Tag Archives: offshore hedge funds

Offshore Hedge Funds – Side by Side Hedge Fund Structure

Offshore hedge funds can be structured in a number of different ways including a stand alone structure, a master-feeder structure and a side by side structure.  This article discusses the side by side hedge fund structure and also provides a side by side offshore hedge fund organizational chart.  As we have noted earlier in an article regarding offshore hedge fund structural considerations, a side by side offshore hedge fund is a structure consisting of two distinct entities which are managed in the same way by a single management company.

I attached the following Offshore Side by Side Hedge Fund Organizational Chart so that hedge fund managers can get an idea of the structures involved and the flow of payments. This specific chart details (1) a management fee and a performance allocation paid from the domestic counterpart and (2) a management fee and a performance fee paid from the offshore counterpart.  Offshore hedge fund managers should discuss these aspects of their offshore hedge funds with their attorneys. Continue reading

Congress to examine Hedge Fund AML Requirements Next Year

In an article yesterday we discussed the withdrawal of proposed rules which would require hedge funds to implement anti-money laundering compliance programs (see Hedge Funds and AML Requirements).  Yesterday Senator Carl Levin, a democrat from Michigan, released a statement condemning the withdrawal of proposed hedge fund AML rule by the Treasury.  Senator Levin statement said, “The Administration’s five-year failure to extend anti-money laundering controls to hedge funds with offshore money – despite the hedge fund industry’s willingness to accept those controls – is inexplicable, ill-timed, and unwise.”  Futher, Sentor Levin noted that Congress will face the issue in the future.   “The absence of anti-money laundering controls on hedge funds is another regulatory gap that the Congress will have to tackle after the election.”  The full statement, reprinted below, can be found here.


November 3, 2008
Contact: Press Office
Phone: 202.228.3685

Statement of Senator Carl Levin on Treasury Withdrawal of Proposed Rule to Require Anti-Money Laundering Controls at Hedge Funds

Senator Carl Levin, Chairman of the U.S. Senate Permanent Subcommittee on Investigations, today released the following statement regarding anti-money laundering controls at hedge funds. Section 202 of S. 681, a 2007 bill Levin introduced to stop a wide range of offshore abuses, would require Treasury to issue a final rule requiring hedge funds to implement anti-money laundering controls.

“Last week, with no warning, the Bush Administration revoked a 2002 proposed rule to require hedge funds to install anti-money laundering controls. Hedge funds are unregulated financial companies that can handle millions of dollars in offshore money without any legal obligation to check who is behind the funds or report suspicious activities. A 2006 investigation by my Subcommittee showed how hedge funds can bring suspect offshore funds into the United States, highlighted the lack of hedge fund regulation, and recommended Treasury finalize its proposed anti-money laundering rule.

“But instead of plugging the hedge fund regulatory gap by issuing a final rule, the Administration went the opposite way, withdrew its anti-money laundering proposal, and offered nothing in its place. The Administration’s five-year failure to extend anti-money laundering controls to hedge funds with offshore money – despite the hedge fund industry’s willingness to accept those controls – is inexplicable, ill-timed, and unwise. The absence of anti-money laundering controls on hedge funds is another regulatory gap that the Congress will have to tackle after the election.”

Other HFLB articles:

Congress Targets Aggressive Tax Positions by Offshore Hedge Funds

After my first year of law school I was a legal intern for a company which sold products to lawyers.  The CEO was a former tax attorney and on multiple occasions told me with pride that “tax attorneys are the brain surgeons of the law.”  Whatever he meant by that, it has been apparent throughout my career that tax attorneys are certainly important and that almost every issue will, in some way, involve taxes.  This is especially true with regard to the investment management industry and hedge funds specifically.

Congress has become more keen on reigning in aggressive tax positions by hedge funds, specially offshore hedge funds.  The republished statements by Senator Carl Levin below details transactions used by some offshore hedge funds, including swap transactions and stock loans, in order to avoid payment of taxes on dividends.  The statements below provide an overview of the transactions, while the accompanying report, which can be found here, provides more in depth reporting on the transactions.  The release can be found here.

