investment funds which sits alongside existing Irish fund structures.  See “New Irish Fund Structure Offers Re-Domiciliation Possibilities and Tax Advantages for Hedge Funds,” The Hedge Fund Law Report, Vol. 8, No. 10 (Mar. 12, 2015).  There has been widespread industry interest in the Irish collective asset-management vehicle (ICAV), with a number of leading asset managers such as Permal, Deutsche Bank and Legg Mason already having established ICAVs and a host of other asset managers in the process of either converting to or establishing new ICAVs.  Since the Central Bank of Ireland opened the ICAV register on March 16, 2015, there have been over 30 ICAVs authorized, representing in excess of $30 billion of inflows into Irish funds.  In a guest article, Ian Conlon of Maples and Calder explains the key features and advantages of the new ICAV structure and discusses how hedge fund managers can establish ICAVs, redomicile funds to Ireland and convert existing Irish fund vehicles so they can take advantage of the newly available structure.  For additional insight from Maples and Calder, see “Considerations for Hedge Fund Managers Evaluating Forming Reinsurance Vehicles in the Cayman Islands,” The Hedge Fund Law Report, Vol. 7, No. 33 (Sep. 4, 2014); and “Use by Private Fund Managers of the British Virgin Islands for Private Equity Fund Formation and Private Equity Investments,” The Hedge Fund Law Report, Vol. 5, No. 45 (Nov. 29, 2012).

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  • From Vol. 8 No.31 (Aug. 6, 2015)

    Hedge Funds Are Required to Disclose Basket Option Contracts and Basket Contracts

    The IRS has recently set its sights on “basket option contracts” and “basket contracts,” suspecting that certain hedge funds and other taxpayers have improperly used those structures to defer recognition of ordinary income and short-term gains on assets within the basket, and to claim long-term capital gains treatment on exercise of the option or termination of the contract.  IRS Notice 2015-47 deems basket option contracts to be “listed transactions.”  IRS Notice 2015-48 deems basket contracts to be “transactions of interest.”  The Notices apply to transactions in effect on or after January 1, 2011; taxpayers who were parties to basket option contracts or basket contracts on or after that date will have to report them retroactively, even for years for which they have already filed returns.  This article summarizes the key provisions of each Notice.  For more on taxation of options, see “Tax Practitioners Discuss Taxation of Options and Swaps and Impact of Proposed IRS Regulations,” The Hedge Fund Law Report, Vol. 8, No. 7 (Feb. 19, 2015).  For a discussion of other strategies that investors have used to seek long-term gains treatment on investments, see “Tax Practitioners Discuss Taxation of Swaps, Wash Sales, Constructive Sales, Short Sales and Straddles at FRA/HFBOA Seminar (Part Four of Four),” The Hedge Fund Law Report, Vol. 7, No. 5 (Feb. 6, 2014).  The IRS has previously targeted certain swaps.  See “IRS Directive and HIRE Act Undermine Tax Benefits of Total Return Equity Swaps for Offshore Hedge Funds,” The Hedge Fund Law Report, Vol. 3, No. 12 (Mar. 25, 2010).

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  • From Vol. 8 No.29 (Jul. 23, 2015)

    Seward & Kissel Private Funds Forum Analyzes Trends in Hedge Fund Seeding Arrangements and Fee Structures (Part One of Two)

    A hedge fund manager must keep abreast of current trends in hedge fund structures and terms in order to raise capital from investors, anticipate prospective changes in the marketplace and adapt accordingly.  At the recent Seward & Kissel Private Funds Forum, panelists examined key capital raising and fund structuring trends in the hedge fund industry.  This article, the first of a two-part series, summarizes the panelists’ discussion of seeding arrangements and fee structures as well as ERISA and taxation considerations upon hedge fund structuring.  The second article will explore the use of special fund structures, activist strategies and alternative mutual funds.  For additional insight from the firm, see “Seward & Kissel New Hedge Fund Study Identifies Trends in Investment Strategies, Fees, Liquidity Terms, Fund Structures and Strategic Capital Arrangements,” The Hedge Fund Law Report, Vol. 8, No. 9 (Mar. 5, 2015).  For more on hedge fund seeding arrangements, see “Report Offers Insights on Seeding Landscape, Available Talent, Seeding Terms and Players,” The Hedge Fund Law Report, Vol. 8, No. 1 (Jan. 8, 2015); and “New York City Bar’s ‘Hedge Funds in the Current Environment’ Event Focuses on Hedge Fund Structuring, Private Fund Examinations, Compliance Risks and Seeding Arrangements,” The Hedge Fund Law Report, Vol. 7, No. 11 (Mar. 21, 2014).

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  • From Vol. 8 No.28 (Jul. 16, 2015)

    Hedge Funds Organized as Delaware LLCs May Be Transparent for U.K. Tax Purposes

    A recent U.K. Supreme Court ruling has thrown into question the treatment of Delaware limited liability companies (LLCs) for U.K. tax purposes.  The unanimous final judgment in the case reversed the previous decisions of the Upper Tribunal and the Court of Appeal and upheld the original ruling of the First-tier Tribunal.  The decision addressed the question of whether a member of a Delaware LLC was entitled to double taxation relief on his share of the LLC’s profits, which had been taxed in the U.S. and remitted to the U.K.  This article provides relevant background information; summarizes the Supreme Court’s decision and reasoning; and considers the implications of the judgment for hedge funds organized as Delaware LLCs and investors in such funds.  For more on U.K. taxation, see “U.K. Disguised Fee Rules May Result in Increased U.K. Taxation of Investment Fees to Individuals Affiliated with Hedge Fund Managers (Part Two of Two),” The Hedge Fund Law Report, Vol. 8, No. 16 (Apr. 23, 2015); and “Potential Impact on US Hedge Fund Managers of the Reform of the UK Tax Regime Relating to Partnerships and Limited Liability Partnerships,” The Hedge Fund Law Report, Vol. 7, No. 10 (Mar. 13, 2014).

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  • From Vol. 8 No.23 (Jun. 11, 2015)

    What Hedge Funds Need to Know About Tax Relief Under the New Australian Investment Manager Regime

    A new Australian investment manager regime (IMR) is set to take effect on July 1, with possible retroactive effect to 2011.  Following the U.K. Investment Manager Exemption model, the IMR is intended to provide eligible foreign investors with relief from Australian tax with respect to most investments in Australia.  In a guest article, Nikki Bentley and Seema Mishra, partner and special counsel, respectively, at Henry Davis York, discuss the history and current status of the IMR provisions; elements and scope of Australian tax exemptions under the IMR; certain considerations when establishing a hedge fund in Australia under the IMR; the potential impact of the IMR on the hedge fund industry in Australia; and a comparison of the Australian IMR to other similar regimes.  For more on the Australian IMR, see “Key Hedge Fund Tax Developments in the U.K., the European Union, Ireland, Germany, Spain, Australia, India and Puerto Rico,” The Hedge Fund Law Report, Vol. 6, No. 26 (Jun. 27, 2013).

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  • From Vol. 8 No.23 (Jun. 11, 2015)

    IRS Proposes Rules to Limit Reinsurance by Hedge Funds

    The IRS recently issued a notice of proposed rulemaking that, if approved, could make it more onerous for hedge fund managers to establish or operate offshore reinsurance companies.  Although hedge fund managers have taken advantage of a carve-out in the rules regarding Passive Foreign Investment Companies and set up reinsurance structures in no-tax and low-tax offshore jurisdictions, the proposed regulations seek to limit that practice by drawing a distinction between companies engaged in “active” reinsurance and those that are merely vehicles used to defer or reduce the tax that would otherwise be due with respect to investment income.  This article summarizes the proposed regulations.  For more on the intersection of hedge fund management and reinsurance, see “Considerations for Hedge Fund Managers Evaluating Forming Reinsurance Vehicles in the Cayman Islands,” The Hedge Fund Law Report, Vol. 7, No. 33 (Sep. 4, 2014); and “How Can Hedge Fund Managers Use Reinsurance Businesses to Raise and Retain Assets and Achieve Uncorrelated Returns? (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 3 (Jan. 17, 2013).

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  • From Vol. 8 No.16 (Apr. 23, 2015)

    U.K. Disguised Fee Rules May Result in Increased U.K. Taxation of Investment Fees to Individuals Affiliated with Hedge Fund Managers (Part Two of Two)

    Whilst the U.K. tax treatment of management fees relating to, and performance fees arising from, fund arrangements has been the subject of debate for some time, the recent introduction of new U.K. legislation has brought the issue into sharper focus in the United Kingdom.  Accordingly, hedge fund personnel operating within the United Kingdom may be affected by the new legislation and thus subject to increased taxation on fees and compensation earned with respect to their investment management activities.  In a guest article, the second in a two-part series, Sidley Austin partner Will Smith details exceptions to the application of the new legislation, known as the “disguised fee rules,” and discusses certain practical consequences which may arise under the new legislation.  The first article discussed the background and enactment of the disguised fee rules and provided a summary of their technical application.  For additional insight from Smith, see “Potential Impact on US Hedge Fund Managers of the Reform of the UK Tax Regime Relating to Partnerships and Limited Liability Partnerships,” The Hedge Fund Law Report, Vol. 7, No. 10 (Mar. 13, 2014).  For insight from Smith’s partner Leonard Ng, see “Sidley Austin, Ivaldi Capital and Advise Technologies Share Lessons for U.K. Hedge Fund Managers from the January 2015 AIFMD Annex IV Filing,” The Hedge Fund Law Report, Vol. 8, No. 12 (Mar. 27, 2015).  For insight from Sidley more generally, see “Sidley Partners Discuss Trends in Hedge Fund Seed Deals, Governance, Succession, Estate Planning and Tax Structuring (Part Two of Two),” The Hedge Fund Law Report, Vol. 7, No. 37 (Oct. 2, 2014).

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  • From Vol. 8 No.15 (Apr. 16, 2015)

    U.K. Disguised Fee Rules May Result in Increased U.K. Taxation of Investment Fees to Individuals Affiliated with Hedge Fund Managers (Part One of Two)

    Whilst the U.K. tax treatment of management fees relating to, and performance fees arising from, fund arrangements has been the subject of debate for some time, the recent introduction of new U.K. legislation has brought the issue into sharper focus in the United Kingdom.  Accordingly, hedge fund personnel operating within the United Kingdom may be affected by the new legislation and thus subject to increased taxation on fees and compensation earned with respect to their investment management activities.  In a guest article, the first in a two-part series, Sidley Austin partner Will Smith discusses the background and enactment of the new legislation known as the “disguised fee rules” and provides a summary of their technical application.  The second article in the series will detail exceptions to the application of the disguised fee rules and discuss certain practical consequences which may arise under the new legislation.  For additional insight from Smith, see “Potential Impact on US Hedge Fund Managers of the Reform of the UK Tax Regime Relating to Partnerships and Limited Liability Partnerships,” The Hedge Fund Law Report, Vol. 7, No. 10 (Mar. 13, 2014).  For insight from Smith’s partner Leonard Ng, see “Sidley Austin, Ivaldi Capital and Advise Technologies Share Lessons for U.K. Hedge Fund Managers from the January 2015 AIFMD Annex IV Filing,” The Hedge Fund Law Report, Vol. 8, No. 12 (Mar. 27, 2015).  For insight from Sidley more generally, see “Sidley Partners Discuss Evolving Hedge Fund Fee Structures, Seed Deal Terms, Single Investor Hedge Funds, Risk Aggregators, Expense Allocations, Co-Investments and Fund Liquidity (Part One of Two),” The Hedge Fund Law Report, Vol. 7, No. 36 (Sep. 25, 2014).

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  • From Vol. 8 No.15 (Apr. 16, 2015)

    Tax Proposals and Tax Reforms May Affect Rates and Impose Liabilities on Hedge Fund Managers

    Hedge fund managers need to be constantly aware of new tax regulations or changes in the tax code that could affect the investments they make, the taxes they pay and any flow-through issues that could impact investors.  Under the Economic Growth and Family Fairness Tax Reform Plan (commonly known as the Rubio-Lee plan), taxation of capital income would cease; corporate tax would be based on income earned in the U.S. and interest would no longer be expensed; capital investments would be expensed with no depreciation schedules; and most itemized deductions would end.  The 2016 federal budget proposal would increase the capital gains and qualified dividend rate to 28%; the tax on accrued market discounts would be assessed as it accrues; and carried interest would be taxed as ordinary income.  Under California State law, Sales Sourcing rules may have an impact on the taxation of hedge fund investments from out-of-state managers.  Finally, peer-to-peer lending platforms raise questions regarding proper tax characterization.  During a roundtable discussion on March 24, 2015, Pepper Hamilton LLC partners Gregory Nowak and Steven Bortnick discussed the foregoing issues.  This article summarizes the key points raised during that roundtable.  For a discussion of other proposed tax regulations, see “Tax Practitioners Discuss Taxation of Options and Swaps and Impact of Proposed IRS Regulations,” The Hedge Fund Law Report, Vol. 8, No. 7 (Feb. 19, 2015).  See also “Key Tax Issues Facing Offshore Hedge Funds: FDAPI, ECI, FIRPTA, the Portfolio Interest Exemption and ‘Season and Sell’ Techniques,” The Hedge Fund Law Report, Vol. 8, No. 3 (Jan. 22, 2015).

