Hedge Fund Tax Havens: Investing Secrets For The Rich

Hedge funds are alternative investments that are only available to accredited investors on the private market. They are considered illiquid and require a long-term investment horizon. Due to their large minimum investment requirements, they are usually inaccessible to the average investor and cater to high-net-worth individuals. Hedge funds are structured as pass-through entities, allowing them to pass their tax obligations to their investors. Additionally, they take advantage of strategies like using carried interest to reduce their tax liabilities. One such strategy involves entering the reinsurance business in a country like Bermuda, where profits can grow tax-free. These practices have sparked criticism for favouring the wealthy, but efforts to implement changes have been met with resistance.

Using carried interest to reduce tax liability

Carried interest is a share of the profits earned by general partners of hedge funds. It is paid to these partners based on their role in the fund, rather than any initial investment made. As a performance fee, carried interest aligns the general partner's compensation with the fund's returns. Typically, this amounts to 20% of a fund's returns, with the partner also charging a 2% annual management fee.

Carried interest is often only paid if the fund achieves a minimum return, known as the hurdle rate. It is considered a return on investment and is taxed as a capital gain, rather than ordinary income, usually at a lower rate. This is a controversial practice, with critics arguing that it allows some of the richest Americans to unfairly defer and lower taxes on the majority of their income.

The carried interest portion of a general partner's compensation vests over a number of years. It is only earned if a fund achieves a pre-agreed minimum return and can be forfeited if the fund underperforms. This is known as a clawback provision, which is not an industry standard but has been used to argue that carried interest should not be taxed as ordinary income.

The preferential tax rate for carried interest is especially important for private equity funds and their managers. A private equity fund uses carried interest to pass through a share of its net capital gains to its general partner, who then passes the gains on to the investment managers. The managers pay a federal personal income tax on these gains at a rate of 23.8% (20% tax on net capital gains plus 3.8% net investment income tax).

The Tax Cuts and Jobs Act of 2017 slightly curtailed the tax preference for carried interest by requiring an investment fund to hold assets for more than three years, rather than one, for gains to be considered long-term. However, this change rarely affects hedge funds, which generally hold assets for more than five years.

By treating income as carried interest, hedge funds can substantially reduce their tax liabilities.

Reinsurance businesses in Bermuda

Bermuda is a British Overseas Territory in the North Atlantic Ocean, with a capital city of Hamilton. The territory's economy is largely based on offshore insurance and reinsurance, and tourism. Bermuda has established itself as a world leader in the reinsurance market, attracting some of the largest and most reputable firms in the industry. The island is also known as a tax haven, with no corporate income tax, making it an attractive location for multinational corporations looking to optimise their global tax positions.

The reinsurance industry in Bermuda is highly regarded for its innovation, particularly in insurance products such as catastrophe bonds, insurance-linked securities (ILS), and other alternative risk transfer mechanisms. The regulatory environment is also robust yet flexible, ensuring efficient operation while maintaining solvency and reliability. The Bermuda Monetary Authority (BMA) oversees the sector, applying international standards of supervision recognised by major economies worldwide.

Reinsurance companies in Bermuda play a critical role in global risk management, providing insurance companies with the necessary support to cover large-scale risks, such as natural disasters, catastrophic events, and significant financial losses. The territory's reinsurance market has grown over the last 20 years, responding to the increasing worldwide demand for property and casualty insurance and reinsurance.

Some of the leading reinsurance companies based in Bermuda include:

• RenaissanceRe
• Sompo International Holdings (Sompo International)
• XL Catlin (now part of AXA XL)
• PartnerRe
• Arch Capital Group

These companies have solid capital positions, low to moderate financial leverage ratios, and are known for their expertise in managing catastrophe risk.

In summary, Bermuda's reinsurance businesses benefit from a favourable regulatory environment, tax advantages, and a sophisticated legal system. They play a pivotal role in the global reinsurance market, especially in covering risks related to natural catastrophes.