It is likely we will hear more about this as discussions of hedge fund regulation continues.  We saw last year there was a popular movement toward eliminating the performance allocation for publicly traded hedge fund companies and for hedge fund companies in general (see HR 2834).  The speech below also shows that Congress is aware of aggressive tax practices of some offshore hedge funds.  While these are two different issues (the former is a policy issue and the later is an enforcement issue), they signal that Congress is ready to attack hedge funds on all fronts.

Please let us know if you have any questions.


September 11, 2008
Contact: Press Office
Phone: 202.228.3685

Opening Statement of Senator Carl Levin U.S. Senate Permanent Subcommittee on Investigations Hearing on Dividend Tax Abuse: How Offshore Entities Dodge Taxes on U.S. Stock Dividends

One of the problems that this Subcommittee has tackled in recent years is the stunning fact that each year, the United States loses perhaps $100 billion in tax revenues to offshore tax havens that aid and abet corporations and wealthy individuals dodging payment of taxes owed to Uncle Sam.

Since 2001, we have examined this problem from multiple angles, exposing the ways that people use tax havens to hide their assets and income, and how tax havens have created a whole industry to help them exercise control over their offshore assets and use those assets and the revenues they produce for their own benefit, often sneaking funds back into the United States without paying the taxes owing. Just two months ago, in July, this Subcommittee held a hearing showing how banks in those offshore tax havens have knowingly helped U.S. clients hide billions of dollars in secret bank accounts never reported to the IRS.

Today, our spotlight is on another facet of tax haven abuses: we call it dividend tax abuse. And the focus today is not on U.S. citizens, but on non-U.S. persons who are supposed to be paying taxes on the dividends they receive from U.S. corporations, but don’t. They don’t pay those taxes, because major financial institutions like Lehman Brothers, Morgan Stanley, Deutsche Bank, UBS, Merrill Lynch, Citigroup, and others have created financial gimmicks whose primary purpose to enable clients to dodge U.S. taxes owed on U.S. stock dividends, but which are dressed up with phrases like “dividend enhancement,” “yield enhancement,” and even “dividend uplift.” Using stock swaps, stock loans, and exotic financial instruments, the financial institutions have built a series of financial black boxes, surrounded by mind-numbing complexity, designed to keep their clients’ money tax-free.

Foreigners who invest in the United States already enjoy a minimal tax burden. For example, non-U.S. persons who deposit money with a U.S. bank or securities firm pay no U.S. taxes on the interest earned. They pay no U.S. taxes on capital gains. U.S. citizens do pay taxes on that income, but the tax code lets foreign investors operate without tax in an effort to attract foreign investment.

But there is one tax on the books that even foreign investors are supposed to pay. If they buy stock in a U.S. company, and that stock pays a dividend, the non-U.S. stockholder is supposed to pay a tax on the dividend. The general tax rate is 30%, unless their country of residence has negotiated a lower rate with the United States, typically 15%.

In addition, to make sure those dividend taxes are paid, U.S. law requires the person or entity paying a stock dividend to a non-U.S. person to withhold the tax owed Uncle Sam before any part of the dividend leaves the United States. If the “withholding agent” fails to retain and remit the dividend tax to the IRS, and the tax is not paid by the dividend recipient, the tax code makes the withholding agent equally liable for the unpaid taxes.

That’s the law. But the reality is that many non-U.S. stockholders never pay the dividend taxes they owe. In 2003, the latest year for which data is available, the Government Accountability Office determined that about $42 billion in dividend payments were sent abroad, but less than 5%, or $2 billion, was sent to the IRS. In other words, billions of dollars left the country untaxed.

The Subcommittee’s investigation has determined that part of the reason for unpaid dividend taxes is that, for more than ten years, U.S. financial institutions have been helping non-U.S. clients dodge payment.