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  • From Vol. 8 No.7 (Feb. 19, 2015)

    Tax Practitioners Discuss Taxation of Options and Swaps and Impact of Proposed IRS Regulations

    The IRS is nudging hedge funds and other market participants toward mark-to-market accounting for many swaps and other derivatives.  Some rules, such as those for Section 1256 contracts, are already in place, while other regulations are in the works.  At a recent presentation, leading tax practitioners offered an overview of the current regime of taxation of swaps and options and insights into how proposed IRS regulations may affect that regime.  See also “Tax Practitioners Discuss Taxation of Swaps, Wash Sales, Constructive Sales, Short Sales and Straddles at FRA/HFBOA Seminar (Part Four of Four),” The Hedge Fund Law Report, Vol. 7, No. 5 (Feb. 6, 2014).

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  • From Vol. 8 No.4 (Jan. 29, 2015)

    IRS Memo Analyzes Whether Offshore Fund That Engaged in Underwriting and Lending Activities in the U.S. through an Investment Manager Was Engaged in a “Trade or Business” in the U.S. and Subject to U.S. Income Tax

    An unnamed offshore fund engaged in certain lending and underwriting activities in the U.S. through an independent investment manager.  The fund asked the IRS whether its activities constituted a “trade or business” in the U.S., such that its U.S. income that was effectively connected to that trade or business would be subject to U.S. income tax.  The IRS’ Office of Chief Counsel issued a memorandum (Chief Counsel Advice Memorandum) in response to that inquiry addressing: (1) when an offshore hedge fund is deemed to be engaged in a U.S. trade or business; and (2) the application to offshore hedge funds of the safe harbors for “trading in stocks or securities.”  This article provides a detailed discussion of the Chief Counsel Advice Memorandum.  For a discussion of another Chief Counsel Advice Memorandum relating to the U.S. tax implications of offshore lending, see “Implications of Recent IRS Memorandum on Loan Origination Activities for Offshore Hedge Funds that Invest in U.S. Debt,” The Hedge Fund Law Report, Vol. 2, No. 41 (Oct. 15, 2009).

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  • From Vol. 8 No.3 (Jan. 22, 2015)

    Key Tax Issues Facing Offshore Hedge Funds: FDAPI, ECI, FIRPTA, the Portfolio Interest Exemption and “Season and Sell” Techniques

    The U.S. imposes tax on U.S.-source income payable to foreign persons and entities, including offshore hedge funds and foreign investors.  Under that regime, a person or entity that pays or receives “effectively connected income” (ECI) or “fixed, determinable, annual or periodical” income (FDAPI) may be subject to withholding and reporting requirements.  This article offers an overview of ECI and FDAPI, the related reporting and withholding requirements, and the key exceptions to those requirements available to private fund managers.  For a discussion of the flip side of this issue, i.e., taxation of investments outside the U.S., see “Tax Practitioners Discuss Taxation of Foreign Investments and Distressed Debt Investments at FRA/HFBOA Seminar (Part Three of Four),” The Hedge Fund Law Report, Vol. 7, No. 4 (Jan. 30, 2014); and “How Can Hedge Funds Recoup Overwithholding of Tax on Non-U.S. Source Interest and Dividends?,” The Hedge Fund Law Report, Vol. 6, No. 35 (Sep. 12, 2013).

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  • From Vol. 8 No.3 (Jan. 22, 2015)

    How Do Regulatory Investigations Affect the Hedge Fund Audit Process, Investor Redemptions, Reporting of Loss Contingencies and Management Representation Letters?

    A fund’s financial auditors are charged with taking reasonable steps to assure that the fund’s financial statements are free from material misstatements.  A regulatory investigation or allegation of misconduct against a fund or its manager can delay completion of an audit, lead to a qualified audit opinion or even derail the audit and lead to resignation of the auditor.  In that regard, a recent PracticeEdge session offered by the Regulatory Compliance Association (RCA) considered the steps a fund manager should take when faced with a regulatory investigation or allegation of misconduct, how to develop an effective response plan, and the impact that the matter will have on the annual audit process and the firm’s financial statements.  See also “Is This an Inspection or an Investigation? The Blurring Line Between Examinations of and Enforcement Actions Against Private Fund Managers,” The Hedge Fund Law Report, Vol. 5, No. 13 (Mar. 29, 2012).  In April of this year, the RCA will be hosting its Regulation, Operations and Compliance (ROC) Symposium in Bermuda.  For more on ROC Bermuda 2015, click here; to register for it, click here.

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  • From Vol. 7 No.47 (Dec. 18, 2014)

    What Hedge Fund Managers Need to Know About Year-End Tax Mitigating Strategies

    Because hedge fund managers are almost invariably tasked with understanding and executing sophisticated investment strategies on behalf of investors, the assumption might be that they need less assistance in assessing personal income and other tax strategies.  However, experience does not bear this assumption out.  Managers are often so focused on fiduciary, operational and compliance responsibilities that their own family wealth strategy is comparatively neglected.  A robust family wealth strategy covers at least wealth creation, tax planning, asset protection, generational transfer and charitable initiatives; sustainable wealth creation is limited without the other components of a well-developed strategy.  Accordingly, in a guest article, Alan S. Kufeld, partner at Flynn Family Office, highlights some of the pillars of a well-developed strategy for hedge fund managers, focusing specifically on those most relevant to year-end tax planning.  In particular, Kufeld’s article discusses the minimum viable tax planning horizon; gifting of a “vertical slice” of fund interests; trust and estate structuring and planning; structuring around the 3.8% Medicare surtax; use of insurance structures to mitigate tax; the looming requirement to repatriate previously deferred compensation; charitable activities; and the role of family offices in perpetuating wealth generated from hedge fund activities.  See “Tax Efficient Hedge Fund Structuring in Anticipation of the New 3.8% Surtax on Net Investment Income and Proposals to Limit Individuals’ Tax Deductions,” The Hedge Fund Law Report, Vol. 5, No. 40 (Oct. 18, 2012).

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  • From Vol. 7 No.46 (Dec. 11, 2014)

    A Roadmap for Hedge Fund Managers in Preparing For, Negotiating and Surviving IRS Partnership Audits

    A recent program offered a roadmap for hedge fund managers in preparing for, handling and surviving IRS partnership audits.  The program specifically focused on trends, statistics and mechanics of partnership audits; partnership audit procedures and IRS staffing; five of the most important issues in current partnership audits; and best practices in preparing for an audit.  Many domestic hedge funds and management companies are structured as partnerships or other pass-through entities.  Accordingly, the discussion of IRS partnership audit issues has direct relevance to U.S. hedge fund managers, hedge funds and hedge fund investors.  This article summarizes the most noteworthy insights from the program.  See also “Hedge Fund Tax Experts Discuss Allocations of Gains and Losses, Contributions to and Distributions of Property from a Fund, Expense Pass-Throughs and K-1 Preparation at FRA/HFBOA Seminar (Part One of Four),” The Hedge Fund Law Report, Vol. 7, No. 2 (Jan. 16, 2014).

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  • From Vol. 7 No.46 (Dec. 11, 2014)

    Experts Discuss Viability and Use of Hedge Fund Appreciation Rights in Light of Revenue Ruling 2014-18

    Section 457A of the Internal Revenue Code, enacted in 2008, generally prohibits deferral of compensation paid by entities that are not subject to U.S. tax.  The tax risk created by that section caused private fund managers to avoid performance fees payable in respect of multi-year measurement periods, which could be considered to be deferred compensation.  Earlier this year, the IRS issued Revenue Ruling 2014-18, which generally confirms that fund managers may use fund appreciation rights (analogous to stock appreciation rights) to provide performance-based compensation on a tax-deferred basis.  A recent program considered the impact of that ruling, with an emphasis on the benefits that fund appreciation rights may provide as a compensation vehicle.  The program was moderated by COOConnect founding partner Dominic Hobson.  The speakers were David E. Francl, Director, Hedge Funds and Operations, in Intel’s Treasury Department; Andrew L. Oringer, a Partner at Dechert LLP; and Thomas M. Young, a Managing Director at Optcapital LLC.  For more on Revenue Ruling 2014-18, see “Are Compensatory Options on Offshore Hedge Fund Shares Subject to the Anti-Deferral Provisions of Internal Revenue Code Section 457A?,” The Hedge Fund Law Report, Vol. 7, No. 23 (Jun. 13, 2014).

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  • From Vol. 7 No.43 (Nov. 13, 2014)

    Ten Steps That Hedge Fund Managers Can Take to Maximize the Tax Deductibility of Settlement Payments (Part Two of Two)

    Tax structuring is a concept more often associated with business transactions than with legal settlements.  But in a recent presentation, Shearman & Sterling partner Lawrence M. Hill highlighted the fundamental role of tax in the net economics of legal settlements.  Informed tax structuring can dramatically reduce the dollars that go out the door in a legal settlement, and tax counsel (like litigation counsel) can powerfully affect the economics of settlements.  In his presentation, Hill discussed ten specific strategies that private fund managers and other business entities can use to maximize the tax deductibility of legal settlements.  This article – the second in a two-part series – describes those ten strategies in detail.  The first article in this series offered a comprehensive overview of the law governing taxation of settlements.  For private fund managers, understanding these principles and implementing them during settlement negotiations can conserve resources, preserve reputation, save time, limit the use of directors and officers and other insurance and avoid the use of indemnification and exculpation provisions in governing documents.

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  • From Vol. 7 No.42 (Nov. 6, 2014)

    Valuation and Cybersecurity Best Practices for Hedge Fund Managers: An Interview with Brian Guzman, Partner and General Counsel at Indus Capital Partners, LLC (Part One of Two)

    The HFLR recently conducted a detailed and expansive interview with Brian Guzman, Partner and General Counsel at Indus Capital Partners, LLC.  At a thematic level, the interview covered valuation, cybersecurity, examinations, the AIFMD, and international and tax issues.  At a granular level, the parts of the interview on valuation covered the role and composition of valuation committees; the role of fund boards in the valuation process; best practices with respect to valuation of credit derivatives, distressed debt and other illiquid assets; valuation challenges facing fund of funds managers; use and limits of third-party pricing services; testing of valuation policies and procedures; valuation disclosure; and the relevance of different regional accounting regimes in the hedge fund valuation process.  On cybersecurity, we covered the top challenges and effective strategies for addressing those challenges.  This article includes the parts of our interview on valuation and cybersecurity.  A follow-up article will cover the parts of our interview on examinations, the AIFMD and international and tax issues.  This interview was conducted in connection with (1) the Regulatory Compliance Association’s Compliance, Risk and Enforcement Symposium, which took place on November 4 in New York City – Guzman participated in this Symposium and we will cover it in subsequent issues of the HFLR – and (2) the RCA’s upcoming Regulation, Operations and Compliance (ROC) Symposium, to be held in Bermuda in April 2015.  For more on ROC Bermuda 2015, click here; to register for it, click here.  For additional insight from Guzman, see “FCPA Compliance Strategies for Hedge Fund and Private Equity Fund Managers,” The Hedge Fund Law Report, Vol. 7, No. 23 (Jun. 13, 2014); and “RCA Symposium Clarifies Current Market Practice on Side Letters, Conflicts of Interest, Insider Trading Investigations, Whistleblowers, FATCA and Use of Managed Accounts Versus Funds of One (Part One of Two),” The Hedge Fund Law Report, Vol. 6, No. 24 (Jun. 13, 2013).

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  • From Vol. 7 No.42 (Nov. 6, 2014)

    Are Legal Settlements Tax Deductible?  (Part One of Two)

    Whether or not legal settlements, or parts of them, are tax deductible can materially affect the net economics of such settlements.  And settling entities – for example, hedge fund managers in insider trading, employment or other civil actions – can influence the deductibility of settlements through structuring, drafting of settlement agreements and other actions.  In a recent presentation, Shearman & Sterling tax partner Lawrence M. Hill provided an overview of key concepts, best practices and applicable case law bearing on the deductibility of settlements.  In particular, he discussed the differing tax treatment of the following categories of settlement amounts: compensatory damages, punitive damages, multiple damages, damages not specified as compensatory or punitive in the relevant settlement agreement, relator’s fees, legal fees, restitution, disgorgement, fines, penalties and civil forfeiture.  He also offered tips on drafting settlement agreements to maximize the proportion of settlements that validly may be characterized as deductible.  This article, the first in a two-part series, examines the law governing tax deductibility of settlements, as explained by Hill in his presentation.  The second article in the series will relay Hill’s specific guidance on taxation of damages in practice and how a company can make its case that a settlement should be deductible.  For more on tax issues relevant to hedge fund managers, see “Internal Memo Describes IRS Position on Whether Limited Partner Exemption from Self-Employment Tax Is Available to Owners of an Investment Management Company,” The Hedge Fund Law Report, Vol. 7, No. 35 (Sep. 18, 2014); and “Are Compensatory Options on Offshore Hedge Fund Shares Subject to the Anti-Deferral Provisions of Internal Revenue Code Section 457A?,” The Hedge Fund Law Report, Vol. 7, No. 23 (Jun. 13, 2014).

