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How to Avoid “Hedge Fund Hell”

One of the most confusing aspects of offshore investing is the U.S. tax treatment of offshore mutual funds. Unless you’re careful, buying an offshore fund—including the hugely popular offshore hedge funds—can easily become a "tax hell."

When you purchase a U.S. mutual fund, your income or gain is passed through to you in proportion to your holdings and reported to the IRS on Form 1099. Since offshore funds and unit trusts don’t file Form 1099, the IRS requires investors in these funds to determine their share of the income and pay tax on it. This isn’t always easy to do. And if it’s not possible to make the necessary calculations, using IRS-approved methods, the IRS imposes punitive taxes and interest payments on whatever taxes are deferred.

The U.S. Tax Code refers to offshore funds organized as corporations as passive foreign investment companies (PFICs). You’d think the IRS would make it easy to avoid deferring income or gain in a PFIC. But that’s not possible unless the PFIC qualifies under one of two sets of rules (both summarized in The Lifeboat Strategy):

  • Qualified electing fund (QEF) rules
  • Mark-to-market rules

If an offshore fund doesn’t qualify under either the QEF or mark-to-market rules (and many if not most don’t) the results are as follows:

  • When tax is paid, all income and gains are taxed at the highest ordinary income rate bracket that applies (presently 35%), not your actual tax bracket.
  • All losses are non-deductible.
  • You must calculate gains as if they were made evenly, for each year that you held the fund.
  • An interest charge applies for each year tax was deferred on these gains. As of late 2006, this rate was around 8%. For offshore funds held for many years, the tax and interest due can easily exceed the total gain. However, the law provides that the tax and interest charge shall not exceed the amount of the gain. (Whoever said the IRS doesn’t have a heart?)

Most offshore banks aren’t familiar with these rules. U.S. investors in offshore funds who don’t report and pay tax on income or gain each year will generally come under the PFIC rules, and can wind up owing huge amounts of interest to the IRS for the "privilege" of deferring taxes due.

There are four ways U.S. investors can avoid the draconian PFIC regulations for funds that don’t qualify under the QEF or mark-to-market rules:

  1. Purchase offshore funds through IRAs and other types of pension or profit-sharing plan
  2. Purchase offshore funds through a variable annuity
  3. Purchase offshore funds through a life insurance policy.
  4. Purchase offshore funds organized as non-limited liability partnerships

Again, The Lifeboat Strategy contains details for each of these options. But the fourth one deserves special emphasis. That’s because limited liability foreign partnerships won’t avoid "hedge fund hell" (i.e, the PFIC regulations). The downside of a non-limited liability partnership is obvious: you could potentially be liable for the debts of the partnership beyond your original investment.  However, if there is no personal liability for the debts of the foreign partnership, then the IRS will classify it as a foreign corporation. In the case of offshore funds, that means a limited liability foreign partnership will also be a PFIC.

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