Listen to this roll call of well known financial institutions. Morgan Stanley enabled its clients to dodge payment of $300 million in U.S. dividend taxes from 2000 to 2007. Lehman Brothers estimated that in one year alone, 2004, it helped clients dodge perhaps $115 million in U.S. dividend taxes. For UBS, the figure is $62 million in unpaid dividend taxes over a four-year period, 2004 to 2007. One hedge fund adviser, Maverick Capital, calculated that, from 2000 to 2007, its offshore funds used so-called “dividend enhancement” products from multiple firms to escape dividend taxes totaling nearly $95 million. In 2007, Citigroup surprised the IRS by paying $24 million in unpaid dividend taxes on a select group of swap transactions from 2003 to 2005, where no dividend taxes had been paid.

Who were the clients? Hedge funds organized offshore, often by Americans; tax haven banks; and a host of sophisticated foreign investors with the means and the know-how to engage in financial transactions beyond the reach of ordinary folks. But that’s not the whole story. Some of those foreign investors begin to look a lot less foreign once you take a closer look.

I’m referring in particular to so-called “offshore” hedge funds. When the Subcommittee began contacting them, all of their key personnel turned out to be here in the United States. The so-called “offshore” hedge funds’ main offices were here in the United States; their key decisionmakers were here; their investment professionals and technical people live here. Most of these offshore hedge funds claim to be located in the Cayman Islands. The Cayman Islands, in fact, have 10,000 hedge funds, more than any other country in the world. But the Cayman hedge funds we examined did not operate in any meaningful sense from the Caymans. Instead, their physical presence often amounted to little more than a Cayman post office box or a plaque on the wall of the infamous Ugland House, that small white building where more than 18,000 companies maintain a Cayman address.

Hedge funds run by Americans and invested in the U.S. stock market often create a shell of a presence in tax havens, presumably in part to avoid paying U.S. taxes. Then, when confronted by the one U.S. tax imposed on foreign investors receiving U.S. stock dividends, they turn to financial gymnastics to escape paying that tax as well. It adds insult to injury when hedge fund managers who live in the United States, enjoy all its benefits, protections and prosperity, and use U.S. markets to make money, arrange tax dodges so their offshore hedge funds escape the minimal U.S. tax obligations they are supposed to pay.

Hedge funds and other offshore entities couldn’t perform their dividend tax escape act without the cooperation and assistance of financial institutions. It is those financial institutions that devise the abusive transactions and send the U.S. dividend payments offshore to their clients in the form of dividend equivalent or substitute dividend payments, without remitting any taxes to the U.S. Treasury. Their own emails show that they took those actions knowingly to attract and retain clients and to profit from the fees. With their assistance, billions of dollars in U.S. dividends flowed out of this country, and very few taxes were withheld.

I want to take a moment here to explain two of the most common schemes used to dodge dividend taxes. They involve swaps and stock loans. In both cases, financial sleight of hand is used to recast taxable dividend payments as untaxable transfers offshore.

Swap Transaction. First consider swaps. Swaps sound complicated, but they are essentially a financial bet, in this case a bet on the future of a stock price.

Take a look at this chart. It shows an offshore hedge fund in blue, which is controlled by a U.S. investment manager in green. The financial institution, shown in red, tells the hedge fund – which owns U.S. stock – that it can escape the 30% withholding tax on an upcoming stock dividend by purporting to sell the stock to the financial institution and simultaneously entering into a swap with the financial institution tied to the price of that stock.

Under the swap, the financial institution promises to pay the hedge fund an amount equal to any price appreciation in the stock price and the amount of any dividend paid during the term of the swap. The payment reflecting the dividend is a “dividend equivalent.” In return, the hedge fund agrees to pay the financial institution an amount equal to any price depreciation in the stock price. The financial institution hedges its risk by holding the physical shares of stock that were “sold” to it by the hedge fund. It also charges a fee, which usually includes a portion of the tax savings that the hedge fund will obtain by dodging the withholding tax.

The swap gives the hedge fund the same economic risks and rewards that it had when it owned the physical shares of the stock. So why do it? Because under the tax code, dividend payments are taxed, but dividend equivalent payments made under a swap are not.