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  • From Vol. 7 No.39 (Oct. 17, 2014)

    Ackman’s Pershing Square Public Offering Features Novel Performance Fee Mechanism

    Following in the footsteps of other private fund managers who have sought permanent capital through public offerings, activist investor Bill Ackman’s Pershing Square Holdings, Ltd. has raised about $2.7 billion through a recent offering of its shares on Euronext Amsterdam.  Prior to the offering, the company converted into a closed-end investment vehicle; its shareholders will be able to achieve liquidity by selling their shares on that exchange.  This article focuses on the novel approach to the company’s calculation of performance fees and on the tax treatment of the entity and its investors in Guernsey, where it is organized, and the Netherlands, where its shares now trade.  For discussions of other fund managers who have gone to the public markets for permanent capital, see “Anatomy of a Blank Check IPO by a Hedge Fund Manager,” The Hedge Fund Law Report, Vol. 7, No. 13 (Apr. 4, 2014); and “Prospectus for Suspended Ellington Financial IPO Details Mechanics of a Hedge Fund Permanent Capital Vehicle,” The Hedge Fund Law Report, Vol. 2, No. 50 (Dec. 17, 2009).  Other managers have used public offerings to monetize the value of their businesses, to provide capital for expansion and to create liquidity for founders and employees.  See “Ares Management IPO Raises Permanent Capital and Creates Liquidity for Founders’ Interests,” The Hedge Fund Law Report, Vol. 7, No. 14 (Apr. 11, 2014); and “Mechanics of a Hedge Fund Manager IPO,” The Hedge Fund Law Report, Vol. 5, No. 16 (Apr. 19, 2012).

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  • From Vol. 7 No.35 (Sep. 18, 2014)

    Internal Memo Describes IRS Position on Whether Limited Partner Exemption from Self-Employment Tax Is Available to Owners of an Investment Management Company

    The Office of Chief Counsel of the Internal Revenue Service (IRS) recently released a Memorandum that considers whether members of a limited liability company that serves as an investment manager to several investment funds are entitled to rely on the exemption from self-employment taxes afforded to “limited partners” under §1402(a)(13) of the Internal Revenue Code.  The IRS’ position is important because the federal Medicare tax applies to all self-employment earnings; there is no income limit, as there is for social security tax.  See also “Tax Efficient Hedge Fund Structuring in Anticipation of the New 3.8% Surtax on Net Investment Income and Proposals to Limit Individuals’ Tax Deductions,” The Hedge Fund Law Report, Vol. 5, No. 40 (Oct. 18, 2012).

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  • From Vol. 7 No.33 (Sep. 4, 2014)

    Considerations for Hedge Fund Managers Evaluating Forming Reinsurance Vehicles in the Cayman Islands

    There has been much talk recently about the formation of reinsurance companies by hedge fund managers.  Indeed, in the Cayman Islands (Cayman), there has been significant increase of interest in the establishment of reinsurance vehicles.  The first open market reinsurance vehicle with a physical presence was established in Cayman in 2004, and now, several years later, conditions are such that others are following suit.  Anecdotal evidence shows that many service providers across the financial services community in Cayman have been advising or otherwise speaking with fund manager clients about setting up reinsurers in Cayman.  This article highlights some key reasons driving interest in Cayman as a domicile for the establishment of reinsurance vehicles.  The authors of this article are Tim Frawley, a partner in the Cayman Islands office of Maples and Calder, and Karey B. Dearden, an Executive Director in Ernst & Young LLP’s Financial Services Office, International Tax Services practice in New York City.  For background on the opportunities and risks associated with hedge fund managers establishing reinsurance vehicles, see “How Can Hedge Fund Managers Use Reinsurance Businesses to Raise and Retain Assets and Achieve Uncorrelated Returns? (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 3 (Jan. 17, 2013).

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  • From Vol. 7 No.24 (Jun. 19, 2014)

    The Impact of Revenue Ruling 2014-18 on Compensation of Hedge Fund Managers and Employees

    The IRS recently issued Revenue Ruling 2014-18, addressing the application of certain anti-deferral provisions of the Internal Revenue Code to nonqualified stock option and stock appreciation right plans (together, Option Plans).  See “Are Compensatory Options on Offshore Hedge Fund Shares Subject to the Anti-Deferral Provisions of Internal Revenue Code Section 457A?,” The Hedge Fund Law Report, Vol. 7, No. 23 (Jun. 13, 2014).  In a guest article, Philip S. Gross and James D. McCann, both Members of Kleinberg, Kaplan, Wolff & Cohen, P.C., discuss some of the potential benefits and detriments of Option Plans from the perspectives of hedge fund managers and investors, and the potential impact of the Revenue Ruling on hedge fund manager taxation, structuring and compensation practices.

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  • From Vol. 7 No.23 (Jun. 13, 2014)

    Are Compensatory Options on Offshore Hedge Fund Shares Subject to the Anti-Deferral Provisions of Internal Revenue Code Section 457A?

    For years, hedge fund managers and investors have discussed the possibility of structuring the performance allocation payable by an offshore fund to its manager as an option on or appreciation right with respect to shares of the offshore fund.  The benefits of structuring the performance allocation as an option or appreciation right include tax deferral, an implicit clawback and a multi-year measurement period.  See “Hedge Fund Managers Considering Fund Appreciation Rights Compensation Structures to Defer Tax on Performance Compensation and to Better Align Manager and Investor Incentives,” The Hedge Fund Law Report, Vol. 2, No. 45 (Nov. 11, 2009).  However, implementation of such structures has been held up by tax risk: The IRS had not opined on whether options or appreciation rights in this context are subject to the anti-deferral provisions of Internal Revenue Code (IRC) Section 457A.  That ambiguity was resolved, in large measure, by a recent IRS revenue ruling.  This article identifies the specific issue addressed by the revenue ruling; summarizes relevant IRC provisions and Treasury Regulations; details the IRS’ analysis in the revenue ruling; and restates the revenue ruling’s conclusion.  Subsequent articles in the HFLR will delve into the consequences of the revenue ruling for structuring hedge fund performance compensation.

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  • From Vol. 7 No.19 (May 16, 2014)

    Vinson & Elkins Expands Tax Capabilities with Addition of Sheri Dillon in D.C.

    On May 12, 2014, Vinson & Elkins announced that Sheri A. Dillon has joined as a partner in Washington, D.C.  Dillon represents clients in a wide variety of federal tax controversy matters, with a particular focus on partnership tax issues.  See “Potential Impact on US Hedge Fund Managers of the Reform of the UK Tax Regime Relating to Partnerships and Limited Liability Partnerships,” The Hedge Fund Law Report, Vol. 7, No. 10 (Mar. 13, 2014); “Use by Hedge Fund Managers of Profits Interests and Other Equity Stakes for Incentive Compensation,” The Hedge Fund Law Report, Vol. 7, No. 15 (Apr. 18, 2014); “Hedge Fund Tax Experts Discuss Allocations of Gains and Losses, Contributions to and Distributions of Property from a Fund, Expense Pass-Throughs and K-1 Preparation at FRA/HFBOA Seminar (Part One of Four),” The Hedge Fund Law Report, Vol. 7, No. 2 (Jan. 16, 2014).

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  • From Vol. 7 No.11 (Mar. 21, 2014)

    New York City Bar’s “Hedge Funds in the Current Environment” Event Focuses on Hedge Fund Structuring, Private Fund Examinations, Compliance Risks and Seeding Arrangements

    On March 5, 2014, the New York City Bar held the most recent edition of its annual “Hedge Funds in the Current Environment” event.  Panelists at the event – including general counsels and chief compliance officers (CCOs) from leading hedge fund managers and partners from top law firms – addressed hedge fund structuring considerations (including the purposes and mechanics of mini-master funds); the myth of the unregulated hedge fund; analogies between regulatory examinations and investor due diligence; seven key areas of regulatory interest in hedge fund examinations; five headline issues confronting CCOs; four pros and seven cons of hedge fund seeding arrangements; and a structuring alternative to seeding ventures.  This article highlights the salient points from the event.  For our coverage of the 2012 edition of this event, see “Davis Polk ‘Hedge Funds in the Current Environment’ Event Focuses on Establishing Registered Alternative Funds, Hedge Fund Manager M&A and SEC Examination Priorities,” The Hedge Fund Law Report, Vol. 5, No. 24 (Jun. 14, 2012).

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  • From Vol. 7 No.10 (Mar. 13, 2014)

    Potential Impact on US Hedge Fund Managers of the Reform of the UK Tax Regime Relating to Partnerships and Limited Liability Partnerships

    Both UK limited partnerships (LPs) and UK limited liability partnerships (LLPs) have, for some years, been widely utilised as part of international investment and management structures of both US sponsors and US managers.  Whilst UK LPs have been widely used as investment vehicles within the private equity industry and, to a lesser extent, in connection with other illiquid investment strategies, the UK LLP has become the vehicle of choice for US managers who have established a presence in the United Kingdom.  The attractions of the UK LLP have been clear, combining the advantage of being taxed as a partnership, whilst still offering limited liability, corporate personality and – importantly – organisational and structural flexibility.  However, as the popularity of the UK LP and, in particular, the UK LLP has increased, so has the level of scrutiny applied by the UK tax authority (HMRC).  Following the conclusion of a 2013 public consultation on measures designed to reform certain aspects of the UK tax regime relating to LPs and LLPs, HMRC have now published draft legislation for inclusion in the UK Finance Bill 2014.  The areas which are subject to the new UK tax legislation can be broadly placed into three categories: (1) countering the use of UK LLPs to disguise what HMRC consider should be employment relationships (and, thereby, avoid certain employment and payroll taxes); (2) countering arrangements whereby economic interests and other entitlements are allocated to or transferred between members of LPs and LLPs; and (3) amending certain aspects of the UK tax regime relating to LPs and LLPs to take account of the remuneration deferral requirements under the EU Alternative Investment Fund Managers Directive.  In a guest article, Will Smith, a partner in the London office of Sidley Austin LLP, discusses the anticipated impact on US hedge fund managers of the draft legislation.

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  • From Vol. 7 No.7 (Feb. 21, 2014)

    A Checklist for Updating Hedge Fund and Service Provider Documents for FATCA Compliance

    The Foreign Account Tax Compliance Act (FATCA) established a broad registration, compliance and reporting regime designed to combat tax evasion by providing the IRS with information about U.S. accounts held at foreign financial institutions (FFIs).  The regime imposes 30% withholding on payments to FFIs that have failed to register with the IRS and provide information on U.S. account holders.  The first step in FATCA compliance is for FFIs to register with the IRS and obtain a global intermediary identification number, without which the FFI will be subject to withholding as of July 1 of this year.  In that regard, the April 25 deadline for inclusion in the initial IRS list of registered FFIs is fast approaching, and hedge fund managers with offshore funds or that have non-U.S. investors need to assure that they are fully compliant with FATCA.  A recent presentation covered the critical steps that funds should be taking to prepare for FATCA’s July 1 effective date and the compliance mechanisms they will need to implement to assure compliance with FATCA.  This article summarizes the key takeaways from that presentation.  See also “Understanding the Intricacies for Private Funds of Becoming and Remaining FATCA-Compliant,” The Hedge Fund Law Report, Vol. 6, No. 35 (Sep. 12, 2013); and “What Impact Will FATCA Have on Offshore Hedge Funds and How Should Such Funds Prepare for FATCA Compliance?,” The Hedge Fund Law Report, Vol. 6, No. 5 (Feb. 1, 2013).

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  • From Vol. 7 No.5 (Feb. 6, 2014)

    Tax Practitioners Discuss Taxation of Swaps, Wash Sales, Constructive Sales, Short Sales and Straddles at FRA/HFBOA Seminar (Part Four of Four)

    As a general matter, investors prefer long-term capital gains over ordinary income and, when faced with losses, short-term losses over long-term capital losses.  Investors and tax professionals are constantly seeking to optimize their tax results, in part by seeking to assure the most favorable tax treatment available when trading.  In some circumstances, such as those involving total return swaps, the IRS has simplified matters by predetermining a fixed percentage of gains and losses that are entitled to short-term or long-term treatment.  The IRS has also adopted several rules in response to trades that generated tax benefits but that did not result in a change of economic position for the investor.  In that regard, two presentations given as part of the 15th Annual Effective Hedge Fund Tax Practices seminar, co-hosted by Financial Research Associates and the Hedge Fund Business Operations Association, covered the fundamentals of the taxation of swaps and the tax treatment of wash sales, constructive sales, short sales and straddles.  This article, the last in our four-part series covering the seminar, summarizes the key takeaways from those presentations.  The first article in this series covered three sessions addressing contribution and distribution of property to fund investors, allocation of investment gains and losses to fund investors and preparation of Forms K-1.  See “Hedge Fund Tax Experts Discuss Allocations of Gains and Losses, Contributions to and Distributions of Property from a Fund, Expense Pass-Throughs and K-1 Preparation at FRA/HFBOA Seminar (Part One of Four),” The Hedge Fund Law Report, Vol. 7, No. 2 (Jan. 16, 2014).  The second article discussed issues impacting foreign investors in foreign funds, including basics of withholding with respect to fixed or determinable annual or periodic gains, profits, or income (FDAPI); the portfolio interest exemption from FDAPI withholding; the pitfalls of effectively connected income (ECI) for offshore hedge funds; and the sources of ECI.  See “Tax Experts Discuss Provisions Impacting Foreign Investors in Foreign Hedge Funds During FRA/HFBOA Seminar (Part Two of Four),” The Hedge Fund Law Report, Vol. 7, No. 3 (Jan. 23, 2014).  The third article addressed taxation of foreign investments, including withholding at the source, rules regarding controlled foreign corporations and issues concerning taxation of distressed debt investments.  See “Tax Practitioners Discuss Taxation of Foreign Investments and Distressed Debt Investments at FRA/HFBOA Seminar (Part Three of Four),” The Hedge Fund Law Report, Vol. 7, No. 4 (Jan. 30, 2014).

