Offshore Mutual Funds and Offshore Hedge Funds

“Invest in our high-flying offshore investment funds tax-free!  Pay no tax until you take your profits back to the U.S.!!” Each year, many U.S. investors fall for similar pitches and invest in offshore investment funds, usually filtering the invested funds through an offshore company, typically an IBC or LLC, specifically established for the purpose of investing in foreign mutual funds.  Other U.S. investors simply are attracted to the potential returns of privately offered offshore hedge funds.  Offshore funds are usually formed offshore for regulatory reasons, or for the advantages they can offer to U.S. tax-exempt investors, such as pension funds.

While it may be true in most cases that no tax is payable in the jurisdiction where the fund is established, U.S. taxes are payable if the owner of the fund is:

  • a U.S. citizen or resident;
  • an foreign entity (corporation, LLC, IBC, foundation, etc.) owned by a U.S. citizen or resident;
  • a foreign trust established by a U.S. citizen or resident; or
  • any other structure, the underlying owner of which is a U.S. citizen or resident, and which is not otherwise legally able to avoid or defer taxation (e.g., where the fund shares are owned within a tax-compliant variable annuity or variable life insurance policy).

U.S. citizens living abroad who simply buy foreign fund shares from a local foreign broker and U.S. resident aliens who have moved to the U.S. and own the portfolio of foreign fund shares they owned abroad also will find themselves subject to the complex U.S. tax rules applied to foreign investment fund shares.

Taxation of Offshore Investment Fund Shares

Foreign investment funds are treated under the Internal Revenue Code as “passive foreign investment companies” (PFICs).  While foreign mutual funds used to offer certain tax deferral benefits to U.S. investors, that has not been the case since 1986.  Offshore funds offer no direct tax benefits to U.S. investors.  Technically speaking, a PFIC is any foreign company that derives at least 75% of its gross income from passive activities or that derives passive income from at least 50% of its assets.  Nearly all of the income of an investment fund is passive income.  So, nearly all offshore funds are PFICs with respect to any U.S. shareholders.

If the fund shares are owned by an intermediary offshore holding company, the PFIC rules generally require that the shareholder(s) of the holding company treat the fund shares as PFIC shares owned by the shareholder(s) for U.S. tax purposes. So, that Cayman Islands company you established to own your offshore hedge fund shares?  It does nothing to help you from a U.S. tax perspective.  All of the fund shares owned by that company will be treated as PFIC shares owned by you.

Often, the reason given for using a foreign entity as the owner is that the use of a foreign entity is necessary to avoid U.S. securities laws regarding the sale of securities which are not registered in the U.S.  It is generally true that a foreign entity is not a ‘U.S. person’ under U.S. securities laws.  However, if a foreign entity is owned by U.S. persons and if the foreign entity was formed principally for the purpose of investing in unregistered securities, SEC rules treat the foreign entity as a U.S. person, thus subjecting advisers who market and sell unregistered securities to SEC sanctions if any activity related to the marketing and sale of such securities takes place in the U.S.  Failure to meet SEC muster in this regard will not cause problems for the investor, although the fund will likely redeem any shares deemed to be held by U.S. persons.

So, how are PFICs taxed?  There are three alternatives from which a taxpayer may choose.

Section 1291 Fund Excess Distributions Method.  First, the default method (i.e., the method used unless one of the alternatives is affirmatively elected) is the excess distributions method.  A fund taxed under the excess distributions method is referred to as a “Section 1291 fund.”  At first glance, treatment as a 1291 fund seems good because the basic premise is that you pay no tax until you cash out.  The devil is in the details.  First, when tax is paid, all income and gains are taxed at the highest ordinary income rate (presently 39.6%).  There is no long-term capital gains treatment.  Second, losses are disallowed.  Third, you have to assume that all of the gains are earned ratably over the time the investment was held — even if the fund lost money the first few years and only made its gains in the last year when you cashed out.   Why is that bad?  Because of the final part of the quadruple whammy – interest charges, compounded annually.  Annually compounded interest at the underpayment interest rate (which is set by the Treasury Department each quarter and has been anywhere from 5% to 10% over the last several years) is charged on deferred tax.  Consider this example:

$100,000 is invested in offshore fund shares on 1/1/1995.  The fund performs poorly from 1995 to 2001, but does phenomenally well from 2002 to 2004, growing to $500,000 by the time the shares are redeemed on 12/31/2004.  The rule requiring the assumption of ratable returns will force you to assume that the $400,000 gain was earned one-tenth in 1995, one-tenth in 1996, etc.  For each year, tax is calculated at the highest tax rate with interest calculated on the deferred tax and compounded annually.  The result would be an effective tax rate of about 69% on redemption after 10 years.  69% of the $400,000 gain — about $277,000 — would be lost to tax.  The much-touted power of compounding obviously works in the government’s favor here.