Dividend equivalent payments made under a swap are tax free, because in 1991, the IRS issued a series of regulations to determine what types of income will be treated as coming from the United States and therefore taxable. These so-called “source” rules treat U.S. stock dividends as U.S. source income, because the money comes from a U.S. corporation. But the 1991 regulation takes the opposite approach with respect to swaps. It deems swap agreements to be “notional principal contracts” and says that the “source” of any payment made under that contract is to be determined, not by where the money came from, but by where it ends up. In other words, the payment’s source is the country where the payment recipient resides.

That approach turns the usual meaning of the word, “source, “ on its head. Instead of looking to the origin of the payment to determine its “source,” the IRS swap rule looks to its end point — who receives it. That “source” is not really a “source” by any known definition of the word. It is the opposite – not the point of origin but the end point.

The result is that when a financial institution makes a dividend equivalent payment to an offshore client under a swap agreement, the tax code provides that the payment is from an offshore “source.” So the swap payment is free of any U.S. tax. In our example, the U.S. financial institution makes the swap payment to the offshore hedge fund, minus its fee, and stiffs Uncle Sam for the amount of taxes that should have been sent to the IRS. The swap is then terminated, and the stock is “sold” back to the hedge fund. Under this gimmick, the hedge fund ends up in the same position as before the swap, as a stockholder, except it has pocketed a dividend payment without paying any tax.

Stock Loan. Stock loans are also used to dodge dividend taxes. These transactions pile a stock loan on top of a swap to achieve the same tax-free result.

The first step is that the client with an upcoming dividend loans its stock to an offshore corporation controlled by the financial institution. This offshore corporation promises, as part of the loan agreement, to forward any dividend payments back to the client.

The next step is that offshore corporation enters into a swap with the financial institution that controls it, referencing the same type of stock and number of shares that is the subject of the stock loan. Essentially, two related parties are placing a bet on the stock, which makes no economic sense except, once that stock pays the dividend, the swap arrangement allows the financial institution to send it as a tax-free dividend equivalent payment to the offshore corporation it controls. The offshore corporation then forwards the same amount to the client. Because the payment is sent to the client as part of a stock loan agreement, it is called a “substitute dividend.” The tax code treats substitute dividends in the same way as the underlying dividend. So if the underlying dividend came from a U.S. corporation, the substitute dividend would normally be taxed as U.S. source income.

But in this transaction, the parties claim the substitute dividend is tax-free by invoking the wording of an obscure IRS Notice 97-66 never intended to be applied to this situation. That notice says that when two parties in a stock loan are outside of the United States and subject to the same dividend tax rate, they don’t have to pay the dividend tax when passing on a substitute dividend. The assumption is that the tax was already paid by another party in the lending transaction. Some tax lawyers have seized on the wording to claim that this IRS Notice, which was intended to prevent overwithholding, could be used to eliminate dividend withholding entirely, so long as one offshore party passes on a substitute dividend to another offshore party subject to the same dividend tax rate. The IRS told the Subcommittee that Notice 97-66 was never intended to be interpreted that way, but in the ten years since it was issued and abusive stock loans have exploded, the IRS has never put that in writing.

The end result in our example is that the client pockets a substitute dividend payment – minus the financial institution’s fee – without paying any tax. The stock loan is terminated, and the stock is returned to the client. The big advantage of this approach over a swap, is that the client doesn’t have to explain why he got his stock back after the transaction. The stock was, after all, only on loan. Tax avoidance was clearly the economic purpose of the two transactions just described. The client owned U.S. stock both before and after each transaction. Neither the swap nor the stock loan altered the client’s market risk. The only risk involved in either transaction was that Uncle Sam would catch on and assess the dividend taxes that should have been paid but weren’t. To make it harder for Uncle Sam to catch on and prove what is going on, financial institutions have added more complexity, more bells and whistles, to their transactions. But the purpose of the transactions remains the same – to enable clients to escape paying the taxes they owe.