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  • From Vol. 7 No.4 (Jan. 30, 2014)

    Tax Practitioners Discuss Taxation of Foreign Investments and Distressed Debt Investments at FRA/HFBOA Seminar (Part Three of Four)

    During the 15th Annual Effective Hedge Fund Tax Practices seminar sponsored by Financial Research Associates and the Hedge Fund Business Operations Association, tax experts at two separate sessions addressed the taxation of foreign investments, including withholding at the source, rules regarding controlled foreign corporations and issues concerning the taxation of distressed debt investments.  This article, our third in a four-part series covering the seminar, summarizes salient points from those two sessions.  Panelists for the “Working Through Tax Implications of Foreign Investments” session included, among others, Len Lipton, a managing director at GlobeTax Services and Philip S. Gross, a partner at Kleinberg, Kaplan, Wolff & Cohen, P.C.  The session entitled “Tax Considerations for Distressed Debt Transactions” was presented by David C. Garlock, Director of Financial Services at Ernst & Young LLP.  The first installment in this series covered three sessions addressing the contribution and distribution of property to fund investors, the allocation of investment gains and losses to fund investors and the preparation of Forms K-1.  See “Hedge Fund Tax Experts Discuss Allocations of Gains and Losses, Contributions to and Distributions of Property from a Fund, Expense Pass-Throughs and K-1 Preparation at FRA/HFBOA Seminar (Part One of Four),” The Hedge Fund Law Report, Vol. 7, No. 2 (Jan. 16, 2014).  The second installment discussed issues impacting foreign investors in foreign funds, including basics of withholding with respect to fixed or determinable annual or periodic gains, profits or income (FDAPI); the portfolio interest exemption from FDAPI withholding; the pitfalls of effectively connected income (ECI) for offshore hedge funds; and the sources of ECI.  See “Tax Experts Discuss Provisions Impacting Foreign Investors in Foreign Hedge Funds During FRA/HFBOA Seminar (Part Two of Four),” The Hedge Fund Law Report, Vol. 7, No. 3 (Jan. 23, 2014).

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  • From Vol. 7 No.3 (Jan. 23, 2014)

    Tax Experts Discuss Provisions Impacting Foreign Investors in Foreign Hedge Funds During FRA/HFBOA Seminar (Part Two of Four)

    Offshore hedge funds, whether structured as corporations or partnerships, are subject to the provisions of the U.S. Internal Revenue Code (IRC) that govern taxation of nonresident aliens and foreign entities.  Generally, a foreign person is subject to U.S. taxation on its U.S.-source income.  Taxable U.S.-source income generally falls into two categories: (1) effectively connected income (ECI), which is income earned in connection with a U.S. trade or business, and (2) “fixed or determinable annual or periodic gains, profits, or income” (FDAPI).  ECI is subject to U.S. taxation in the same manner as income earned by U.S. citizens and residents: recipients are required to file U.S. tax returns.  In contrast, IRC Sections 1441, 1442 and 1443 provide for taxation of FDAPI that is not ECI, and that is payable to foreign individuals, corporations and tax-exempt entities, at the flat rate of 30% of the gross amount payable (or lower treaty rate, if applicable).  The 30% tax must be withheld at the source (i.e., by the payer).  This second installment in our series covering the 15th Annual Effective Hedge Fund Tax Practices seminar, sponsored by Financial Research Associates and the Hedge Fund Business Operations Association, summarizes key lessons learned from a session entitled “Handling Issues Relative to Inbound Tax Matters.”  That session outlined the basics of withholding with respect to FDAPI; the portfolio interest exemption from FDAPI withholding; the pitfalls of ECI for offshore hedge funds; and the sources of ECI.  The speakers included Jill E. Darrow, Partner and head of the New York tax practice of Katten Muchin Rosenman LLP.  The first installment covered three sessions addressing the contribution and distribution of property to fund investors, the allocation of investment gains and losses to fund investors and the preparation of Forms K-1.  See “Hedge Fund Tax Experts Discuss Allocations of Gains and Losses, Contributions to and Distributions of Property from a Fund, Expense Pass-Throughs and K-1 Preparation at FRA/HFBOA Seminar (Part One of Four),” The Hedge Fund Law Report, Vol. 7, No. 2 (Jan. 16, 2014).

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  • From Vol. 7 No.2 (Jan. 16, 2014)

    Hedge Fund Tax Experts Discuss Allocations of Gains and Losses, Contributions to and Distributions of Property from a Fund, Expense Pass-Throughs and K-1 Preparation at FRA/HFBOA Seminar (Part One of Four)

    Most U.S.-domiciled hedge funds are organized as partnerships for tax purposes, which gives them flexibility in structuring the economic terms of investments in a fund, including through the allocation of gains and losses.  Fund income, expenses, gains and losses are allocated to investors periodically and passed through to them annually on Schedule K-1 of the fund’s partnership tax return.  Those allocations and contributions of property to, and distributions of property from, partnerships have important tax ramifications for fund investors.  Against this backdrop, three presentations during the 15th Annual Effective Hedge Fund Tax Practices seminar, co-hosted by Financial Research Associates and the Hedge Fund Business Operations Association, covered the fundamentals of the tax treatment of partnership contributions and distributions, special rules on deductibility of fund expenses and the allocation of fund gains and losses, as well as how those items will be reflected on the Form K-1 delivered by a fund to its investors.  See “What Critical Issues Must Hedge Fund Managers Understand to Inform Their Preparation of Schedules K-1 for Distribution to Their Investors?,” The Hedge Fund Law Report, Vol. 6, No. 11 (Mar. 14, 2013).  This article summarizes the key lessons from those three presentations.

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  • From Vol. 6 No.48 (Dec. 19, 2013)

    Akin Gump Partners Present Overview of Recent Developments in Fund Taxation, Fund Manager Transactions and Hedge and Private Equity Fund Investment Terms

    Akin Gump Strauss Hauer & Feld LLP (Akin Gump) recently presented its annual Private Investment Funds Conference.  During the conference, Akin Gump partner Stuart E. Leblang presented the annual tax update; partners Stephen M. Vine, Ackneil M. (Trey) Muldrow III and Stephen M. Jordan discussed recent trends in transactions involving equity stakes in fund manager businesses; and partners Blayne A. Grady and Burke A. McDavid addressed the current environment for hedge fund and private equity fund terms.  This article details salient takeaways from each of these sessions.

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  • From Vol. 6 No.47 (Dec. 12, 2013)

    U.S. Tax Court Decision Highlights the Quantitative and Qualitative Factors Considered in a “Trader” vs. “Investor” Analysis, with Implications for the Deductibility of Fund Expenses by Hedge Fund Investors

    Earlier this year, the U.S. Tax Court issued a decision that provided insight on when a person engaged in trading securities would be deemed a “trader” as opposed to an “investor.”  The distinction is important in the hedge fund space: Investors in “trader funds” are able to deduct a greater portion of the fund’s expenses on their personal income tax returns.  Generally, expenses passed through to investors from an “investor fund” are capped at two percent of the investor’s adjusted gross income, while expenses passed through by a “trader fund” are fully deductible against hedge fund income by investors.  See “What Critical Issues Must Hedge Fund Managers Understand to Inform Their Preparation of Schedules K-1 for Distribution to Their Investors?,” The Hedge Fund Law Report, Vol. 6, No. 11 (Mar. 14, 2013).  This article summarizes the factual background of the case, including a discussion of the taxpayer’s trading activities, the Court’s legal analysis and its decision.  See also “U.S. Tax Court Decision Considering ‘Investor’ vs. ‘Trader’ Status Could Impact the Tax Status of Hedge Funds and the Deductibility of Fund Expenses by Hedge Fund Investors,” The Hedge Fund Law Report, Vol. 6, No. 40 (Oct. 17, 2013).

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  • From Vol. 6 No.42 (Nov. 1, 2013)

    What Should Hedge Fund Managers Understand About Transfer Pricing and How to Manage the Related Risks?

    Hedge fund firms with multinational operations should understand the implications of transfer pricing for their operations.  Transfer pricing establishes the price charged between controlled parties involved in cross-border transfers of goods, intangibles and services, as well as financial transactions (e.g., loans).  While transfer pricing is most often applicable to international transactions involving distinct legal entities within a global group, the concept of “controlled parties” can extend to entities involved in domestic transactions, as well as partnerships and individuals.  Taxing authorities around the world have enacted transfer pricing rules to ensure that income is not arbitrarily shifted to other taxpayers or jurisdictions, and that reported profits are aligned with functions, assets and risks.  The arm’s length standard is the fundamental basis of most transfer pricing law, and seeks to price a transaction between controlled parties as if it occurred between two unrelated parties.  Many countries require taxpayers to maintain documentation to demonstrate that intercompany transactions comply with the arm’s length standard and can impose significant penalties absent this documentation.  As a matter of course, many taxing authorities (including the Internal Revenue Service in the U.S.) request this documentation at the outset of an audit.  In a guest article, Jessica Joy, Stefanie Perrella and Matt Rappaport – Managing Director, Vice President and Analyst, respectively, at Duff & Phelps – present an overview of transfer pricing and relevant U.S. laws.  Further, the authors discuss current events that may be indicative of how lawmakers and regulators will approach transfer pricing for hedge fund firms going forward, and present illustrative transfer pricing issues of particular relevance to hedge fund firms.

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  • From Vol. 6 No.42 (Nov. 1, 2013)

    Hedge Funds Realize Material Return by Funding Litigation Over a Tax Refund in a Bank Holding Company Bankruptcy

    Litigation funding – generally, debt, equity or other investments in third-party legal cases – can offer absolute and uncorrelated returns.  See “In Turbulent Markets, Hedge Fund Managers Turn to Litigation Funding for Absolute, Uncorrelated Returns,” The Hedge Fund Law Report, Vol. 2, No. 25 (Jun. 24, 2009).  In a recent example of a successful execution of such a strategy, several hedge funds funded litigation on behalf of a bankrupt bank holding company involving a tax refund dispute with the Federal Deposit Insurance Corporation (FDIC).  Those funds are poised to profit handsomely following a decision by the U.S. Bankruptcy Court for the District of Delaware (Court) in favor of the bank holding company.  The four hedge funds financed the tax refund litigation on behalf of the bank holding company after the bankruptcy trustee ran out of money to finance continuing litigation.  The hedge funds also held notes issued by the bank holding company.  At issue was whether a huge tax refund was owned by the bank holding company or by a bank subsidiary.  If the bank subsidiary owned the refund, its receiver, the FDIC, would take it all.  However, if the bank holding company owned the refund, the FDIC would have to share it with other creditors of the bank holding company, including the hedge funds and other noteholders.  This article summarizes the facts of the case, the Court’s legal analysis and the anticipated distribution of the tax refund.  This article also identifies an ongoing bankruptcy that is factually similar (i.e., a bank holding company bankruptcy involving a dispute over a sizable tax refund) and may therefore lend itself to a similar litigation funding strategy.

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  • From Vol. 6 No.40 (Oct. 17, 2013)

    U.S. Tax Court Decision Considering “Investor” vs. “Trader” Status Could Impact the Tax Status of Hedge Funds and the Deductibility of Fund Expenses by Hedge Fund Investors

    Whether a hedge fund is deemed to be an “investor fund” or a “trader fund” can have a significant financial impact on its investors because investors in trader funds are able to deduct a greater portion of the fund’s expenses on their personal income tax returns.  Expenses passed through to investors from an investor fund are capped at two percent of the investor’s adjusted gross income, while expenses passed through by a trader fund are fully deductible against hedge fund income.  See “What Critical Issues Must Hedge Fund Managers Understand to Inform Their Preparation of Schedules K-1 for Distribution to Their Investors?,” The Hedge Fund Law Report, Vol. 6, No. 11 (Mar. 14, 2013).  A recent U.S. Tax Court decision involving an individual who traded stocks and call options provides an excellent overview of the criteria the Internal Revenue Service considers in determining whether an individual or entity is a “trader.”  Although the decision involves an individual, the criteria considered by the Court are likely to apply to the tax status of hedge funds.  This article summarizes the factual allegations as well as the Court’s legal analysis and holding in the case.

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  • From Vol. 6 No.35 (Sep. 12, 2013)

    How Can Hedge Funds Recoup Overwithholding of Tax on Non-U.S. Source Interest and Dividends?

