FacultyFaculty/Author Profile

Hedge Funds


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SPEAKER 1: I'm going to go ahead and begin the introduction while Philippe's coming up. So our next session is on hedge funds. It's going to provide tax planning guidance for managers and investors, examine section 704(c) methods, and provide some operational considerations. And to guide us through this session, we have Philippe Benedict.

He's a partner with Schulte Roth in New York, focusing his practice on the tax aspects of investment funds, mergers and acquisitions, international transactions, real estate transactions, and financial instruments. He has also advised many major transactions involving sales or spin-offs of investment fund managers. He earned his LLM in taxation and his JD from NYU. And while pursuing his JD, he was the recipient of a Gruss Fellowship. And he obtained his BS summa cum laude from Adelphi University. Take it away, Philippe.

PHILIPPE BENEDICT: Thank you. Thank you for the introduction. As I go along here and go through the tax issues for hedge funds, I'll try to compare it to PE. We just heard a wonderful session on PE. Try to give you sort of the distinctions and the differences. Please feel free to ask questions. Makes it more interesting as we go along, so don't hesitate to just raise your hand and ask questions about the topics.

We have typically, unlike PE, in a hedge fund structure, as we'll see through a couple of structure charts in a moment, you typically have a separate vehicle, not an AIV but a separate vehicle for your US investors and your non-US investors. And it's actually a little more involved than that. On the US side, on the US feeder side, US fund side, it's US taxables and state pensions-- what we refer to and was referred to in the last session as super tax-exempts, people who do not have-- take the position that they don't have to pay UBTI on leverage. That's on the pass-through side on the domestic fund side, so US taxables and to US tax-exempt who are state pensions.

On the offshore side, typically coming through a Cayman corp, that's not a pass-through for tax. You have the non-US investors, including the sovereign wealth funds usually, the 892 investors, and tax exempt, who are you UBTI sensitive, which is essentially most tax exempts other than state pensions. They come in through a Cayman corp.

And the reason why they're coming to a Cayman corp is because typically, unlike PE, there is a significant amount of leverage in hedge fund strategy. They're very much levered up. It is high leverage. And for tax exempt investor, even if you don't have any pass-through income that otherwise would generate UBTI, just the virtue of the leverage, just the fact that the fund is using leverage-- not talking about swaps, like embedded leverage. I'm talking about margin leverage, typical leverage borrowing from a bank line of credit. That's UBTI for your tax exempt-- US tax-exempt investors.

So again, unless they are state pensions that do not pay tax on UBTI, for most tax exempt, they need to have what we refer to as a Cayman blocker to access deals in a-- through U-- through managers. and the reason for that is, is because if they came in through a pass-through vehicle, all the leverage would flow up as you UBTI. They come into a Cayman blocker with very few exceptions. The leverage at the master or the offshore feeder level doesn't flow through as UBTI to the tax exempt. So again, that's one reason, and that's really the reason why tax exempt investors, other than state pensions, go offshore in the Cayman corp.

Non-US investors also like to be shielded by a Cayman corp. The reason for that is, again, unlike PE, hedge funds trade very actively. There's a lot of trades. So once you are a trader and not an investor, you could be taxed in the US unless you meet a safe harbor under section 864(b) of the code.

And although most hedge funds meet this safe harbor, from a non-US investor's perspective, they prefer having a shield. They don't want to take a chance. The trading is more active. It looks more like a trader business, which then needs to be protected by a safe harbor, which most activities are, but not necessarily all activities in our flow fund.

By coming through a Cayman blocker, they have a shield. They don't have direct exposure to US tax from a filing perspective and from paying taxes perspective. Again, most hedge funds do not end up having an ECI, effectively connected income, because they ultimately follow the safe harbor. But from an investor's perspective, from an off-shore front perspective, it's something that they like. They like knowing there's a shield there so if for any reason there's a little bit of ECI, of effective connected income, it's shielded from them. It's just leakage at the level of the Cayman blocker.

So again, because of the nature of the trades from a UBTI perspective for tax exempt, the leverage, which is UBTI, and for non-US investors, the fact that it's not just a question of going to a pass-through and having operating income but the actual trading could also be effectively connected income, that risk, they don't want to take, which is why they go into an offshore blocker which shields them from direct ECI, filing a tax exposure. So just want to make sure that everybody understands the difference here. Again, in a PE fund where you have the one-off-- or maybe not one-off but pass-through structure, you use an AIV for that. But otherwise, everybody comes into a main fund which is a pass-through entity, whether it's a Cayman LP or Delaware LP.

Hedge is very different. In most situations, the non-US and the UBTI-sensitive US tax-exempt will not go into it pass-through. We want to go into a Cayman corp. Just to go through those structures, there are variations on the structures for hedge fund, but none of them, almost none of them, have a single entity.

The most simple structure is a side-by-side domestic fund and offshore fund. Again, the domestic front is a partnership for tax. That's for the taxables and for the state pensions, not UBTI-sensitive tax-exempt. The offshore fund, as we just said, is a corporation for US tax. It's a Cayman corporation hopefully not taxed in the US-- i.e., hopefully not engaged in a trade or business. And that entity is, again, for the non-US investors and the US tax-exempt UBTI-sensitive investors.