On the other hand, a low underpayment interest rate and a high fund performance can produce an arbitrage benefit for the taxpayer.

$100,000 is invested in offshore fund shares on 1/1/2002.  The fund performs exceptionally well from from 2002 through 2005, with an average 19% annual return over the period, growing to $200,000 by the time the shares are redeemed on 12/31/2005.  The rule requiring the assumption of ratable returns require you to assume that the $100,000 gain was earned one-fourth in 2002, one-fourth in 2003 etc.  For each year, tax is calculated at the highest tax rate with interest calculated on the deferred tax and compounded annually.  At the relatively low underpayment interest rates in effect from 2003 to 2005, the interest charge on the tax of $35,000 would be about $2,500.  However, because the investor was able to invest funds that otherwise would have been used to pay taxes on gains each year, which, for most high-performing hedge funds, are usually short-term gains taxed at ordinary rates, the investor makes an arbitrage gain, assuming that $35,000 was invested in a way that produced a return better than the $2,500 interest charge.

Mark-to-Market Method.  The mark-to-market method allows an owner of PFIC shares to mark gains to market at each year end.  In other words, you pay tax on the difference between the fair market value of the shares at the beginning of the year and the fair market value of the shares at the end of the year, and you start fresh each January 1st.  Gains and losses are all ordinary, not capital.  This method is blissfully simple, compared to the other two methods. However, there are requirements that must be met by the fund in order for a shareholder to make the mark-to-market election, two of the most important of which are that the fund must be listed on an exchange with fund prices readily available (e.g., from the Financial Times, etc.) and that the fund cannot require a minimum investment of more than $10,000.  Because most offshore hedge funds are not listed on an exchange and/or require large minimum investments, the mark-to-market method is not available for many hedge funds.

Qualified Electing Fund Method.  If a fund meets certain accounting and reporting requirements, a shareholder can elect to treat the fund as a Qualified Electing Fund (QEF).  The effect is that the offshore fund shares are taxed like U.S. shares.   In addition, a QEF shareholder can elect to defer tax on undistributed fund income, paying the tax (plus interest at the underpayment rate) when the income is actually distributed.  Sounds like a good deal.  Why doesn’t everyone make a QEF election for offshore fund shares?

shares because it is impossible to do so in most cases. Offshore funds, even those that are essentially offshore clones of U.S. funds, simply do not keep U.S. books and tax records and provide U.S. tax information to their shareholders, which is a requirement for making the QEF election.  Only a very small handful of publicly traded foreign funds keep records that allow shareholders to make a QEF election for U.S. tax purposes.

Whichever of the foregoing three methods is chosen, an IRS Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, must be filed.  A separate Form 8621 must be filed each year for each foreign fund owned.  If you are a do-it-yourself filer, be prepared to spend a good deal of time working through the Form 8621 instructions to learn how to complete it properly, and be prepared to invest in underpayment interest calculation software.  If you use an accountant, be prepared to spend a good deal of money while your accountant learns how to complete it properly.  Whatever you do, be sure it is filed.  Failure to file the 8621 when required to do so can result in substantial penalties.

There are some exceptions to the annual Form 8621 filing requirement, the most notable of which excuses you from the annual filing requirement if you have not made a QEF election, have not received an excess distribution, do not have a recognizable gain treated as an excess distribution, and the aggregate value of all PFIC stock you own does not exceed $25,000 ($50,000 for a joint filer).

The bottom line?  Don’t believe any foreign investment adviser regarding the U.S. tax consequences of any investment.  Know the consequences of investing in offshore funds before you invest by getting tax advice from a U.S. tax practitioner with experience in PFIC taxation.

Our firm has considerable experience in advising investors and fund managers on PFIC tax issues, as well as in preparing Form 8621 and the necessary attachments.  For more information, contact Chris Riser at criser (at) riserlaw.com or schedule an initial telephone consultation by calling 706-552-4800.