    Many hedge fund managers may be surprised to learn that their funds and investors are overpaying on taxes levied in relation to cross-border investment income earned by their funds.  Foreign governments often withhold taxes on income earned from such investments at higher rates than are delineated in tax treaties because they cannot ascertain the ultimate beneficial owners of such investments.  Nonetheless, the process to recoup such overpayments – dubbed tax reclamation – is complex and varies widely from jurisdiction to jurisdiction.  To help our subscribers understand the benefits, process and intricacies of tax reclamation, The Hedge Fund Law Report recently conducted an interview with Len Lipton, Managing Director at GlobeTax, a tax reclamation services provider.  Specifically, our interview with Lipton covered, among other topics: what tax reclamation is; general steps in the tax reclamation process; statutes of limitations for filing reclaims; the feasibility of self-filing; operational, legal and other challenges fund managers face in the tax reclamation process; the decision whether to self-file or to outsource tax reclamation to a third-party service provider; conducting due diligence on third-party tax reclamation service providers; whether certain fund structures increase tax reclamation challenges; types of information to be disclosed to file a reclaim; whether the type of investor impacts the tax reclamation process and recovery; whether a fund must disclose its portfolio to file for a reclaim; and whether there are regulatory or other drawbacks facing managers pursuing tax reclamation.  This article contains the full transcript of our interview with Lipton.

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  • From Vol. 6 No.34 (Aug. 29, 2013)

    Massachusetts Appeals Court Holds That Hedge Fund Investors Can Sue Hedge Fund Auditor Based on Payment of Taxes on Fraudulent “Phantom Income”

    Can a hedge fund investor sue the hedge fund’s auditor if the fund turns out to be a fraud?  While courts have come down on both sides of this question, the thrust of the caselaw has thus far been unfavorable to investors and favorable to auditors and other service providers seeking to avoid liability.  See, e.g., “When Can Hedge Fund Investors Bring Suit Against a Service Provider for Services Performed on Behalf of the Fund?,” The Hedge Fund Law Report, Vol. 6, No. 18 (May 2, 2013).  However, the Massachusetts Appeals Court (Court) recently upheld a trial court decision allowing investors in a fraudulent hedge fund to proceed with a suit against the funds’ auditor.  In particular, the Court identified various direct claims available to the hedge fund investors based on (among other things) the passing through of profits and losses to investors and the payment of taxes by investors on phantom income that did not exist.  For more on phantom income and the tax consequences of it, see “How Can Hedge Fund Managers Use Profits Interests, Capital Interests, Options and Phantom Income to Incentivize Top Portfolio Management and Other Talent?,” The Hedge Fund Law Report, Vol. 6, No. 33 (Aug. 22, 2013).  The Court’s decision may create opportunities for investors in similar factual scenarios (and in disputes governed by Delaware law) to take direct action against auditors and other hedge fund service providers, at least where investors suffer a harm independent of any harm suffered by the fund.  This article summarizes the factual background of the case, the Court’s legal analysis and the implications of the Court’s decision.

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  • From Vol. 6 No.33 (Aug. 22, 2013)

    How Can Hedge Fund Managers Use Profits Interests, Capital Interests, Options and Phantom Income to Incentivize Top Portfolio Management and Other Talent?

    The competition for key talent among hedge fund managers is fierce, and many have resorted to offering their key employees a stake in the manager’s business to attract the best and the brightest.  “Equity” compensation has become so prevalent that more than one-quarter of hedge fund manager employees have reported owning an equity interest in their firms.  See “Hedge Fund Manager Compensation Survey Addresses Employee Compensation Levels and Composition Across Job Titles and Firm Characteristics, Employee Ownership of Manager Equity and Hiring Trends,” The Hedge Fund Law Report, Vol. 6, No. 8 (Feb. 21, 2013).  The forms of equity compensation that hedge fund managers can offer include profits interests, capital interests, options and phantom income in the firm.  Each of these options has economic and other ramifications, both for the offering firm and the offeree.  A recent program provided an overview of the various forms of equity participation that a hedge fund manager can offer its personnel.  Among other things, the panelists discussed the intricacies of profits interests; the current status of carried interest legislation; four different types of equity compensation that managers can offer personnel (including profits interests, capital interests, options and phantom income); tax consequences of becoming a “partner” as a result of the receipt of equity participation in the firm; and the applicability of Section 409A of the Internal Revenue Code to various forms of equity compensation offered by managers.  This article summarizes the key takeaways from the program.

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  • From Vol. 6 No.30 (Aug. 1, 2013)

    Tax and Structuring Considerations for Funds Organized to Invest in Master Limited Partnerships

    Many businesses that operate in the energy and natural resources sector are organized as master limited partnerships (MLPs) due to favorable tax treatment, including income tax deferral for investors in the early years of their MLP investments.  Funds established to own MLPs can provide diversified exposure to the MLP sector for investors.  While many of these funds are organized as registered funds, hedge fund managers willing to establish such registered funds may be positioned to capitalize on the opportunity to attract investors interested in tax-efficient energy and natural resource investing.  See generally “How Can Hedge Fund Managers Organize and Operate Alternative Mutual Funds to Access Retail Capital (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 6 (Feb. 7, 2013).  A recent panel discussion sponsored by Ropes & Gray LLP discussed various options that are available to fund managers interested in establishing an MLP-focused fund.  Panelists, including Michael Doherty and Amy Snyder, both partners at Ropes & Gray LLP, as well as guest speaker Robert Prado, a director at PricewaterhouseCoopers LLP, addressed the tax benefits provided by MLPs and tax and structuring considerations for funds seeking to invest in MLPs.  This article summarizes the primary lessons from the panel discussion.

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  • From Vol. 6 No.26 (Jun. 27, 2013)

    Key Hedge Fund Tax Developments in the U.K., the European Union, Ireland, Germany, Spain, Australia, India and Puerto Rico

    Tax considerations have a powerful impact on hedge fund manager compensation and investor returns.  Accordingly, tax considerations are front and center when managers select domiciles for their funds and management entities; structure funds and related entities; and enter and exit positions.  Hedge fund taxation is inherently complicated and continuously changing; and the complexity is compounded for managers investing and operating globally.  To bring some clarity and coherence to this challenging subject, a recent program examined completed and pending changes to relevant tax laws in the U.K. (including the “reporting fund” regime), the European Union (including the financial transaction tax), Germany, Ireland, Spain, Australia, India and Puerto Rico.  Participants in the program provided detailed explanations of the current state of the tax law in each jurisdiction, how the law is likely to change and best practices for structuring and investing around current and anticipated tax law.  This article memorializes the insights from the program, focusing in particular on practical consequences for hedge fund managers of tax law changes.  For more on tax reporting considerations relevant to hedge fund managers, see “What Critical Issues Must Hedge Fund Managers Understand to Inform Their Preparation of Schedules K-1 for Distribution to Their Investors?,” The Hedge Fund Law Report, Vol. 6, No. 11 (Mar. 14, 2013).

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  • From Vol. 6 No.11 (Mar. 14, 2013)

    What Critical Issues Must Hedge Fund Managers Understand to Inform Their Preparation of Schedules K-1 for Distribution to Their Investors?

    Most hedge funds are taxed as partnerships and therefore pass through items of income, gains and losses to their fund investors, rather than facing taxation on such items at the partnership level.  As a result, hedge fund managers are responsible for preparing and distributing to their investors a Schedule K-1 to Form 1065, which shows an investor’s share of a fund’s income, gains, losses, credits and other items for each tax year that must be reported to the Internal Revenue Service on the investor’s individual income tax return.  Nonetheless, preparation of this schedule can present a litany of challenges which can confound many hedge fund managers.  Moreover, preparation of K-1s cannot be entirely outsourced to an accounting firm; a manager must understand what the accounting firm is doing and be able to evaluate its work.  Recognizing the complexity and importance of this topic, a recent webinar provided a top-level refresher course on the tax considerations that influence the structuring of hedge funds and addressed numerous issues involved in the preparation of Schedule K-1, such as the difference between “trader funds” and “investor funds,” and allocation and adjustment rules that have tax consequences for hedge fund investors.  This article summarizes key takeaways from that program.

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  • From Vol. 6 No.11 (Mar. 14, 2013)

    U.K. Tax Tribunal Overturns Hedge Fund Manager’s Attempt to Avoid Tax on Hedge Fund Profits through the Acquisition and Disposition of Film Distribution Rights

    On February 13, 2013, a U.K. tax tribunal (Tribunal) overturned a tax avoidance scheme in which a prominent hedge fund manager attempted to create artificial losses through the acquisition and disposition of film distribution rights to shelter millions of pounds in personal income generated from his hedge fund.  This case is the latest victory for Her Majesty’s Revenue and Customs in its recent vigorous enforcement against aggressive tax avoidance schemes by hedge fund managers.  See “U.K. Hedge Fund Manager Taxed on Bonuses Delivered Through Tax-Avoidance Scheme,” The Hedge Fund Law Report, Vol. 5, No. 34 (Sep. 6, 2012).  This article summarizes the Tribunal’s factual findings and legal analysis in this case.

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  • From Vol. 6 No.7 (Feb. 14, 2013)

    FATCA Implementation Summit Identifies Best Practices Relating to FATCA Reporting, Due Diligence, Withholding, Operations, Compliance and Technology

    On December 6, 2012, the Hedge Fund Business Operations Association and Financial Research Associates, LLC jointly sponsored a “FATCA Implementation Summit” in New York City (Summit).  Participants at the Summit discussed compliance requirements, recommendations and strategies in connection with the Foreign Account Tax Compliance Act (FATCA), in particular with respect to registration, reporting, due diligence and withholding.  Participants also addressed the operational and technological demands presented by FATCA, and best practices for meeting those demands.  This article summarizes the practical takeaways from the Summit and offers recommendations that hedge fund managers can apply directly to their FATCA compliance programs.

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  • From Vol. 6 No.5 (Feb. 1, 2013)

    What Impact Will FATCA Have on Offshore Hedge Funds and How Should Such Funds Prepare for FATCA Compliance?

    The Foreign Account Tax Compliance Act (FATCA) will begin to impact the offshore investment fund industry in 2013, requiring a “foreign financial institution” (FFI) to enter into an agreement with the Internal Revenue Service (IRS) and disclose certain information regarding its U.S. account holders on an annual basis.  FFIs are broadly defined to include offshore hedge funds or other offshore private investment funds, and compliance with FATCA may be difficult for many of these funds.  The principal goal of FATCA is to prevent U.S. taxpayers from using foreign accounts and investments to hide income from the IRS and evade payment of U.S. tax.  As the penalties for failure to comply with FATCA are harsh – including the imposition of a 30 percent withholding tax on certain U.S. source payments – managers of offshore hedge funds should begin to prepare for FATCA and its due diligence reporting requirements.  On January 17, 2013, the IRS issued long-awaited final regulations under FATCA, clarifying many of the items left open by the proposed regulations released in February of 2012 and previously issued IRS guidance.  In a guest article, Michele Gibbs Itri, a partner at Tannenbaum Helpern Syracuse & Hirschtritt, LLP, discusses the impact that current FATCA rules will have on offshore investment funds and describes the steps that fund managers can take now to comply with these rules to avoid any FATCA tax on the funds’ U.S. investments.

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  • From Vol. 5 No.43 (Nov. 15, 2012)

    Understanding the Benefits and Uses of Series LLCs for Hedge Fund Managers

    Hedge fund managers are continually striving to maximize the advantages available through their choice of legal entity for structuring their funds and management companies.  The series limited liability company (Series LLC) offers a relatively new variation on the traditional limited liability company structure that provides not only liability protection for members vis-à-vis non-members, but also liability protection for members of a given series of interests within the Series LLC vis-à-vis members of other series of interests within the same Series LLC.  In a guest article, Yehuda M. Braunstein, a Partner at Sadis & Goldberg LLP, and Todd K. Warren, Of Counsel at Sadis & Goldberg LLP, discuss: the history and evolution of the Series LLC; the various structural requirements and issues to be considered; the advantages and challenges that are presented by the Series LLC; practical tips regarding how to utilize the Series LLC; and potential uses of the structure by hedge fund managers.

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  • From Vol. 5 No.40 (Oct. 18, 2012)

    Tax Efficient Hedge Fund Structuring in Anticipation of the New 3.8% Surtax on Net Investment Income and Proposals to Limit Individuals’ Tax Deductions

    In the current political environment, high income U.S. persons are likely to see their income tax rates on investment income rise and their ability to deduct investment-related expenses further curtailed.  Consequently, such investors and their advisors are likely to become more concerned about the difference between pre-tax and after-tax returns from competing investment alternatives.  It is generally known that hedge funds are somewhat tax-inefficient investments for U.S. high income individual investors.  Some funds often employ trading strategies that generate attractive pre-tax returns, but often generate income taxed at the highest rates.  Although the mutual fund industry has rolled out many new funds for the general public that are marketed as “tax managed” or “tax efficient” funds, the same trend has not been as evident in the hedge fund world.  This fact is a bit unusual since, as discussed in this article, individual investors in hedge funds organized as tax partnerships face a much greater risk of tax inefficiency than investors that invest in shares of corporations that are mutual funds (regulated investment companies under the Internal Revenue Code).  Given the increasing competition for assets under management as well as the factors described above, hedge fund managers should engage in tax planning throughout the tax year to make their funds more tax-efficient and should consult with their tax advisors with respect to the tax changes which will surely come in the future.  In some cases, fund managers should reconsider the structures of their funds that are available to such U.S. individual investors.  In a guest article, A.J. Alex Gelinas, a tax partner at Sadis & Goldberg LLP, analyses tax changes relevant to hedge fund managers and investors that are about to go into effect, or that are likely to go into effect in the future as Congress faces the need to increase tax revenues, and the effect such tax law changes may have on the marketing of hedge funds to U.S. high income individuals.  The article provides concrete tax structuring suggestions and also serves as a comprehensive overview of fundamental principles of tax structuring for hedge funds.

