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Offshore Taxes, UBTI & UBTI Blockers
U.S. Tax Exempt Investors One reason to setup an offshore fund is so the fund can accept U.S. tax-exempt investors. Under the U.S. income tax laws, a tax exempt organization (such as an ERISA plan, a foundation, an endowment, etc.) engaging in an investment strategy that involves borrowing money (margin) is liable for a tax on “unrelated business taxable income” (UBTI). This is true even though the investor is otherwise tax exempt. As U.S. funds are formed through pass-through entities (such as the limited partnership or limited liability company) the UBTI activity passes through the entity to the tax exempt investor, thereby giving rise to the tax issue. U.S. taxable investors don't care because they need to pay tax in any event. However, U.S. tax-exempt investors are quite concerned. The UBTI tax can be avoided by arranging for the tax-exempt entity to invest in an offshore fund formed as a corporation. The UBTI gets blocked, so to speak, at the wall of the corporation. This is not an easy tax issue to grasp. UBTI is income from regularly carrying on a trade or business that is not substantially related to the organization's exempt purpose. UBTI excludes various types of income such as dividends, interest, royalties, rents from real property (and incidental rent from personal property), and gains from the disposition of capital assets unless the income is from debt-financed property. Using margin to trade creates debt financed property. As a fund's income attributable to the use of margin may constitute UBTI to them, tax-exempt investors generally refrain from investing in funds classified as partnerships using leveraged trading strategies. As a result, fund sponsors organize separate offshore funds for tax-exempt investors. U.S. Individual Investors U.S. taxable investors in an offshore fund structured as a corporation may be exposed to onerous tax rules applicable to controlled foreign corporations, foreign personal holding companies, or a passive foreign investment companies (PFIC). To attract U.S. individual investors, fund sponsors of an offshore fund or offshore master fund should elect to have it treated as a partnership (for U.S. tax purposes only) so that these U.S. investors avoid harsh tax rules. Under the U.S. entity classification rules (i.e., check-the-box) an offshore fund elects to be treated as a partnership for U.S. tax purposes by filing Form 8832, "Entity Classification Election." U.S. State Taxes Although offshore funds generally do not have nexus to the states, many states still require partnerships to file state partnership tax returns if they have partners that are residents of their jurisdiction. This could result in an offshore fund with U.S. partnership tax status being required to file a state tax return even though it arguably may not be required to file a Form 1065 since the partnership has no U.S. income. Such state and local partnership returns may require the identity of all partners (including foreign partners) to be included as part of the return. An offshore fund electing partnership status should carefully analyze the connection of its activities to the United States and the residencies of its U.S. investors to determine federal and state filing requirements as well as provide proper disclosure as to these filing obligations to its foreign investors.
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Unrelated Business Taxable Income (UBTI) Although certain organizations, such as qualified retirement plans, generally are exempt from federal income tax, unrelated business taxable income (UBTI) passed through partnerships to tax-exempt partners is subject to that tax. UBTI is income from regularly carrying on a trade or business that is not substantially related to the organization’s exempt purpose. UBTI excludes various types of income such as dividends, interest, royalties, rents from real property (and incidental rent from personal property), and gains from the disposition of capital assets, unless the income is from “debt-financed property.” Debt-financed property is any property that is held to produce income with respect to which there is acquisition indebtedness (such as margin debt). As a hedge fund’s income attributable to debt-financed property allocable to tax-exempt partners may constitute UBTI to them, tax-exempt investors generally refrain from investing in offshore hedge funds classified as partnerships that expect to engage in leveraged trading strategies. As a result, fund sponsors organize separate offshore hedge funds for tax exempt investors and have such corporate funds participate in the master-feeder fund structure.
The UBTI Blocker One impetus to set up an offshore hedge fund is the case of the tax-exempt investor. Under the U.S. income tax laws, a tax-exempt organization (such as an ERISA plan, a foundation, an endowment, etc.) engaging in an investment strategy that involves borrowing money is liable for a tax on “unrelated business taxable income” (UBTI). This is true even though the investor is otherwise tax-exempt, which presents not only an income tax issue for the plan, but also a political issue as well (i.e., the need to explain why a tax exempt fund is paying income tax). As U.S. funds are almost entirely made up of pass-through entities, such as the limited partnership or limited liability company structures, the UBTI activity passes through the entity to the tax-exempt investor, thereby giving rise to the tax issue. Taxable investors are not concerned because they need to pay tax in any event. However, tax-exempt investors are concerned. The UBTI tax can be avoided by arranging for the tax-exempt entity to invest in a non-U.S. corporate structure. The UBTI gets blocked, so to speak, at the wall of the corporation and therefore is no longer problematic for that type of investor. As a result, tax-exempt investors wishing to participate in the alternative investment market understand this aspect of the marketplace and are amenable to investing offshore. Note that there also are ERISA issues that need to be considered.