Fairly straightforward structure. Side-by-side fund, not the most common structure, but in a way, just the least boxes involved-- one for the offshore, one for the onshore. You will see in a moment that most hedge funds are not structured as side-by-side structure. They are structured as master-feeder structures. And if you look at the-- before we go to the master-feeder, let's just spend a moment on a mini-master fund structure.

This is also a side-by-side. The second chart here is also showing you a side-by-side structure where the domestic fund and the actual fund do not invest through a commingled vehicle. The only difference here is that is a mini-master below the offshore fund. Why is the mini-master there?

The mini-master is there to accommodate a carry structure for the US manager. If all you have is two funds, US and Cayman, and the Cayman is a corporation, you can't pay an allocation out of a corporate vehicle. You have to pay a fee. Fee is ordinary income.

If you want to get an allocation, if the GP, the members of the GP, want to get that benefit of allocation, just like you have allocations in the world, you have to have a partnership. So even though the investors come into the offshore feeder, as you see in the structure here, but the GP carry is paid out of the mini-master fund, which is below the offshore fund, which is a partnership for tax-- whether it's a Cayman LP or it's a Cayman entity that checks a partnership box-- but it's a partnership for tax, and allows the GP, if you look at the line here, to be paid an incentive allocation from the offshore fund.

Now, what's interesting here is that there is-- before we get into the pros and cons of structuring a carriers and allocation of a fee-- because there is a debate on this issue, and there is more of a debate today because of tax reform than there used to be-- but let's just think about your investor base. On the domestic side, you almost always see an allocation. Very unusual to see a fee structure on a domestic site, even if the fee may make more sense in some unusual situations for the GP/manager. The reason for that is, is because you domestic investors, the US taxable investors, do not want-- can't tolerate a nondeductible incentive fee. They can tolerate and nondeductible management fee, but they will not tolerate 20% phantom income by having a nondeductible incentive fee.

How can you get to a nondeductible incentive fee? If there is any risk that your fund is not a trader-- although, most hedge funds trade actively, which is the reason we mentioned before as to why offshore investors want the corporate shield. Because most hedge funds trade actively. But by no means do all hedge funds qualify as a trade as a no-brainer.

Obviously, you have quant funds. They do thousands of trades a day or more. They're definitely traders. There's no issue there.

But more and more of the hedge fund world is sort of merging with PE to a certain extent. And you see more and more hedge funds do either side pockets-- or not so much side pockets these days, but they make private investments. So all or some of the activities of hedge funds may be treated as investment activities, even if they are not reported as investment activities, because you may be on the borderline between the two.

But there is some risk. If there is any risk that your carry-- that your fund is not a trader or that, alternatively, a portion of your fund activities is not trading, doing a fee for your domestic investor is really, basically-- even if you treat yourself as a trader, but the risk of the service recharacterizing you as an investor and having your investor suffer phantom income on carry because of the non-deductibility of the fee for an investor, which is now fully nondeductible because of tax reform-- you get zero deduction for it-- is not something that you can-- that I would recommend anyone doing. So from a domestic fund perspective, other than very few exceptions, which generally speaking, refers first to quant funds or other very, very actively traded funds, it's almost always an allocation. Because once you do an allocation, we don't have a deductability issue.

The way the allocation works, it's reallocated from the LPs to the GP. So it never shows up. If you make $100 and you're paying a 20% incentive fee, the LP's tax return will show $100 of income and $20 of deduction. If you're not a trading fund, that's nondeductible. So you've got $20 dollars of phantom income.

In the allocation, the LP's K-1 will only show, just like in the PE context, $80 of income, because $20 of income shows up on a GP's K-1. So they never have to deduct the $20, which is why it's the preferred way.

AUDIENCE: I know these structures have been around for a while. But that seems like the carry that goes to the manager, it comes out of the same four funds. And it flows up and we have various different [INAUDIBLE] vehicles. And you have to--I don't know if it's cross-- cross-promote it, but it's very partnership-ending. Is there a risk that all these separate partnerships that the promote is based upon the same underlying [INAUDIBLE] and the structure kind of collapses on itself? I know the structure's been around for a while.

PHILIPPE BENEDICT: Yeah, the fees always go to a separate entity. So just to promote it goes through-- if you look at the structure here, you have a GP of the fund that gets the domestic fund incentive allocation and the mini-master fund incentive allocation. It's all going to one entity. The fee, the management fee, is going to an investing manager. It's a side-by-side structure. So from that perspective, you'll almost-- very unusual to see the fee and allocations being mixed together in one entity.

In terms of different funds with different carry, different people do different things. Some do it all into one GP. Some do it in different GPs. But usually, even if the service were to commingle all the promotes, in most situations, there's no taint there, because the promote is usually clean. Unless there's ECI or lending-- if you have a lending fund, maybe the lending carry could taint your other areas. But if it's long-short equity or macro, anything like it, even if everything goes into one GP, there's no-- there's no--

AUDIENCE: It doesn't really-- it still gets the same-- you still get back to the same point, yeah, whether it's collapsed or not, right?