And it’s clear that the participants knew their transactions were little more than tax dodging. In one email exchange about a proposed stock loan, a potential client informed Merrill Lynch that its tax counsel had said “the transaction works, as I said, once, maybe twice,” but “repeated use, coincidentally around dividend payment time, would provide a strong case for the IRS to assert tax evasion.” Another client explaining a Lehman swap transaction to a colleague wrote that the swap “is used to circumvent the tax.” That’s the unvarnished truth. The participants in these transactions also took steps to limit their exposure in case the IRS stepped in. Some of the financial institutions, for example, set an annual limit on the amount of unpaid dividend taxes that they would facilitate through their transactions, to limit their exposure as withholding agents. Some of the clients demanded that the financial institutions indemnify them against any tax liability. A few financial institutions, such as UBS, Merrill Lynch, and Morgan Stanley, have stopped offering the most blatantly abusive transactions, while others have continued doing as many deals as ever.

Some may claim that, by exposing this tax dodging and being determined to end it, we are trying to discredit structured finance or the financial markets. But I support financial transactions used for legitimate purposes, including swaps and stock loans that facilitate capital flows, reduce capital needs, or spread risk. What I oppose is the misuse of financial transactions to undermine the tax code, rob the U.S. treasury, and force honest Americans to shoulder the country’s tax burden. What I oppose are transactions whose patent economic purpose is tax dodging. For the last ten years, as dividend tax dodging took hold and became an open secret among market insiders, the U.S. Treasury Department and the IRS sat on their hands. When firms began claiming they could turn taxable dividend payments into untaxed dividend equivalents under swaps, Treasury and the IRS said nothing. When firms began claiming that the 1997 IRS notice designed to cure overwithholding could eliminate all withholding in offshore stock loans, Treasury and the IRS failed to issue corrective guidance. When firms openly advertised so-called “dividend enhancement” products to clients, Treasury and the IRS saw nothing, heard nothing, and took no enforcement action.

The government’s failure to act does not in any way excuse the actions of the financial institutions or their clients. They are not saved from their own abusive conduct by the failure of regulators to stop them, any more than going through a red light is okay if you’re not caught. Nonetheless, the silence and inaction of the Treasury and IRS in the face of rampant dividend tax dodging has encouraged and continues to encourage financial institutions to offer their clients financial concoctions designed to enable them to dodge U.S. dividend taxes. It is past time to end that silence, end that inaction, and get those concoctions off the market. It is also past time for Congress to take on this billion-dollar offshore tax abuse and, like so many others, enact the legislation needed to put a stop to it.

I want to thank my Ranking Member, Senator Coleman, for his support of this investigation and invite him to make opening remarks.

BVI FSC may request additional information for hedge fund “recognition”

For offshore hedge funds one of the central questions during the formation process is which jurisdiction will you choose? While there are many possibilities, there are two jurisidictions which a vast majority of the hedge funds will choose – either the BVI or Cayman Islands. Because both offer the same liability protections and tax favored status, the question comes down to cost and regulation.

Generally Cayman is considered to be the “premier” jurisdiction with many of the blue chip hedge funds domiciled here. Cayman also had a bit of a first-mover status and has just announced that it had it’s 10,000th fund. Cayman is also the more expensive jurisdiction.

Because of these facts many funds, including many start-up hedge funds, will choose to go with the BVI. One issue with the BVI is that the fund “recogition” process is much more capricious. Where Cayman offers funds a very dependable timeline to fund start ups, the BVI’s “recognition” process can be delayed by the BVI’s Financial Services Commission (“FSC”), which has the authority to request certain information for BVI professional funds. In fact, the FSC is free to request any additional information as they please. (Note: this is also true during the entity formation stage, which is distinct from the fund formation stage.) In the past they have asked for more detailed information on the past job duties of Directors. They have also requested future confirmations on certain items in the offering documents related to a manager’s past performance. They have also requested information related to the service providers.

As a result of the requests they have made, the final “recognition” of certain funds has been delayed. However, this will not happen on a routine basis (it has happened, with my previous clients, maybe once every 10 funds) and normally the information request and subsequent recognition is handled relatively quickly so that there has really been no delay of a manager’s launch date.

When deciding on a jurisdiction, this is something to be aware of, but it should not be dispositive on your decision one way or another.