Pass-through entities

Private equity firms and hedge funds are generally structured as pass-through entities, allowing them to pass their entire tax obligation on to their investors or limited partners. This means that, as partnerships, they are not taxed themselves (like corporations are), and they can avoid double taxation.

Limited partners will receive a Schedule K-1 from the fund each year, which breaks down their share of the fund's profits or losses. This must be reported on their individual tax returns. Limited partners are considered passive investors, so they are exempt from paying self-employment tax for Social Security and Medicare.

General partners are taxed differently and often more favourably. They typically earn a 2% annual management fee, plus 20% of any profits the fund produces. This 20% is treated as carried interest, entitling it to preferential capital gains tax treatment. Carried interest is often criticised as an egregious tax break for the wealthy, but efforts to repeal it have so far been unsuccessful.

Passive foreign investment companies

• At least 75% of the corporation's gross income is "passive", i.e., derived from investments or other sources unrelated to regular business operations.
• At least 50% of the company's assets are investments that generate income in the form of interest, dividends, or capital gains.

PFICs are subject to strict and complex tax guidelines by the IRS, and U.S. investors holding shares of a PFIC must file IRS Form 8621. This form is used to report distributions, gains, income, and increases in QEF elections. It is a lengthy and complicated form, and PFIC investors are typically advised to seek professional tax assistance.

PFICs were first recognised in tax reforms passed in 1986 to close a tax loophole that allowed U.S. taxpayers to shelter offshore investments from taxation. The tax reforms aimed to bring such investments under U.S. taxation and apply high tax rates to discourage the practice.

Common examples of PFICs include foreign-based mutual funds and startups that fall within the scope of the PFIC definition. Foreign mutual funds are often considered PFICs if they generate more than 75% of their income from passive sources like capital gains and dividends.

U.S. investors holding shares of foreign mutual funds, investment trusts, ETFs, or holding companies may be subject to PFIC taxation. To avoid this, investors can consider domestic mutual funds and ETFs that hold foreign assets.

PFIC rules were modified by the 2017 Tax Cuts and Jobs Act, which introduced an exception for the insurance industry. The PFIC insurance exception states that a foreign corporation's income from insurance business will not be considered passive income unless the applicable insurance liabilities exceed 25% of its total assets.

Foreign investors and tax-exempt entities

Foreign Investors:

Foreign investors in U.S. hedge funds need to be mindful of Effectively Connected Income (ECI) rules. ECI refers to income "effectively connected" to a U.S. trade or business and is taxable for foreign investors in U.S. alternative investment funds. While portfolio income (such as interest, dividends, and capital gains) is generally not subject to ECI rules, certain activities can trigger ECI. For example, ordinary income from operating entities and real estate income are typically subject to ECI.

To mitigate ECI, foreign investors can use an "offshore blocker" entity, investing in that entity rather than directly in the main fund. This way, the foreign investor only receives dividends or capital gains from the blocker entity, avoiding direct U.S. tax and the need to file U.S. tax returns. The Cayman Islands and other offshore jurisdictions are commonly used for these blocker corporations.

Tax-Exempt Entities:

Tax-exempt entities, such as charities, pension funds, and university endowments, face unique tax considerations when investing in hedge funds. These entities are generally tax-exempt on income related to their specific tax-exempt purpose. However, they are subject to tax on Unrelated Business Taxable Income (UBTI). UBTI is income generated from activities unrelated to the tax-exempt entity's primary purpose.

To avoid UBTI, tax-exempt entities can also utilise offshore blocker corporations. By investing in the blocker corporation, which then invests in the hedge fund, the tax-exempt entity's income is classified as dividends or capital gains, which are not subject to UBTI. This structure ensures that the tax-exempt entity does not incur unnecessary taxes on its investment income.

Both foreign investors and tax-exempt entities can benefit from careful structuring when investing in hedge funds to minimise their tax obligations. These strategies can help them avoid certain types of taxable income and reduce their overall tax burden. However, it is important to consult with legal and tax professionals to ensure compliance with the relevant regulations and to avoid potential pitfalls.

Frequently asked questions