PHILIPPE BENEDICT: Yeah, that's right. That's right. So again, on the domestic side, mostly an allocation. On the offshore side, investors don't care. From your investor pool perspective, there are non-US people, US tax-exempt people, that don't have the same deductibility issue with debt US investors-- US taxable investors. Have so from their perspective, whether you do an incentivize as an allocation or as a fee, it really doesn't matter to them, because the deductibility of the fee is not something that's relevant to you-- to them. That's why on the offshore side, you would do what makes sense for the GP members. If the carry makes sense, then you do an allocation with the mini-master fund or, as we'll see in a moment, perhaps with a master fund. If the fee makes more sense, then you would pay a fee. And you would have no need for this sub-mini-master fund.

Now again, why-- what are the pros and cons? We'll get to a little bit later as to what the pros and cons of structuring the carry as a carry or as a fee. There are pros and cons. But as you may know, the tax reform has changed the treatment of carry from one year to three years. And so essentially, holding an asset for more than a year is no longer sufficient to give the GP members the benefit of long-term cap gain.

You have to hold it for more than three years, which isn't a problem for most PE funds but is a real problem for hedge funds. Because even hedge funds that dabble into private equity and may hold assets for more than a year, but very unusual for them to hold the asset for more than three years. So with tax reform, it became less clear that a carry allocation is going to generate a long-term cap gain for your carry member. And if it doesn't generate long-term cap gain, maybe a fee makes more sense. And again, there are pros and cons to fee versus allocation. But these are the issues that you have to deal with on an offshore structure.

If you may remember many, many years ago-- I mean before '09-- people did offshore structures to get deferral. They got up to 10-year deferral from the offshore fund. It was compounding with a return tax-free. So that was the flavor of the day through '08. Then, they came out with section 457(a), essentially eliminating long-term deferrals in offshore funds. So many funds restructured their offshore structure from a fee to an allocation with a mini-master. They would dump everything into a mini-master and do exactly what you see on this chart.

Then came Obamacare in 2013 with 3.8% Medicare tax on investment income. And again, so if you don't have much long-term cap gain, the carry is subject to this nondeductible 3.8%. The fee may not be subject to any Medicare taxes we see in a moment. So some people went back to carry. Now to avoid the Obamacare tax-- again now, with the three-year rule-- I suspect you'll see more people-- and I've seen it already-- restructuring at least their t piece into an incentive fee versus an incentive allocation. But this structure that we see here is there to accommodate an allocation if you still expect to get some benefit from an allocation on the offshore side versus a fee. Any other questions on that?

The next structure is a master-feeder. I would say most hedge funds operate as master-feeders. The benefit of a master-feeder is obvious. You're doing everything at the level of the master, unless we introduce one more entity here. But the basic master-feeder, everything is done at the master level. Much simpler from a back office perspective.

All your trades are there. If you have a credit fund, you get one leverage facility, and you can use all your assets as a base. Don't have to re-balance between two side-by-side funds. Much easier to operate a master-feeder structure.

So if tax wasn't a factor, I suspect most funds would be--or maybe all funds would be master-feeder. Essentially, a domestic fund, again, for your taxable and state pensions and then offshore fund, which is a Cayman corp, treat it as a corporation for your tax-exempt and offshore investors all feeding into a pass-through a vehicle, a master fund. And in the structure you see here, there's an incentive fee offshore and an incentive allocation onshore. Again, if one wanted an allocation you could do it here. You could do an allocation directly from the master to the GP, because the master is also a pas-through entity. So this is just the preferred structure for many, many funds-- most macro funds, most credit funds other than credit funds that do loan origination, and some long-short equity funds.

However, in some situations, you need the flexibility to do trades above the master. If you have tax-sensitive trades for your offshore fund where you may need a US blocker-- I mean, the conversation that we had before, in the last session about PE funds and using blockers-- so if you have tax-sensitive trades that need US blockers, you don't necessarily want a US blocker for your taxable investors. If you did everything at the master level, there would be an issue there.

So if you want to do trades above the master, what you need to do is introduce an intermediate fund into pause between your offshore fund and the master. What it does for you, it gives you the best, so to speak, of both worlds. It allows you to do most of your trades at the master level, so you get all the benefits of having one pool of assets for most of your trades.

But if there's a tax-sensitive trade, whether it's an investment in a pass-through vehicle, it's an investment in real estate-- US real estate, which is FIRPTA for your offshore investors. Or if it's a loan origination activity which you don't want to do in the master fund because that would be effectively connected income for your offshore fund-- so you either don't do it on the offshore side, or you do it through a blocker. But if you do it, you don't do it at a master level. You do it above the master at the intermediate fund level and a domestic fund level.

Your carry-- if you have a carry allocation is taken at the intermediate fund level and the domestic fund level. You don't take it at a master level because you want to capture carry on the investments above the master. So again, this is structure that's used for funds that want to do most of what they do in the master. They're not just doing loan origination. They usually do secondaries, but they might do a primary every so often. But they want the flexibility to do trades above the master.

I mean, in my experience, in most situations, they don't end up using the flexibility, but they like to have it because you never know. So it's not a huge cost to have an additional entity in there. And it's much easier to do day one than to have to insert date two, which is why you see this structure in some funds that have broad mandates that may include ECI activities.