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  • From Vol. 5 No.35 (Sep. 13, 2012)

    AIMA Canada Handbook Provides Roadmap for Hedge Fund Managers Doing Business in Canada

    Pershing Square’s successful proxy contest for control of Canadian Pacific Railway is the most prominent recent example, but by no means the only example, of the increasing importance of Canada for hedge fund managers.  See also “Ontario Securities Commission Sanctions Hedge Fund Manager Sextant Capital Management and its Principal for Breach of Fiduciary Duty,” The Hedge Fund Law Report, Vol. 5, No. 24 (Jun. 14, 2012).  Specifically, Canada is growing in importance as a place where hedge fund managers may invest, raise capital and recruit talent.  In an effort to assist hedge fund managers in navigating the Canadian tax and regulatory landscape, AIMA Canada, a chapter of the Alternative Investment Management Association (AIMA), recently published the AIMA Canada Handbook (Handbook).  This article summarizes the key topics covered in the Handbook, including a background discussion of the Canadian securities industry; registration requirements for fund managers operating in Canada; regulations applicable to registrants; exemptions from fund manager registration; tax consequences for hedge funds and investors; structuring Canadian hedge funds; and the outlook for the Canadian hedge fund industry, including an update on the capital raising environment.

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  • From Vol. 5 No.34 (Sep. 6, 2012)

    U.K. Hedge Fund Manager Taxed on Bonuses Delivered Through Tax-Avoidance Scheme

    On July 16, 2012, the First-Tier Tribunal of the U.K. Tax Chamber issued a decision rejecting an appeal by hedge fund manager Sloane Robinson Investment Services Limited of a tax imposed on bonuses it delivered to its director-employees through a tax avoidance scheme.  This article summarizes the decision, including the factual findings, the parties’ arguments and the Tribunal’s legal analysis.  This article also provides insight on what the decision means for tax and compensation structuring for U.K. hedge fund managers.

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  • From Vol. 5 No.32 (Aug. 16, 2012)

    Structuring, Regulatory and Tax Guidance for Asia-Based Hedge Fund Managers Seeking to Raise Capital from U.S. Investors (Part Two of Two)

    Over the past several years, U.S. investors have broadened their alternative investment horizons by exploring investment opportunities with Asia-based fund managers.  Asia-based fund managers provide a unique perspective on alternatives which translates to differing investment strategies that appeal to U.S. investors seeking uncorrelated returns or “alpha.”  Nonetheless, Asia-based fund managers that seek to attract U.S. investor capital must recognize the intricate regulations that govern investment manager and fund operations in the U.S. and other jurisdictions, such as the Cayman Islands where many funds are organized to attract U.S. investors.  This is the second article in a two-part series designed to help Asia-based fund managers navigate the challenges of structuring and operating funds to appeal to U.S. investors.  The authors of this article series are: Peter Bilfield, a partner at Shipman & Goodwin LLP; Todd Doyle, senior tax associate at Shipman & Goodwin LLP; Michael Padarin, a partner at Walkers; and Lu Yueh Leong, a partner at Rajah & Tann LLP.  This article describes in detail a number of the key U.S. tax, regulatory and other considerations that Asia-based fund managers are concerned with or should consider when soliciting U.S. taxable and U.S. tax-exempt investors.  The first article described the preferred Cayman hedge fund structures utilized by Asia-based fund managers, the management entity structures, Cayman Islands regulations of hedge funds and their managers and regulatory considerations for Singapore-based hedge fund managers.  See “Structuring, Regulatory and Tax Guidance for Asia-Based Hedge Fund Managers Seeking to Raise Capital from U.S. Investors (Part One of Two),” The Hedge Fund Law Report, Vol. 5, No. 31 (Aug. 9, 2012).

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  • From Vol. 5 No.31 (Aug. 9, 2012)

    Structuring, Regulatory and Tax Guidance for Asia-Based Hedge Fund Managers Seeking to Raise Capital from U.S. Investors (Part One of Two)

    U.S. hedge fund investors are continuously seeking attractive investment opportunities and are increasingly expanding their search to incorporate Asia-based hedge fund managers.  At the same time, Asia-based hedge fund managers are navigating the challenging capital raising environment by reaching beyond their borders to attract U.S. investors.  However, Asia-based fund managers seeking to attract capital from U.S. investors must contend with a plethora of U.S. and foreign regulations in raising and managing such capital.  As such, Asia-based fund managers must work closely with U.S., Cayman and local counsel to develop a cohesive and carefully thought out fund and management structure, intertwining the various regulatory requirements of the applicable jurisdictions, all of which must be adhered to by the fund manager, any sub-advisers and their respective affiliates.  This is the first in a two-part series of guest articles designed to help Asia-based fund managers navigate the challenges of structuring and operating funds to appeal to U.S. fund investors.  The authors of this article series are: Peter Bilfield, a partner at Shipman & Goodwin LLP; Todd Doyle, senior tax associate at Shipman & Goodwin LLP; Michael Padarin, a partner at Walkers; and Lu Yueh Leong, a partner at Rajah & Tann LLP.  This first article describes the preferred Cayman hedge fund structures utilized by Asia-based fund managers, the management entity structures, Cayman Islands regulations of hedge funds and their managers and regulatory considerations for Singapore-based hedge fund managers.  The second article in the series will detail a number of the key U.S. tax, regulatory and other considerations that Asia-based fund managers should consider when soliciting U.S. taxable and U.S. tax-exempt investors.

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  • From Vol. 5 No.29 (Jul. 26, 2012)

    The Nuts and Bolts of FATCA Compliance: An Interview with James Wall of J.H. Cohn Concerning Due Diligence, Document Collection, Reporting and Other Operational Challenges

    The Foreign Account Tax Compliance Act (FATCA) has that unfortunate combination of qualities that strikes fear into the hearts of hedge fund managers and investors: ambiguity and significant penalties.  FATCA is set to become effective as of January 1, 2013, but final rules have not yet been promulgated by the U.S. Department of the Treasury.  At the same time, sizable financial penalties can be imposed for noncompliance.  Accordingly, the hedge fund industry is paying close attention to FATCA developments.  Given the serious ramifications of non-compliance with FATCA and the significant uncertainty regarding the details of final regulations, The Hedge Fund Law Report conducted an interview with James K. Wall, a Principal and International Tax Director at J.H. Cohn LLP, concerning FATCA and its implications for hedge fund managers and investors.  Our interview with Wall covered various topics, including key questions hedge fund managers still face relating to FATCA compliance; due diligence and compliance measures that hedge fund managers must take; operational challenges in becoming FATCA compliant; whether the hedge fund or the manager should be responsible for bearing costs and expenses in connection with FATCA compliance; dealing with recalcitrant investors; policies and procedures that hedge fund managers should consider adopting for FATCA compliance; what to communicate to fund investors about FATCA; and whether fund governing documents must be amended to include FATCA-related provisions.  This article contains the transcript of our interview with Wall.  See also “U.S. Releases Helpful FATCA Guidance, But the Law Still Remains,” The Hedge Fund Law Report, Vol. 5, No. 10 (Mar. 8, 2012).

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  • From Vol. 5 No.26 (Jun. 28, 2012)

    Hedge Funds and Managers Must File Foreign Bank Account Reports by June 30, 2012

    Every U.S. person or entity that had either a financial interest in, or signatory authority or other authority over, a financial account in a foreign country must file Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts), commonly referred to as an “FBAR,” if the aggregate value of such account(s) exceeded USD $10,000 at any time during calendar year 2011.  In a guest article, Joseph Pacello, a tax principal at Rothstein Kass, and Deirdre Joyce, a senior international tax manager at Rothstein Kass, discuss, with respect to FBAR filings: imminent filing deadlines; key definitions; notable changes for 2010 and subsequent year reporting; FBAR constructive ownership rules; significant penalties for failure to file; the 2012 offshore voluntary disclosure program; six specific examples of FBAR reporting requirements; and filing instructions.  The article concludes with a chart comparing Form 8938 and FBAR filing requirements.

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  • From Vol. 5 No.25 (Jun. 21, 2012)

    European Court of Justice Invalidates French Withholding Tax that Applied Only to Dividends Paid to Non-Resident Open-End Investment Funds

    One of the fundamental goals of the European Union (EU) is to reduce barriers to economic activity between and among member states.  Barriers can include tax policies designed to advantage certain member states over other member states.  In that vein, the European Court of Justice (ECJ) recently considered whether France’s policy of imposing a 25% withholding tax on dividends payable by French companies to non-resident investment funds while exempting resident investment funds from withholding violates Article 63 of the Treaty on the Functioning of the European Union and thus creates an impermissible barrier to economic activity among member states.  This article summarizes the background and the ECJ’s analysis in this case.  The petitioners in the case are global investment managers that manage funds organized as Undertakings for Collective Investment in Transferable Securities (UCITS).  Thus, the ECJ’s analysis is directly relevant to UCITS managers, and it is also relevant to managers of non-UCITS investment vehicles with any nexus to Europe.

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  • From Vol. 5 No.13 (Mar. 29, 2012)

    Managing Risk in a Changing Environment: An Interview with Proskauer Partner Christopher Wells on Hedge Fund Governance, Liquidity Management, Transparency, Tax and Risk Management

    The Hedge Fund Law Report recently interviewed Christopher M. Wells, a Partner at Proskauer Rose LLP and head of the firm’s Hedge Funds Group.  Wells has decades of experience advising hedge funds and their managers, and a broad-based practice that touches on substantially every aspect of the hedge fund business.  Our interview with Wells was similarly wide-ranging, covering topics including: hedge fund governance; investor demands for heightened transparency; co-investment opportunities; liquidity management issues; side pocketing policies and procedures; holdbacks of redemption proceeds; tax issues, including preparations for compliance with the Foreign Account Tax Compliance Act (FATCA) and the electronic delivery of Schedules K-1; and risk management, including practical steps to prevent style drift and unauthorized trading.  This interview was conducted in conjunction with the Regulatory Compliance Association’s Spring 2012 Regulation & Risk Thought Leadership Symposium.  That Symposium will be held on April 16, 2012 at the Pierre Hotel in New York.  For more information, click here.  To register, click here.  (Subscribers to The Hedge Fund Law Report are eligible for discounted registration.)  Wells is expected to participate in a session at that Symposium focusing on hedge fund governance and related issues.

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  • From Vol. 5 No.12 (Mar. 22, 2012)

    IRS Introduces New Disclosure, Consent and Notice Procedures to Govern the Electronic Delivery of 2011 Schedules K-1 by Partnerships, Including Many Hedge Funds and Hedge Fund Managers

    On February 13, 2012, the Internal Revenue Service (IRS) issued new procedures for partnerships to provide Schedules K-1 to their partners electronically.  Among other things, the new procedures introduce rigorous consent and disclosure procedures that govern the electronic delivery of Schedules K-1 by partnerships, including limited partnerships, such as many hedge funds and hedge fund managers.  As such, hedge funds and hedge fund managers that wish to provide electronic delivery of their Schedules K-1 to fund investors or partners in the management company, respectively, should promptly and carefully evaluate the new procedures and their potential impact on the processes they are currently following to obtain consent to electronic delivery of such Schedules K-1.  In a guest article, Roger Wise and Kenneth Wear, Partner and Associate, respectively, at K&L Gates LLP, discuss the mechanics and implications of the new K-1 procedures.

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  • From Vol. 5 No.10 (Mar. 8, 2012)

    U.S. Releases Helpful FATCA Guidance, But the Law Still Remains

    The United States announced an unprecedented multi-country agreement and published detailed proposed regulations addressing implementation of the Foreign Account Tax Compliance Act (FATCA) on February 8, 2012.  In a guest article, Michael Hirschfeld, a Partner at Dechert LLP, explains the details of the agreement and proposed regulations and their impact on hedge fund managers.

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  • From Vol. 5 No.5 (Feb. 2, 2012)

    How Safe Is It to Ignore Foreign Tax Claims or Judgments Against Cayman Islands Hedge Funds in the Context of a Winding Up of the Fund?

    Cayman Islands hedge funds are subject to no Cayman Islands tax of any nature, but they may become liable to foreign tax claims – for example through trading swaps – or they may become subject to judgments for tax imposed against them in other jurisdictions.  How should such claims and judgments be regarded by liquidators in the context of winding up the fund, whether in a liquidation imposed by the court, or in a voluntary liquidation?  Must effect be given to such claims or judgments, or can such claims and judgments simply be ignored, and the winding up completed without regard to them?  Or should the winding up only be completed once the tax claim or judgment has been abandoned by the foreign tax authority, or only with Cayman court sanction that the claim or judgment be disregarded for the purposes of the winding up?  In a guest article, Christopher Russell, Partner and head of the litigation and insolvency department of Ogier, Cayman Islands, and Shaun Folpp, a Managing Associate in the litigation and insolvency department of Ogier, Cayman Islands, address these and related questions.

