Offshore hedge funds are structured outside the United States by foreign laws. Starting a hedge fund offshore used to give several advantages to managers who only deal with domestic hedge funds. Offshore hedge funds and investors have historically enjoyed a tax-free status, although this has changed under the implementation of FATCA (Foreign Account Tax Compliant Act).
Offshore hedge funds are going to bear the brunt of the impact of FATCA on a business and operational front. Under FATCA, many U.S. and foreign investors are made to submit additional documentation as part of the on-boarding procedure. Offshore funds are now liable for new due diligence implementation as well as complying with the adoption of United States tax withholding and reporting. As of 2014, they are responsible for reporting information on any U.S. accounts and account holders – any equity or debt interests determined as being U.S. investor owned (or U.S. owned foreign corporations) will have additional tax penalties under the new rules. This creates a heavy operational burden.
Any funds with a direct (or even indirect) exposure to U.S. markets have no other option than to comply. Any offshore hedge fund refusing to cooperate incurs a stiff 30% withholding tax on income and all direct or indirect proceeds from the U.S.-based investments. Any U.S. Investor unwilling to comply with the FATCA legislation and submit the required information also faces a 30% tax on his or her share of the income from the gross proceeds of the indirect and direct U.S. assets. It’s a broadly written rule and it’s an assumption that it will apply to dividends and redemption payments and other types of fund distributions. The good news is this rule doesn’t begin until 2017 for equity investments.
Many U.S. Hedge funds have offshore ‘feeder’ funds as a benefit for tax-exempt investors like tax-exempt foundations, retirement funds and endowments. These types of investors usually use offshore funds as a way of tax-risk management on UBTI (unrelated business taxable income). The main aim of the FATCA legislation is to target and identify American investors engaged in hiding income in offshore investments or offshore financial institutions, i.e. offshore funds, offshore trusts or foreign banks. Under FATCA, the offshore hedge funds must spend their own money to identify U.S. account holders and investor in an effort to comply with the extraterritorial legislation and regulation. Any privacy laws are trumped with the legislation requiring the foreign entities to make any investors sign a discloser waiver waiving any law prohibit the release of private information about their accounts or investments. Without signing the waiver, the accounts and holdings are then held to the 30% tax accordingly.
Even though the legislation won’t begin affecting the hedge funds until 2014, many of the institutions that will be affected are beginning to roll out the changes as soon as possible to have as smooth a planning and implementation period as possible. Strictly speaking, FATCA doesn’t begin until January 1, 2013 so any new due diligence and document collection activity will need to begin by the middle of next year. The reports due the IRS begin in 2014, for the 2013 year, and any types of withholding or payments begin on January 1, 2014.