The next structure chart is similar to the master feeder that we talked about earlier with one variation here, and the variation here, as you can tell, is that there is another entity for your offshore investors, which is a offshore pass-through fund. That becomes a third feeder into the master. And the reason for that structure is to allow treaty-eligible investors-- many, many European investors and some of the other investors have treaty between themselves and the US. It allows them to come into the master through a pass-through entity-- typically a Cayman LP, but not always a Cayman LP. And that way, if, for example, there is a significant dividend on a stock that's-- the master fund is investing here, a US dividend-- as you may know, dividends are subject to 30% withholding tax.

Interest, generally, is exempt from withholding tax. US source interest qualifies usually for a portfolio interest exemption. US dividends are subject to a 30% withholding tax. That's just the way it is for-- if all you do is you have a Cayman feeder, and you fund it generating significant amount of US dividends, there's a 30% leakage for your offshore feeder, for your offshore investors indirectly. This allows your offshore investors who have treaty to get a reduction in their withholding tax rate on US dividends. With the right tax forms that you can get from them, you might get to a 15%, sometimes lower interest rates, going down-- withholding rate-- going down from 30% to generally 15% and sometimes lower. So it's an interesting structure for tax treaty investors who are willing to come into a pass-through structure for the benefit of getting this treaty reduction in withholding tax on dividend.

Now, why is it showing up? It doesn't show up a lot. But why is this even in the conversation and it wasn't before? Because historically, offshore fund had-- if they were going to invest in a stock-- in a US stock that paid significant dividends, they would look into doing it in a swap form. Because you were doing it in a swap form, historically, you were able to avoid on public stock. To do a swap that's typically respected, you aim to avoid a 30% withholding, because there's to holding on swap payments as long as the swap is respected.

Now with 871(m) in the code, which is in effect now, at least for delta one transaction, a straight swap on a US stock is subject to 30% withholding tax. You have to look through. So because of this new look-through that came into effect and is already in effect for delta one one-on-one-transactions-- it's trade swap-- you have much more leakage than you used to have on dividends, that because swaps is no longer the solution. And do anything other than a swap gets really complicated.

But a straight swap no longer solved the 30% withholding tax issue. So because you no longer have this ability, you really-- you might as well do a physical trade. Offshore investors who are eligible for treaties who may not want to come into a domestic feeder and be commingled with the US investors may be interested in this type of transaction.

The one modification on that-- but really, it's sort of much more complex-- is there's a potential to set up a Cayman LP as a feeder and check the corporate box on it, so it gives you the shield for your tax-exempt, for the US tax-exempt. Because it'll be a corporation for tax. And using the reverse hybrid rules and still give the non-US investor treaty benefit. It's complicated and broker-dealers are not really equipped to deal with it very well. It takes time to educate them on this stuff, even today.

But it's a structure you'll see every so often, where a offshore feeder will be set up as an LP. We'll check the corporate box, and we would still be allowed, with the right tax forms, to access treaty benefits. It's not going to help your sovereign wealth funds under 892, but it will help the treaty's-- the treaty investors under section 894, reversed hybrid rules. So again, these are all variations on the theme of a master-feeder, where you could maybe tweak the margin to get yourself better results on US dividends. Any questions?

One issue that you don't necessarily need to deal with in the PE world but we deal with on the hedge fund side on a daily basis is PTP, publicly traded partnership. The reason why you-- this is something that we think about when we set up a domestic feeder or master which are meant to be partnership for US tax is because people have liquidity. Unlike a PE fund, in a hedge fund, by definition, maybe there's a lockup period in some situations; sometimes not.

But after the initial period, people have typically quarterly liquidity rights with certain notices. Sometimes, it's monthly. Sometimes, it's quarterly. But people are able to redeem out. This is one of the major difference between PE and hedge. Hedge has redemption rights. People can come out of a hedge fund. They're not stuck in the fund beyond the time they want to. Sometimes there are some gates and other issues, where it may take some time to get all that cash out. But there is a right to redeem.

Because there's a right to redeem, it could be viewed as a liquid market, so to speak, and may not allow you to qualify the partnership as a partnership because of the publicly traded partnership rules. Now obviously, no one in his right mind would think that giving someone liquidity on a-- even on a monthly basis makes something a public vehicle. The issue that we are dealing with is that the issue is such a big issue, being a pass-through is so important to your taxable investors, that you really have to be at a [? will ?] level of comfort on PTP-- i.e., you have to be very, very sure that you have a theory based on the regulations to rely on as to why your fund is not a publicly traded partnership. So it's not enough to have a gut feel that this is good. Your investors want a much stronger level of confidence.

There's essentially three ways you can avoid PTP status for your domestic fund, which is a partnership for US tax. One is by staying below 100 partners-- 100 or below, which is basically a safe harbor. And in that situation, you do not have a PTP. Obviously, most hedge funds, even if they start below 100, hope to go above 100, unless they are 3(c)(1) funds, but that's sort of beyond the scope of this. But the bottom line is anybody who is starting a hedge fund is hoping to have more than 100 investors one day, so that's not a permanent solution, to stay below 100.

The second one-- I'm just jumping to the third one on your chart is the qualifying income test. If 90% of your gross income is passive income, is qualifying income, then you are OK. You're not a PTP. Even if you gave daily liquidity, for that matter, you would not be a PTP. What is passive income? Cap gain, dividend, interest-- all of that is fine. Even swap income should be OK.

