Hedge Funds Facing Higher Tax Bills

The sponsor of the Foreign Tax Bill, which the offshore income deferral issue has arisen out of, Representative Bill Thomas (R-California), notes that passing of the legislation banning the use of offshore income deferral could see the government claim $1.2 billion to $1.3 billion almost immediately, according to a report by Financial Times.   The bill, if signed into law, could, in turn, translate into lower hedge fund returns and/or higher fees for plan sponsors as fund managers seek to recoup the tax losses.

IRS Ire

The Internal Revenue Service (IRS) and US Securities and Exchange Commission (SEC) have cast a wary eye at this practice in recent months.   The current structure of offshore tax deferral allows hedge fund mangers to exchange income on the balance sheet for a “mere promise to pay.” Since a promise may be nothing more than just that; it could never materialize and not create a taxable event.

Hedge fund managers have used this modus operandi to tally hundreds of millions of dollars in fees each year.   To take advantage of this form of deferral, hedge funds must choose to account for their income on a “cash” rather than an “accrual” basis. The cash method allows managers to account for income when it is received, as opposed to the accrual method, which requires them to account for income when their services are performed.

However, the IRS is now building its case that these seemingly irregular elections in fact allow fund managers to retain control over the offshore income, resulting in no real deferral.   Failing to account for the deferral properly and the possibility of no deferral led to IRS crackdowns, such as the case of III Offshore Advisor (See  Ill Offshore Advisors Attracts IRS Scrutiny ).  .

III Offshore

The tax man came down on Florida-based III Offshore, alleging the hedge fund company made profits of $201 million between 1994 and 1997, through offshore income deferral techniques.

However the hedge fund only reported an income of $9 million. In addition, a letter from the IRS points to what the agency calls “an ingenious plan to accumulate tax-free income,” set up by III.   The IRS alleges the onshore company elected to account for its services on an accrual basis but the offshore company, which performs the same services, adopted the cash basis. The IRS says this scenario shows the offshore company was created to avoid taxes.