HIRE Act Brings New Obligations to Hedge Fund Arena

With the passage of the Hiring Incentives to Restore Employment (HIRE) Act, the landscape in which hedge funds will be conducting their ongoing business activities continues to undergo dramatic change

With an ever-increasing goal of more regulation within the financial community (partially due to the collapse of the financial markets that can be traced to the mortgage crisis and headline-grabbing Ponzi scandal), registration is now required for hedge funds with asset bases above a certain threshold. The HIRE Act includes numerous provisions that lawmakers have said are designed to curb perceived advantages of operating in foreign jurisdictions and through the use of certain derivatives. These new provisions are expected to make it more difficult for U.S.-based hedge fund managers to stimulate foreign investment, while imposing greater compliance requirements on hedge funds.

In recent guidance, the Internal Revenue Service has eliminated the need for U.S. persons who have invested in offshore hedge funds to complete Form 90-22.1, “Report of Foreign Bank and Financial Accounts (FBAR)”, as previously required to be filed annually if the U.S. person had a financial interest in, or signature authority over, specified foreign accounts.

The agency’s recent notice (2010-23) indicated that a foreign hedge fund was not a commingled fund subject to this reporting. Similarly, several years ago, in an effort to eliminate duplicative unnecessary informational reporting, U.S. shareholders of passive foreign investment companies held through other entities (partnerships) were relieved of the obligation to complete Form 8621, “Report by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund,” when the income from the PFIC was already included in income.

As a means to promoting transparency, the HIRE Act imposes new reporting obligations on foreign funds and their investors. The HIRE Act’s disclosures do not replace existing FBAR filings, but add additional disclosure requirements.

With respect to hedge funds, the proposed Title 31 FBAR regulations (under the Bank Secrecy Act) reserve on whether foreign hedge funds are considered foreign financial accounts.¹ The Title 31 reporting requirements are, at least in this preliminary stage, largely duplicative to the HIRE Act’s Title 26 (income tax) reporting requirements. One notable distinction between the two is that the HIRE Act report will be afforded the same confidentiality as other Title 26 filings. The current FBAR is available to a number of U.S. Treasury and law enforcement agencies.

In addition to potential foreign account reporting under the HIRE Act, U.S. persons will have to provide an annual informational return with respect to their ownership in a PFIC, even where the fund generates no income or there is no gain on the sale of fund stock. Moreover, for tax years beginning after 2012, foreign financial institutions (which, as defined, would include literally all foreign investment vehicles), will be required to provide detailed information about their U.S. investors, including names, addresses and taxpayer identification numbers. If a fund fails to enter into an agreement with the IRS to provide such information, any “withholdable payment,” — generally income as well as the proceeds from sale of securities — would be subject to withholding at the rate of 30 percent. The requirement to disclose this information and to potentially withhold additional taxes where such information is not available will certainly impair the ability of hedge funds to continue to raise capital. The financial landscape is definitely changing.

There has also been much debate about certain inequities and the desire to eliminate perceived abuses with respect to the use of derivatives. In this regard, The HIRE Act defines dividends to include substitute dividends and dividend equivalent payments (typically an important component of certain notional principal transactions such as total return swaps) made pursuant to certain specified notional principal contracts, thereby subjecting these payments to withholding when made or credited to non-U.S. persons. This provision is effective 180 days after the date of enactment and may redefine the derivatives market.

The future of the master-feeder structure

And the HIRE Act is not the only thing on the horizon that may impact the financial markets and the manner in which hedge funds are structured. Prior to the Emergency Economic Stabilization Act of 2008, it was common for investment managers to defer receipt of earned incentive fees from managing offshore hedge funds. This deferral meant that the fee was not subject to current taxation and, when combined with an interest charge equivalent to the rate of return of the offshore fund, the investment manager was able to keep the pre-tax dollars invested in the fund. The 2008 act imposed immediate income recognition for non-qualified deferred compensation from tax indifferent parties, removing the ability to defer taxes on this income.

Hedge fund managers have reacted to the law change by restructuring their agreements to allow for payment of their offshore incentive fee in the form of an allocation of income in a partnership structure. This afforded them the ability to potentially receive some of the incentive fee in the form of tax-favored long-term capital gains and qualified dividends and also to defer immediate taxation of the entire fee since the incentive allocation would typically include an element of unrealized gain. This restructuring took the form of what is known as either a mini-master or a master-feeder structure. See related article: Considering a Master-Feeder Structure? Be Sure to Consider These Tax Issues First for more information.

It is much more common now for start-up domestic funds with an offshore equivalent to utilize a master-feeder structure. In this structure, a master fund (typically foreign) is formed and elects to be treated as a partnership for tax purposes. A stand-alone domestic fund and a stand-alone offshore fund invest capital into the master fund, wherein all trading occurs. The general partner of the master fund is another partnership, which receives the allocation of incentive fees as calculated with respect to the domestic and offshore fund’s investments. The use of the master also affords for more efficient trading.

Because of the perception that incentive allocations represent a form of compensation for services that are taxed at a favorable reduced tax rate of 15 percent, much has been written about the need to re-characterize this “carried interest” as ordinary income subject to self-employment taxes.

However, it should be taken into account that only a portion of the allocated income receives the benefit of the current reduced rate. Non-qualified dividends, interest and short-term capital gains continue to be taxed at regular rates and, for a trader fund, constitute the majority of its income.

Until legislation is enacted to close this perceived loophole, the continued use of a mini-master structure to mitigate the tax effects triggered by the loss of deferral should be expected. And given the recent success of the current Congress, legislation to re-characterize carried interests seems likely. Should this occur, the traditional hedge fund manager as we know him or her today may slowly disappear — and the cost of being successful will dramatically increase. As that price rises, added costs (tax increases for the fund managers) may ultimately be passed on to investors, reducing their true economic returns, further eroding investor confidence and potentially creating a greater pullback of capital from the financial markets.

Richard Nichols is a managing director in the New York office of McGladrey He can be reached at 212.372.1135, or via e-mail, at richard.nichols@mcgladrey.com.

¹Comments on these regulations were due to the U.S. Treasury Financial Crimes Enforcement Network (FinCEN) by April 27, 2010. The American Institute of CPA’s International Tax Technical Resource Panel's FBAR Task Force is submitting comments on these regulations. The task force will also respond to a similar request for comment from the Internal Revenue Service on the HIRE Act’s foreign account reporting.