Which funds have an issue with relying on a qualifying income test? You'll find it in active lending funds-- because an active financing business is not going to generate good income for the 90% test, so lending funds cannot rely on the passive income test-- and also some funds that do physical commodities.

If you do commodities on physical underlying assets-- future underlying assets, like that-- unless this is a principal activity, it's not good income. So if that's all you do or if it's half of what you do, you're OK, because it's a principal activity. And it's exempt. It's good income.

But if you do some, but you don't do a lot of it, but you do enough to perhaps generate more than 10% bad income-- because it wouldn't be good income if it's not your principal activity-- that's where you have an issue. So lending fund and physical commodity where you do some, but it's not a principal activity, but you generate enough income in a certain year that you miss the 90% test, because the income from physical commodity where the physical commodity is not your principal activity is not good income for this purpose.

Cryptocurrency-- it's sort of very topical. A lot of funds do some. There are also cryptocurrencies funds that do just cryptocurrency. But there's a fair amount of funds that do some. It's not clear that cryptocurrency would be good income for that. It's just obviously a question that we need guidance on.

So these are some examples of funds that may not qualify for the passive income. So if you're above 100 partners and you are not at a [? will ?] level on your qualifying income, then you have to make sure that you limit redemptions and transfers, which is a second test here, which is referred to as fact and circumstance. What is fact and circumstance?

Essentially, you need to follow the guidelines and the regulations in limiting transfer and redemption rates. Transfers, with some exceptions, are not allowed unless it's a carryover basis transfer. You are allowed to do a block transfer, for example. That's one exception. If you are more than 2% of the fund and you're transferring that, that's a block transfer.

But if it's not fitting one of the regulatory exception, transfer is not allowed. So you can't transfer. You can redeem out, which is essentially how most people exit hedge funds. But you can't redeem deal more often than quarterly on certain amount of notice.

How much notice do you have to give? It depends. Different law firms have different views on it. Our recommendation is 65 days, quarterly 65. Other people say 60. Some say 45. Some say more. So it's all over the place.

But the bottom line is there has to be some limitations on how many times people can take the money out and how much notice they have to give to get out. And that's how you get to fact and circumstances. So it makes for unhappy conversations if the client wants to accommodate a big investor, wants to make a transfer that doesn't fit into the exemption in the regs. We often have to see where we can go.

And there are exceptions, again, but the basic rule is that every transfer that's not carryover has to be discussed with counsel. Because there's a potential for it to reduce your level of comfort below [? the will ?] level on PTP, which is critical. Any questions? Go ahead.

AUDIENCE: [INAUDIBLE] direct lending and qualifying incomes.

PHILIPPE BENEDICT: Yup.

AUDIENCE: Is the bad income limited to the fee income and the interest is good, or is it all bad income?

PHILIPPE BENEDICT: It's all bad income. Any income derived from finance activity-- and many, many lending funds do very-- earn very little in fees. But the interest is bad.

We touched upon some of this, but I think it would be helpful to just look at it on one shot. What type of issues do offshore fund have to worry about? Again, the premise here is that you are actively trading. So you're actively trading. You can only be exempt from tax if you meet a safe harbor, unlike like PE funds that invest, because hedge funds trade. So they may be taxed in the US, unless they fit into a safe harbor under 864(b)(2).

Trading in stock and securities commodities, notion of principal contract-- all that stuff is covered as under the safe harbor. What you need to avoid is dealer activity. And dealer activity can come in many forms. But for example, backstopping certain offering and getting a fee for that, you start looking a little bit like a dealer.

Other issues that can come up where you are acting as a merchant between buyer and a seller, where you're just making a markup-- unusual, but every so often, funds that do funkier stuff could get close to a dealer issue. The difference between dealer and lending-- because lending is also ECI-- is a dollar of dealer income taints your whole fund. Pass-through income of FIRPTA or maybe even lending doesn't necessarily always taint you fund, but if you have a dollar of dealer income in your offshore fund, you no longer qualify for the safe harbor on all your activities. So a dealer is a big one. We have to avoid being a dealer.

Obviously if you do active lending, you can't do it directly in the offshore fund. Some people do it through leverage blockers. Some people do some season and sell activity. There's different ways-- there are some treaty structures out there. But you can't do directly in the offshore fund directly loan origination. Sometimes, you can even taint the rest. But it's not a per se taint, like the dealer activity.

The other one is pass-through income. So obviously if you invest in partnerships, on the P side, the AIB was their solution. Here, it's not necessarily the case, which is why you might need to do stuff above the master and do it through a blocker on the offshore side and directly in the onshore side through a combined LLC that doesn't flow through the master fund, so pass-through an issue.

FIRPTA, US real estate is an issue. You can buy stock, public stock of a FIRPTA company-- a home-builder or a retailer that happens to be a FIRPTA company-- up to 5%. Up to 5% is not going to generate a FIRPTA issue up to 5% of the class-- publicly-traded shares of the class.

Question is, where do you test your 5%? And it could be an issue for activist fund at [INAUDIBLE] positions. And a better view is that you test your 5% at the master level.