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  • From Vol. 5 No.2 (Jan. 12, 2012)

    Proposed New York City Audit Position Can Increase the Amount of Unincorporated Business Tax Paid by New York Hedge Fund Managers

    Facing budget deficits and rising debt levels, federal, state and local government authorities have ratcheted up efforts to raise revenues, and one of the constituencies in their crosshairs has been hedge fund managers.  While proposals have been put forward at the federal and state level to raise revenues by taxing the carried interest received by hedge fund managers at ordinary income tax levels instead of at the favored long-term capital gains rates, New York City has seemingly opted for another approach by proposing to disallow some expense deductions claimed by hedge fund management entities that are subject to the New York City unincorporated business tax (UBT).  Specifically, the New York City Department of Finance (Department of Finance) has recently asserted a new proposed audit position (Proposed Audit Position) to require that a portion of the expenses of an investment manager entity be reallocated to a general partner entity because it believes that certain of those expenses are incurred in generating the incentive allocation received by the general partner entity.  This feature-length article begins by explaining in detail the UBT and what entities are subject to the UBT.  The article then explains how the UBT applies to hedge fund managers.  The article then moves to a discussion of the Proposed Audit Position, including a discussion of the potential application of the Proposed Audit Position to future audits.  Next, the article explains how audit positions are promulgated and identifies the sources of authority for the Department of Finance’s assertion of the Proposed Audit Position.  The article continues with a discussion how hedge fund managers can respond if the Department of Finance asserts the Proposed Audit Position in disallowing certain investment manager expenses during the course of an audit.  The article closes with a discussion of recommended courses of action for hedge fund managers that seek to mitigate the adverse tax impact of the Proposed Audit Position on their businesses.

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  • From Vol. 5 No.1 (Jan. 5, 2012)

    Legal and Operational Due Diligence Best Practices for Hedge Fund Investors

    In the wake of the financial crisis in late 2008, many investors were left trapped in suspended, gated or otherwise illiquid hedge funds.  Unfortunately, for many investors who had historically taken a passive role with respect to their hedge fund investments, it took a painful lesson to learn that control over fundamental fund decisions was in the hands of hedge fund managers.  Decisions such as the power to suspend or side pocket holdings were vested in managers either directly or through their influence over the board of directors of the fund.  In these situations, which were not uncommon, leaving control in the hands of the manager rather than a more independent board gave rise to a conflict of interest.  Managers were in some cases perceived to be acting in their own self-interest at the expense, literally and figuratively, of the fund and, consequently, the investors.  The lessons from the financial crisis of 2008 reinforced the view that successful hedge fund investing requires investors to approach the manager selection process with a number of considerations in mind, including investment, risk, operational and legal considerations.  Ideally, a hedge fund investment opportunity will be structured to sufficiently protect the investor’s rights (i.e., appropriate controls and safeguards) while providing an operating environment designed to maximize investment returns.  Striking such a balance can be challenging, but as many investors learned during the financial crisis, it is a critical element of any successful hedge fund program.  The focus on hedge fund governance issues has intensified in the wake of the financial crisis, with buzz words such as “managed accounts,” “independent directors,” “tri-party custody solutions” and “transparency” now dominating the discourse.  Indeed, investor efforts to improve corporate governance and control have resulted in an altering of the old “take it or leave it” type of hedge fund documents, which have become more accommodative towards investors.  In short, in recent years investors have become more likely to negotiate with managers, and such negotiations have been more successful on average.  In a guest article, Charles Nightingale, a Legal and Regulatory Counsel for Pacific Alternative Asset Management Company, LLC (PAAMCO), and Marc Towers, a Director in PAAMCO’s Investment Operations Group, identify nine areas on which institutional investors should focus in the course of due diligence.  Within each area, Nightingale and Towers drill down on specific issues that hedge fund investors should address, questions that investors should ask and red flags of which investors should be aware.  The article is based not in theory, but in the authors’ on-the-ground experience conducting legal and operational due diligence on a wide range of hedge fund managers – across strategies, geographies and AUM sizes.  From this deep experience, the authors have extracted a series of best practices, and those practices are conveyed in this article.  One of the main themes of the article is that due diligence in the hedge fund arena is an interdisciplinary undertaking, incorporating law, regulation, operations, tax, accounting, structuring, finance and other disciplines, as well as – less tangibly – experience, judgment and a good sense of what motivates people.  Another of the themes of the article is that due diligence is a continuous process – it starts well before an investment and often lasts beyond a redemption.  This article, in short, highlights the due diligence considerations that matter to decision-makers at one of the most sophisticated allocators of capital to hedge funds.  For managers looking to raise capital or investors looking to deploy capital intelligently, the analysis in this article merits serious consideration.

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  • From Vol. 4 No.42 (Nov. 23, 2011)

    Speakers at Walkers Fundamentals Hedge Fund Seminar Provide Update on Hedge Fund Terms, Governance Issues and Regulatory Developments Impacting Offshore Hedge Funds

    On November 8, 2011, international law firm Walkers Global (Walkers) held its Walkers Fundamentals Hedge Fund Seminar in New York City.  Speakers at this event addressed various topics of current relevance to the hedge fund industry, including: recent trends in offshore hedge fund structures; hedge fund fees and fee negotiations; fund lock-ups; fund-level and investor-level gates; fund wind-down petitions and the appointment of fund liquidators; corporate governance issues; D&O insurance; fund manager concerns with Form PF; and offshore regulatory developments, such as proposed legislation requiring registration of certain master funds in the Cayman Islands, the EU’s Alternative Investment Fund Manager (AIFM) Directive and the British Virgin Islands (BVI) Securities & Investment Business Act (SIBA).  This article summarizes the key points discussed at the conference relating to each of the foregoing topics and others.

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  • From Vol. 4 No.13 (Apr. 21, 2011)

    Recent U.S. Tax Court Decision Suggests That Partners of Hedge Fund Management Companies Organized As Limited Partnerships May Be Subject to Self-Employment Tax

    The U.S. Tax Court has ruled against a law firm limited liability partnership that had taken the position that its partners were not subject to self-employment tax on their respective shares of partnership income.  The case is relevant to the hedge fund industry because some fund management companies are organized as limited partnerships whose individual limited partners also work for the partnership and render management services.  We summarize the Court’s decision, emphasizing the self-employment tax discussion.

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  • From Vol. 4 No.12 (Apr. 11, 2011)

    Investments by Family Offices in Hedge Funds through Variable Insurance Policies: Tax-Advantaged Structures, Diversification and Investor Control Rules and Restructuring Strategies (Part Two of Two)

    Variable insurance policies are an often utilized structure through which family offices and other high net worth investors invest in hedge funds and other private investment funds.  One of the primary advantages of investing in hedge funds and other private investment funds through variable insurance policies is the deferral of income taxes.  However, policy holders must first satisfy two important tests – the “diversification rules” and the “investor control” rules – in order for the policies to qualify for favorable income tax treatment.  This article is the second in a two-part series.  The first article in this series described the mechanics of investing in an insurance dedicated fund through variable insurance policies and offered a roadmap for satisfying the two tests to ensure the variable insurance policies maintain their tax-advantaged status.  See “Investments by Family Offices in Hedge Funds through Variable Insurance Policies: Tax-Advantaged Structures, Diversification and Investor Control Rules and Restructuring Strategies (Part One of Two),” The Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011).  This article describes in detail a recent restructuring transaction in which the authors participated (the “Transaction”) and provides the key terms in the Transaction documents applicable to the diversification and investor control rules.

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  • From Vol. 4 No.11 (Apr. 1, 2011)

    Investments by Family Offices in Hedge Funds through Variable Insurance Policies: Tax-Advantaged Structures, Diversification and Investor Control Rules and Restructuring Strategies (Part One of Two)

    Variable insurance policies are an often utilized structure through which family offices and other high net worth investors invest in hedge funds and other private investment funds.  One of the primary advantages of investing in hedge funds and other private investment funds through variable insurance policies is the deferral of income taxes.  However, policy holders must first satisfy two important tests – the “diversification rules” and the “investor control” rules – in order for the policies to qualify for favorable income tax treatment.  This article is the first in a two-part series of guest articles in the HFLR by James Schulwolf and Peter Bilfield, both Partners at Shipman & Goodwin LLP, and Lisa Zana, a Senior Associate at Shipman.  This article describes the mechanics of investing in an insurance dedicated fund through variable insurance policies and offers a roadmap for satisfying the two tests to ensure the variable insurance policies maintain their tax-advantaged status.  The second article in this series will describe in detail a recent restructuring transaction in which the authors participated and provide the key terms in the transaction documents applicable to the diversification and investor control rules.

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  • From Vol. 4 No.4 (Feb. 3, 2011)

    IRS Enhancing Its Scrutiny of Tax Shelter Disclosures by Hedge Funds

    In late 2010, the IRS Office of Chief Counsel issued a memorandum indicating that some common “protective” disclosures that are made by hedge funds and other investment partnerships are inadequate.  This could result in significant penalties for a fund as well as its investors.  In a guest article, Joseph Pacello, a Tax Partner at Rothstein Kass, discusses: the legal and accounting background of the IRS memorandum, including relevant tax disclosure requirements; the IRS Office of Chief Counsel’s analysis in the memorandum; penalties for failure to properly disclose a reportable transaction; and the likely impact of the IRS memorandum for both funds of funds and direct trading funds.

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  • From Vol. 4 No.2 (Jan. 14, 2011)

    Accounting for Uncertain Income Tax Positions for Investment Funds

    FIN 48, now included in ASC Topic 740 (Income Taxes) under the Financial Accounting Standards Board’s Codification, was issued in 2006 and after two one-year deferrals became effective for all entities issuing financial statements under Generally Accepted Accounting Principles (GAAP) for years beginning after December 15, 2008.  FIN 48 was issued as an interpretation of FASB Statement 109, Accounting for Income Taxes, with the intent of reducing the diversity of practice in financial accounting for income taxes, including U.S. federal, state and local taxes as well as foreign taxes.  A major component of FIN 48 is that its reach includes all statutory open tax years, not just the accounting reporting year.  This requires that each year is looked at on a cumulative basis.  Entities that report on a non-GAAP basis, such as International Financial Reporting Standards (IFRS), are not subject to FIN 48.  FIN 48 has become a hot topic for fund managers and their auditors.  Given the complicated nature of fund structures, global investment strategies and the variety of financial products that managers invest in, it is an important area, and one to which managers should allocate sufficient resources.  In a guest article, Michael Laveman, a Partner at EisnerAmper LLP, discusses in detail the four-step process for adoption of and compliance with FIN 48.

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  • From Vol. 3 No.34 (Aug. 27, 2010)

    Foundation for Accounting Education’s “2010 Hedge Funds and Alternative Investments” Conference Focuses on Taxation of Hedge Funds and Hedge Fund Managers, Structuring, Valuation, Risk Management, Due Diligence, Insurance and Regulatory Developments

    On July 29, 2010, the Foundation for Accounting Education (FAE) presented its 2010 Hedge Funds and Alternative Investments Conference in New York City.  Speakers at the one-day event focused on a range of issues impacting the hedge fund industry, including: FIN 48 (which relates to accounting for uncertain tax liabilities); ASU 2010-10 (which amends Statement of Financial Accounting Standards No. 167, which in turn requires nonpublic companies to publicly disclose their interests in variable interest entities in a similar manner to the disclosure provided by public entities); carried interest taxation developments; state and local tax developments relevant to hedge fund managers; tax implications of globalization of the hedge fund industry; special purpose vehicles; blockers; unrelated business taxable income and effectively connected income; mini-master funds; master-feeder and side-by-side structures; International Financial Reporting Standards; valuation trends; risk management; due diligence; insurance; and regulatory developments.  This article details the key points discussed during the conference.

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  • From Vol. 3 No.31 (Aug. 6, 2010)

    IRS Private Letter Ruling Offers Guidance to Hedge Funds Investing in Auction Rate Preferred Shares

    The classification of interests issued by closed-end funds as debt or equity for tax purposes has significant ramifications for hedge funds that invest in such funds.  Interests that are classified as debt generally allow holders to treat payments received from the fund as interest income and nontaxable principal repayments.  By contrast, interests that are classified as equity generally allow investors to receive dividends, capital gains or a mixture of the two.  A recent private letter ruling (PLR) issued by the Internal Revenue Service (IRS or Service) addressed the classification of preferred stock issued by a closed-end fund as debt or equity.  The IRS determined that the preferred stock should be classified as equity for federal tax purposes.  The PLR is significant for a variety of reasons.  First, the fact that the PLR was issued at all represents a change in procedure for the IRS, which previously declined to issue rulings on the classification of financial instruments as debt or equity because of the fact-specific nature of such classifications.  Second, the PLR has implications for hedge funds interested in the auction rate preferred shares market.  This article examines the PLR, its background and its potential significance for hedge funds invested or considered an investment in auction rate preferred shares.