Customer Testimonial I have had the fortune of working with Hannah Terhune and Capital Management Services on the setup of my hedge fund. As a well funded start up with offshore and onshore investors I needed someone who could help me and my investors navigate the complex tax, regulatory and set up requirements. Her firm supported us each step of the way and we were incredibly impressed with her knowledge, experience and execution. What could have been a very difficult and lengthy process was seamless, well managed and cost effective. We will continue to use Hannah as we grow our assets and would have no hesitation in recommending her to both start up and established managers. Thanks. Warren January 26, 2010
The SEC's 134-page Report-Implications of the Growth of Hedge Funds presents the current status of the hedge fund industry. The report summarized several months of work on the Staff's part and includes a summary of the current status of the hedge fund industry (including audits), as well as a number of recommendations related to regulatory structure. The webccontent authored by veteran hedge fund attorney Hannah Terhune, JD, LLM (Taxation), when she was the Chief (and only) Attorney at Greencompany.com and GreenTraderLaw.com on offshore hedge funds, was cited on page 10 as providing information that the Staff found to be valuable in its understanding of the industry. Almost all of the other 300+ footnotes were to legal cases, results of the SEC-sponsored hedge fund roundtable, and the FINRA/NYSE. You will see from our web site that we supply more information about hedge funds than most books on the subject. It's great to see that Hannah Terhune's expertise is appreciated by the SEC! This is quite a coup for Hannah, and provides one more piece of evidence as to how she can help you!
Customer Testimonial Hannah Terhune and Capital Management Services Group offer a cost effective, comprehensive solution for anyone looking to launch or manage a hedge fund operation. We are a small company operating under a tight budget and we initially decided to use Capital Management Services because they offer great value at an extremely competitive price. Without the customized services and flexible financing solutions Hannah offered, a successful launch of our fund would have been impossible. From day one, Hannah has provided valuable guidance each step of the way along this complicated process. After working with Capital Management Services Group for eight months, it is clear that not only does the group provide services at a great value, but they also have an impressive amount of experience. For every problem we have encountered along the way, Hannah and Capital Management Services Group have been able to provide a quick and affordable solution. To date, Capital Management Services Group has helped us with registration as an investment adviser, compliance issues, drafting offering documents and ongoing administrative services. Capital Management Services Group has consistently provided quality and comprehensive solutions at great price and it is for this reason that we will continue to use their services for all of our ongoing needs. Rene June 25, 2008
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Customer Testimonial Hannah and her team were absolutely perfect for us. We needed reasonable prices, exceptional attention to detail, and someone that explained each step along the way. Getting a new fund off the ground can be a complicated and convoluted process. Hannah's team helped us sidestep any frustration along the way by always being accessible by phone or a quick email. We shopped around a lot before committing to a legal firm. Working with Hannah and team was a screaming bargain for the amount of personal attention and top quality work we received. In hindsight, our decision couldn't have been more perfect. Thanks! Rxx Fxxxxx August 15, 2008
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Customer Testimonial It was indeed a pleasure working with you and your team at Capital Management Services Group to set up our investment management firm and its associated hedge fund. As someone with deep analytical and trading expertise who is unfamiliar with the complex regulatory environment surrounding hedge funds, I greatly appreciate the advice and clarity you brought to the process of establishing the firm. Your breadth of expertise was invaluable in navigating the plethora of choices to be made and more importantly, it was reflected in your ability to make the necessary filings and obtain approvals from all the regulatory agencies. I am also impressed that your estimate for how long the entire process would take was remarkably accurate. As a new business entity, it was a benefit to our firm that you were able to provide your knowledgeable and comprehensive services at extremely reasonable terms. I would not hesitate to recommend your firm to others seeking to launch or expand investment advisory businesses and hedge funds. Best regards, Dr. Sid Valluri Managing Director Odessa Capital Management LLC Sent December 01, 2008
CapitalManagementServicesGroup.com is recognized by discriminating fund managers and traders as being the foremost tax and legal authority in the business. Attorney Hannah Terhune's education and experience are unsurpassed in the area of hedge funds creation and management platforms, and the complex body of tax laws related thereto. Ms. Terhune's exensive knowledge and experience have made her an indispensable resource for serious fund management and trading professionals. Ms. Terhune's articles on the subjects have appeared in over 100 publications worldwide. Chances are, if you have read about the above matters, Ms. Terhune has written about them. Give us the opportunity to use that knowledge and experience for you. CMSG provides the best services and support needed for hedge fund projects and associated activities in one convenient place, saving you time and energy. No need to coordinate work between different firms; we handle the entire process from start to finish. We offer hedge fund and money management accounting, tax services, tax preparation, consulting, entity and retirement plan formation services. Our professionals provide the highest quality services at competitive rates. But don't take our word for it, give us a call and let us prove what we can do for you.
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