So even if your offshore feeder is only a fraction of the overall assets under management, you may not be able to look through the master to test the 5%. So again, if you see some funds that have an activist band and they like real estate, you tend to see them side by side, not as a master-feeder. Or, at least, you see the trades that are FIRPTA trades not being done at the master level because of that issue. There is a theory that you can look through a master, but it's not without risk. And I think most accounting firms are not currently comfortable with that position.

For reasons that escape me, but maybe someone knows-- REITs were given a dispensation. And even though REIT is also FIRPTA-- but they were-- and they used to be also a 5%. They're now at 10%. So they have a very good lobby. And they were able to increase the threshold from 5% to 10% for REIT.

So if you buy into an equity REIT that's investing in US real estate, your master fund can own up to 10% and not have a FIRPTA issue. Obviously, you don't want to go too close to the line. Because there could be redemptions, and you can find yourself being more than 10%, et cetera, et cetera. But it gives you additional cushion that you don't necessarily have in the context of a FIRPTA company that's not in REIT form.

305(c) is similar to 871(m). It deals with deemed dividends. For example, you could have a situation where you have convertible debt, where your conversion ratio is adjusted. That could be deemed to be a deemed dividend and-- that people need to watch out for. That conversion ratio can be deemed to be a dividend and subject to withholding.

871(m) we talked about a little bit before when we talked about a Cayman feeder that's good for treaty investors. Essentially, they keep giving us more time in terms of implementing the full scope of 871(m). For now, it's only there for delta one transaction and applies to a situation where you do a swap on a FIRPTA stock-- on not just a FIRPTA stock-- on any stock that pays dividend. It also applies to MLP. So swap on MLPs, in some situations, you also have to look through. So definitely in play, but only for delta one transactions.

So you could have a situation where you do certain puts and calls, but it doesn't get you the same delta as having the underlying stock, which potentially are still available to people to navigate the dividend withholding issue. But it's gotten a lot more difficult to do, for most people, again, are paying tax-- withholding tax on dividend even through a [? deliberative ?] instrument. Any questions on any of that?

Just to circle back on cryptocurrencies-- cryptocurrencies is an issue. There's a big debate as to what a cryptocurrency is for tax purposes. Is it a security? Is it a commodity? What is it?

And the problem we have is if it's a security, then it's OK. But we don't think it's a security. It's likely to be a commodity.

And because the requirement for a safe harbor for commodity is different security, it has to be a commodity that's trading on an established securities market and of a type that's trading. And for many, many of these currency trades, cryptocurrency trade, there's no established market yet. I think there will be one day, maybe sooner than-- maybe by next year, we'll have very established markets, but for some of these trades, wouldn't necessarily qualify for the commodity safe harbor. So there is an issue there as to whether or not trading on the offshore side in cryptocurrency gets you exempt. Are you exempt from ECI?

If you are just investing and not actively trading, you are fine-- no different than a PE fund that's investing. We don't need a safe harbor for investment activity. You only need the 864(b) safe harbor for trading activity. So if all you're doing is buying long-term security cryptocurrencies, there will be no ECI issue. But if you are actively trading or may be actively trading, then you really have to make sure that you drill down as to what you're doing and whether it qualifies as a commodity or some other exemption.

Another sort of popular trade these days is litigation funding. Depending on what you do, you may find yourself being a financing business. You have to be careful.

If you buy the underlying claims, it's one thing. If you advance money to law firms in litigation funding, may be a different thing. You might be in the lending business to them. So again, that would go into the lending potential umbrella here for ECI for offshore funds. Any questions?

[INAUDIBLE] nothing really new to report right now. And I think most people sort of have been dealing with this for a couple of years by now. So we may even take out that-- this one from future consideration.

Onshore fund tax consideration-- we touched upon some of this when we talked about the different structures, but let's go into a little more detail here. Trader versus investor is an important issue. Most hedge funds are trader, but by no means all. And even if they purport themself as traders, some may be more borderline or may have some activities which are more in private equity space.

Management fees will be nondeductible-- fully nondeductible for US high-net-- for US individuals at this point. It used to be for-- there used to be a 2% limitation. Now, it's completion nondeductible. So if you have an investor fund or if some of the activity is investor activity, then a portion or all of the management fee is nondeductible. That's one reason why you don't want an incentive fee in your domestic fund, unless you are certain you're a trader.

Swap transactions-- again, there's potential for nondeductibility on mark-to-market. Although, mark-to-market is something that many people have stopped doing. But if you do a swap-- not a bullet swap, but you mark-to-market, you swap every year-- the mark-to-market loss could be a 212 expense. It's nondeductible in an investor fund. So if you're dealing with an investor funded that's buying swaps, you've got to make sure that they are either bullet swap or that you're comfortable that you don't have to deal with mark-to-market accounting.

You have limitation on interest expense investment interest, so investment interest is now subject to some federal limitations as well because of tax reform. But depending on what you do, it may or may not be an issue, but clearly, historically and today, there's a real issue with investment interest for state purposes, because it's not deductible from a state perspective if you are not a trading fund. So again, if it is high leverage in the fund and the fund is not trading, in many, many states, you don't get the benefit. You don't get the state benefit.

475 election is a mark-to-market election that many hedge funds do. Many macro funds do it. You have to be a trader to do it.