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  • From Vol. 3 No.26 (Jul. 1, 2010)

    Potential Changes to Partnership Income Allocation Rules May Alter the Timing and Manner of Receipt of Income by Key Personnel at Hedge Fund Managers

    On April 13, 2009, the Internal Revenue Service proposed regulations under Section 706(d) of the Internal Revenue Code (IRC) that could affect the timing and manner of receipt of income, gains and losses by key personnel at hedge fund management companies organized as partnerships or limited liability companies taxed as partnerships.  The proposed regulations will become effective upon adoption, but no earlier than the first partnership taxable year beginning in 2010.  Generally, the proposed regulations would require partnerships to take into account variations in partners’ interests during a taxable year and would prescribe two methods for doing so – an “interim closing of the books” method and a “proration” method.  In addition, the proposed regulations provide guidance on the appropriate allocation of “extraordinary items” and the effect on allocations of changes to partnership agreements.  Finally, the proposed regulations contain a safe harbor for services partnerships and publicly traded partnerships, clarify the allocation of deemed dispositions and amend the minority interest rule.  This article discusses the current “varying interest rule” under IRC Section 706 and details the ways in which the proposed regulations would change the current allocation regime.  In particular, this article discusses the mechanics of the two alternative allocation methods provided in the proposed regulations, timing conventions, changes in partnership allocations among contemporaneous partners, safe harbors, deemed dispositions and the minority interest rule.  This article also discusses the implications of the proposed regulations for hedge fund managers and hedge funds.  In brief, the proposed regulations are likely to have a greater impact on managers than funds because variations in interests of limited partners in hedge funds are and are accounted for as ordinary course events, while variations in interests of partners in hedge fund management companies are non-ordinary course.  That is, subscriptions to and redemptions from a hedge fund occur routinely, whereas the admission of a new partner to a management company, or the termination of such a partner, occur only once in a while.  It is the admission or termination of such key hedge fund manager personnel, or changes in interests of existing key personnel, that could be more directly impacted by the proposed regulations.

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  • From Vol. 3 No.12 (Mar. 25, 2010)

    IRS Directive and HIRE Act Undermine Tax Benefits of Total Return Equity Swaps for Offshore Hedge Funds

    As explained more fully below, total return equity swaps (TRSs) generally are contracts, often between a financial institution and a hedge fund, whereby the financial institution agrees to pay the hedge fund the total return of the reference equity during the swap term (including capital gains and dividends), and the hedge fund agrees to pay the financial institution the value of any decline in the price of the reference equity and interest on any debt embedded in the swap.  In other words, the financial institution pays the hedge fund any upside, and the hedge fund pays the financial institution any downside plus interest.  In this sense, the financial institution is the short party to the swap, and the hedge fund is the long party.  Traditionally, hedge funds have used TRSs for three principal purposes, among others.  First, hedge funds have used TRSs to gain economic exposure to companies without obtaining beneficial ownership of the stock of those companies, thereby avoiding the obligation to file a Schedule 13D and preserving the secrecy of incipient activist campaigns.  Second, offshore hedge funds have used TRSs to obtain economic exposure to dividend-paying U.S. stocks while avoiding the 30 percent withholding tax typically imposed on dividends paid by U.S. public companies to non-U.S. persons.  Offshore hedge funds have been able to use TRSs to avoid such withholding tax because, until recently, dividends were subject to withholding but “dividend equivalent payments” – the amount paid by a financial institution to a hedge fund under a swap by reference to the dividend paid by the relevant equity – were not.  Third, hedge funds have used TRSs to obtain leverage.  That is, the traditional way to get exposure to the total return of a stock was to buy it.  However, TRSs enable hedge funds to get exposure to the total return of a stock by entering into a contract with a financial institution and posting initial and variation margin (which, even taken together, often constitute only a fraction of the market price of the stock).  The first two of those purposes have been dramatically undermined by judicial and legislative action.  Specifically, with respect to the use of TRSs in activist campaigns, in June 2008, the U.S. District Court for the Southern District of New York held that two hedge funds that had accumulated substantial economic positions in publicly-traded railroad operator CSX Corporation, principally via cash-settled TRSs, were deemed to have beneficial ownership of the hedge shares held by their swap counterparties.  Accordingly, the court found that one of the hedge fund group defendants, The Children’s Investment Fund Management (UK) LLP and related hedge fund and advisory entities, violated Section 13(d) of the Securities Exchange Act of 1934 by failing to file a Schedule 13D within ten days of the date on which its beneficial ownership exceeded five percent.  See “District Court Holds that Long Party to Total Return Equity Swap May be Deemed to have Beneficial Ownership of Hedge Shares Held by Swap Counterparty,” The Hedge Fund Law Report, Vol. 1, No. 14 (Jun. 19, 2008).  With respect to the second purpose described above, in January of this year, the IRS issued an industry directive (Directive) outlining TRS structures that, in the agency’s view, may be used to improperly avoid withholding tax on dividends.  See “New IRS Audit Guidelines Target Equity Swaps with Non-U.S. Counterparties,” The Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010).  More recently, on March 18, 2010, President Obama signed into law the Hiring Incentives to Restore Employment (HIRE) Act (H.R. 2847), which contained provisions originally proposed as part of the Foreign Account Tax Compliance Act of 2009.  See “Bills in Congress Pose the Most Credible Threat to Date to the Continued to the Continued Tax Treatment of Hedge Fund Performance Allocations as Capital Gains,” The Hedge Fund Law Report, Vol. 2, No. 52 (Dec. 30, 2009).  Among other things, the HIRE Act will impose a 30 percent withholding tax on dividend-equivalent payments made to non-U.S. persons on or after September 14, 2010 on certain TRSs or pursuant to securities loans and “repo” transactions.  While there is significant overlap between the TRSs targeted in the Directive and those for which withholding will be required under the HIRE Act, the HIRE Act covers a broader range of TRSs.  While the third purpose of TRSs identified above – providing leverage – remains reasonably intact, the CSX case, the Directive and the HIRE Act collectively challenge the utility of TRSs for hedge funds, pose unique structuring challenges and change market dynamics that have existed for 20 years.  Yet the Directive and HIRE Act may also, like other facially adverse actions or events, offer opportunities.  With the goal of helping hedge fund managers navigate the changing tax consequences of TRSs, this article describes: the mechanics of TRSs in greater depth; the business benefits and burdens of TRSs; the Directive, including the specific scenarios identified by the IRS as meriting further attention from field agents; the relevant provisions of the HIRE Act; the likely market impact of the Directive and HIRE Act, including the specific impact on financial institutions, master-feeder hedge fund structures and TRSs written on a “basket” of equities; and potential structuring alternatives to avoid the adverse tax consequences of the Directive and HIRE Act.

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  • From Vol. 3 No.9 (Mar. 4, 2010)

    Bill Redefining “Acquisition Indebtedness” for UBTI Purposes Could Diminish, But Likely Would Not Eliminate, Utility of “Blockers” in Hedge Fund Structures

    A significant and growing proportion of the assets invested in hedge funds globally come from U.S. tax-exempt entities such as endowments, foundations, state pension funds and corporate pension funds that are “qualified” under Internal Revenue Code (IRC) Section 501(a).  Mechanically, tax-exempt entities generally invest in a corporation organized in a low-tax or no-tax, non-U.S. jurisdiction, which in turn invests in an entity that buys and sells securities and other assets.  The buying and selling entity is often organized in a tax-advantaged, non-U.S. jurisdiction as a corporation that “checks the box” for partnership treatment for U.S. tax purposes (although other structures and entity types are also used).  See “Implications of Recent IRS Memorandum on Loan Origination Activities for Offshore Hedge Funds that Invest in U.S. Debt,” The Hedge Fund Law Report, Vol. 2, No. 41 (Oct. 15, 2009).  Tax-exempt hedge fund investors go through these contortions to avoid paying tax, at corporate tax rates, on so-called Unrelated Business Taxable Income (UBTI).  As explained in more detail in this article, the portion of interest, dividends and capital gains generated by a domestic hedge fund in a tax year based on “acquisition indebtedness” will constitute UBTI on which U.S. tax-exempt investors in that fund will owe tax at corporate rates.  Specifically, a domestic hedge fund’s UBTI for a tax year generally is equal to the fund’s total interest, dividends and capital gains for the tax year times a percentage, the numerator of which is the fund’s average acquisition indebtedness and the denominator of which is the average cost basis of the fund’s investments.  For example, if a domestic hedge fund had a total return (including interest, dividends and capital gains) for the tax year of $20 million, an average cost basis of $100 million and average acquisition indebtedness of $30 million, the fund would have $6 million of UBTI for the tax year.  That UBTI would be allocated pro rata to the fund’s tax-exempt investors for tax purposes.  So if the fund had two tax-exempt investors with equal investments, at a corporate tax of 35%, each would owe tax of $1.05 million on its distributive share of the fund’s UBTI for the tax year.  By contrast, if a tax-exempt investor invests in a corporation that in turn invests in a lower-tier trading entity, the UBTI created by the trading entity’s acquisition indebtedness will not flow through to the tax-exempt investor, and the investor will not owe tax on the UBTI (unless the investor’s purchase of shares in the corporation was itself financed by acquisition indebtedness).  This is because the Internal Revenue Service respects the ability of corporations to “block” UBTI.  See “IRS ‘Managed Funds Audit Team’ Steps Up Audits of Hedge Funds and Hedge Fund Managers, and Investigations of Hedge Fund Tax Compliance Issues,” The Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009).  On July 31, 2009, Rep. Sander Levin (D-MI) introduced H.R. 3497, a bill that would revise the definition in the IRC of “acquisition indebtedness” to exclude debt incurred by a U.S. partnership for investments in “qualified securities or commodities.”  (Levin had introduced similar legislation in 2007.)  In short, if Levin’s bill were to become law, it would diminish the rationale for investments by U.S. tax-exempt investors in hedge funds via offshore corporations.  However, offshore corporations exist in hedge fund structures for reasons other than blocking UBTI, so even if Levin’s bill were to become law, the case for offshore corporations could remain compelling.  This article offers a more comprehensive discussion of the taxation of UBTI; tax-exempt investor attitudes towards UBTI; structuring of hedge funds to enable tax-exempt investors to avoid UBTI; the mechanics of the Levin bill; the potential impact of the Levin bill if enacted on tax-exempt hedge fund investors as well as non-U.S. investors; and the likelihood of enactment of the Levin bill.

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  • From Vol. 3 No.4 (Jan. 27, 2010)

    What Effect Will the Carried Interest Provision in the Tax Extenders Act Have on Hedge Fund Managers that Are or May Become Publicly Traded Partnerships?

    On December 9, 2009, the U.S. House of Representatives passed legislation that includes a provision that would tax as ordinary income any net income derived with respect to an “investment services partnership interest.”  This carried interest provision in the Tax Extenders Act of 2009, H.R. 4213, would change the tax treatment of the performance allocation that, in years in which a hedge fund has positive investment performance, constitutes the bulk of a hedge fund manager’s revenue.  Currently, most managers structure performance allocations so that all or most of such compensation is taxed as long-term capital gains at a rate of 15 percent.  The carried interest provision would subject such compensation to tax at ordinary income rates, which for hedge fund managers generally would be at a marginal rate of approximately 35 percent.  For more discussion of the Tax Extenders Act, see “Bills in Congress Pose the Most Credible Threat to Date to the Continued Tax Treatment of Hedge Fund Performance Allocations as Capital Gains,” The Hedge Fund Law Report, Vol. 2, No. 52 (Dec. 30, 2009).  The Extenders Act also contains a provision that would effectively cause any publicly traded partnership (PTP) that derives significant income from investment advisory or asset management services to be treated, for tax purposes, as a corporation.  This is because the provision would treat carried interest income as non-qualifying income for purposes of determining whether a PTP meets the 90 percent “good income” test.  That test specifies that partnerships that (1) satisfy the 90 percent good income test (described in more detail in this article) and (2) are not registered under the Investment Company Act of 1940 will, in general, continue to be treated as partnerships and not as Subchapter C corporations for federal income tax purposes.  This article examines the federal tax treatment of the carried interest received by hedge fund managers, as well as the tax treatment of PTPs.  The article also outlines the likely effects of the Extenders Act on the tax treatment of both, and explains tax planning steps that hedge fund managers may take to avoid some of the adverse tax consequences of the bill.

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  • From Vol. 3 No.3 (Jan. 20, 2010)

    IRS Issues Guidance on Compliance with Section 409A Requirements Applicable to Deferred Compensation Plans of Hedge Fund Managers

    In 2004, as part of the American Jobs Creation Act, Congress amended the Internal Revenue Code to include Section 409A, which generally requires recipients of deferred compensation to elect the time and form of deferred compensation payments in a manner that complies with Section 409A and Sec. 1.409A-1(c) of the Income Tax Regulations.  Failure to elect time and form properly, or utilizing an acceleration of deferred compensation payments, can subject the employee, director, independent contractor or other “service provider,” which may be an individual, corporation, partnership or limited liability company, to an additional 20 percent income tax, accelerated taxation of the deferred payments and heightened interest assessments.  Section 409A was enacted in response to the corporate scandals of the early Naughts, such as Enron, Tyco and WorldCom, and was intended to curb the practice of executives deferring large amounts of compensation and to eliminate the ability of executives to vary the payment schedule by which they received deferred compensation.  In attempting to curb these perceived “evils,” Congress, in enacting Section 409A, created a statute that is hyper-technical in its application, with harsh penalties for noncompliance.  Hedge fund managers, who may be considered “service providers” under the statute, should examine compensation plans that include any form of deferred compensation, including deferral of management or performance fees, for compliance with Section 409A.  Because the penalties for noncompliance are harsh, the Internal Revenue Service (IRS) has issued guidance on correcting plan failures.  In 2008, the IRS provided guidance on operational failures.  However, on January 5, 2010, the IRS issued Notice 2010-6, which provides guidance on correcting document failures.  Both notices provide guidance relevant to hedge fund managers and should be closely examined.  This article examines the scope of Section 409A and Notice 2010-6 and details the applicability of both to hedge funds and hedge fund managers.

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