And what it does to you is essentially, it turns everything into ordinary income. Mark-to-market at the end of the year, all your income is ordinary. All your losses are ordinary. It's very, very beneficial for funds like convertible bond funds, for example, which can find themself in the absence of a 475 election, to have ordinary income and cap losses that they can't offset against each other. So you've got to be very careful in certain credit strategies.

In the absence of a 475(f) election, you really can get hurt with no economic income but taxable income, because you can't offset your ordinary income on the interest, on the long side, with the cap losses on the short side that you may have, so a real issue. So you'll find that is a fair amount of funds out there that trade actively-- they are trader-- that elect 475(f).

Obviously, there's no longer any long-term cap gain. That's the flip side. The benefit is that you don't get whipsawed with phantom income. The detriment is you have no long-term cap gain.

Because by definition, everything is mark-to-market, with a very-- with few exceptions that we'll get to, where you could potentially-- we can actually talk about it now-- is even if you make a 475(f) election, as long as you only make an (f)(1), there's an (f)(1) election and an (f)(2) election. (f)(1) election is for securities. (f)(2) is for commodities. As long as you only make a 475(f)(1) election, if you have future transaction that qualified for 1256 Contract, 60/40 treatment, you can still get it, unless it's a hedge for another position. If it's an unhedged future position in a 475(f), you still got 60/40 treatment.

So it's not like you're giving up an all long-term cap gain. But you're giving up most of it, which will factor in, in the conversation we'll have in a moment about how to structure your carry. Because obviously, if you have a 475 underlying fund where all you carry is ordinary-- so even if you otherwise would generate [? three ?] again, you're going to lose it as a GP member, because you're mark-to-market.

But again, 475 is very handy for funds that may have mismatch of ordinary income and cap losses. It's also helpful on wash sales and other issues. Simplifies people's life. You're giving up something in many situations, but it's much, much, much simpler to administer.

Stuffing-- special to hedge. You don't find it in PE. There's not a huge amount of support for it in the regulations, but there's some. It's industry practice. People stuff.

What does it mean that they stuff? If somebody redeems out of a domestic fund with unrealized gains at the fund level, they essentially escape tax on that unrealized gain. they get cashed out. And the people who remain in the fund have to pay tax on gains that they are getting the economics on, on their redemption, because they're coming out. They're getting cashed out, but you haven't sold those positions. Obviously, less of an issue if you're doing mark-to-market 475, but for most funds, it's a real issue.

What stuffing does is it specially allocates-- usually on a pro rata basis-- long-term gain, short-term gain, and ordinary income. Some don't do it on ordinary income. It depends on who the accountants are. But specially allocates to the redeemer the difference between their tax basis and the redeeming-- and the redeemed amount, so their cap account, essentially.

So if they have a cap a count of 100 and they have tax basis of 50, you would stuff them $50 of gain. It would bring up their tax basis to 100, so they're not double-taxed on it. It may be not-- to a certain extent, they may be trading long-term cap gain and getting some stuffing of short-term cap gain or maybe even ordinary income. But it's not double-taxed, because they would have paid tax on a redemption on that $50 of distribution excess of basis.

Now, you increase their basis with a K-1 allocation through stuffing to bring their basis to 100, so they don't have a second level of tax on the distributions. The right result from a fairness perspective, so no one else is paying tax on their income, they pay their own tax. Again, there's some support in the regs, not a lot of support for it. If you have public securities, we're fairly comfortable that that gets respected. If you're trying to stuff on less public securities, it's a different story, and there's a lot more risk of the service stepping in and saying that you can't do it.

199(a) was mentioned at the last session as well. That's the qualifying business income pass-through deduction. Not relevant to most hedge funds, because they don't generate the type of income that would qualify for that deduction. There's a few exceptions-- if you do private deals, pass-through deals, that pass-through income may qualify. If you have real assets in your fund-- real cars, airplanes-- you may get some benefit there. Not what most hedge funds do for a living.

And also, dividend-- again, the REIT lobby at work. The REITs get-- on ordinary dividends, by definition, get the lower rate, so the 20% deduction, which reduces your rate from 37% to 29.7%. So ordinary dividend-- REIT dividends qualify for this deduction. For most hedge funds, not a big deal-- not a big benefit, because you don't really get much of a benefit on this issue.

Sorry, I'm going back. Need to go forward. Management entity structures-- most investment managers are structured as limited partnership, not as LLCs. The reason for that is because there is a position to be taken under the current language of the code that a distribution to a limited partner [INAUDIBLE] of a management company that's a limited partnership is exempt from medical tax.

We're not talking about [INAUDIBLE]. That doesn't apply to service income. I'm talking about the historical medical tax on earned income used to-- is now a 3.8%. Used to be 2.9%. It's not 3.8%.

That tax, because of the way the code was drafted-- and they've tried to change it many times both through regulations and Congress-- but bottom line is it hasn't been changed yet. That tax doesn't apply as a technical matter on the literal read of the 1402 code section that deals with this. Distributions to LPs, including active LPs, which the managers are, are not subject to the 3.8% tax. Guaranteed payments are.

So if you take a draw for $200,000, $250,000, there's tax on that. But the distribution over and above you draw your guaranteed payment is not currently subject to a tax. It's not risk-free. Service as a [INAUDIBLE] structures, Treasury doesn't like it, but we still think that that's the better read of the statute currently. So why set up an LLC and pay the tax, which you clearly have to pay in an LLC, if you can get the benefit, potentially, of being in an LP structure and not paying the tax? That's why most managers are set up as limited partnerships.

GP is usually an LLC. Again, there is Obamacare no matter what on carry allocation. Doesn't make a difference if you have an LP or an LLC. So other than Texas, which sometimes you see a GP as an LP, usually the GP is an LLC.

Just to go back to one of the questions that was asked earlier, the management company and the GP are typically not the same entity, and they don't flow through a [INAUDIBLE]. They are side-by-side structure, sister entities. Reason for the sister entities is for managers in some states, some cities-- for example, New York City, there's a UBT tax on fees, not on carry, so you want to separate them. But even outside, you have a much better case for deducting your expenses.

Most of your expenses are paid by the management company. You're much better off having the management company just earn fees, so when you deduct expenses, you have a much stronger position that it's all deductible. If the same entity you were to earn both fees and allocation, there would be a real risk here that you have to allocate some expenses to your carry income, which is not business income, and they become nondeductible. So to solidify the ability to get the deduction on management company expenses, limiting the amount of income, the character of the income that the management company gets to fees-- whether it's management fees or incentive fee on an offshore fund structure-- to the extent you do that is very, very helpful.

One issue that you have to be mindful of is the new business loss access was the new business loss access rules that came into place with tax reform in December would not allow a manager to offset overall ordinary business losses on a management company we'd carry from an investment fund. The two will no longer be able to offset each other. So if you have a situation where you're running a net loss in the management company side-- and this could happen, for example, if you're paying phantom carry to your carry members.

Like we talked-- I think Eric mentioned it earlier, they like phantom plans. The one issue you have with phantom plans, other than the fact that you're not giving your investors-- your members the ability to get long-term cap gain, is that you run the risk that your management company is going to run at net loss. Because how do you pay the phantom carry? You need to take cash out of your GP entity and put the cash into the management company, which is not income, because it's a contribution to pay out the bonuses as phantom carry. That may get you in a situation where your management company is running a net loss.

So if your carry is not carried from a trading fund, if your carry is carried from an investment fund or if you have other investment income and you want to offset that investment income either carry from an investor fund or just investment income from other places, you won't be able to offset that income with net losses from a business. It gets carried forward, subject to the NOL 80% limitations, and there is a debate as to whether you are able to use it in year two against all income or, again, only against trading income. It's just not clear. We're waiting for clarification on that.

But definitely an issue where people need to be mindful of that. And we have seen people, and we have clients who have restructured their phantom plan into a real equity plan, a real carry plan, precisely to deal with this issue, to minimize the risk that they will have a net loss on a management company side. Because any carry you can pay out the GP vehicle is not going to end up being a deduction on the management company side.

Now, in terms of-- we have two minutes left, and I want to spend the last two minutes to talk about an offshore fund where you investors don't care how you structure your carry. Does it make sense to structure your carry as an allocation or as a fee in light of the fact that under the tax reform, you have to hold an asset for three years in order to get long-term cap gain as a GP member? And again, the couple of things to be mindful of, because I think they're important-- and all of that is subject to regulations that could clarify otherwise-- but at least our read of the three-year rule to date is that it doesn't impact 1256 60/40 treatment. So if you have a lot of futures that generates 60/40 treatment, you will get that benefit. Because this is a deemed long term. Even if you hold it for one day, it's not a one-year holding period issue where the tax reform is now changed one to three years. You should be able to get 60/40 treatment on those trades.

Qualified dividend also should not be impacted. There's a holding period there, but it's not a one-year holding period. So it's not cross-referenced in the tax reform bill. And you should also be able to get the benefit of 20% tax on qualified dividends.

So 1256 counteracts qualified dividend and, potentially, 1231 gain, which is also-- even though it's a one-year holding period, but it's a different cross-reference in the code-- I think there's a position to be taken on all of them that if you have-- that the GP still gets the benefit of long-term treatment, whether it's 60/40 or qualified dividend, 20%, even after the tax reform. So you have to factor that in. If you think, I'm not generating any long-term gain, because all my gains are less than three years, you have to factor that in your numbers. Because you might be surprised, and you might end up having more long-term benefit than you think you had, even if you have no asset that I had for three years.

Again, that all factors in into, should I restructure my offshore carry into a fee? For many, it may make sense, because you might save yourself some

Obamacare tax that you have on carry, maybe, but not necessarily for everyone. Because people still have futures. People select qualified dividends. And you will lose them in a fee structure.

Thank you very much.

SPEAKER 1: Thank you.

[APPLAUSE]

That was fantastic. I won't even ask, but-- it's so intense. I'm sure everyone learned lots of new things during that one. But nod or shake your hand, so we have our engagement question. Thank you very much.

So we have some nice boxed lunches out. We can take a 30-minute lunch break and meet back at 1:30. That was great.

PHILIPPE BENEDICT: Thank you. [INAUDIBLE]

SPEAKERS: That was like three hours worth--

[MUSIC PLAYING]

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