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Master-Feeder Structure Confusing to some is the use of onshore and offshore feeder funds in a master-feeder hedge fund structure. The master-feeder structure allows a hedge fund manager to manage money for a broad spectrum of investors. The master-feeder fund is, most commonly, a two-tiered investment structure in which investors deposit capital in a “feeder” fund, which in turn invests in a “master” fund that is managed by the same investment manager. The master fund is the entity that invests in the market as prescribed in the fund's offering documents.
The feeder fund is generally where the capital investing process originates: capital (cash or securities) flows from investors into the feeder funds, and these in turn invest all or a portion of that capital into the master fund. The master fund then uses that infusion of capital to invest in securities and thereby generate profit and loss. This profit and loss that the master fund generates is then allocated to all of the master fund’s constituent feeders. From the master fund’s perspective, each feeder can be viewed as an investor. The master fund, structured in most cases as an offshore corporation, engages in all trading activity on behalf of the investors in the feeder funds.
Typical master-feeder structure includes one master fund with one U.S. (“onshore”) feeder and one non-U.S. (“offshore”) feeder. The benefit of this organization is that it does not limit fund to just one type of investor (that is, tax-exempt versus U.S. taxable).
Typically, investors do not invest directly into the master fund. A hedge fund manager can pool investor money into a home country feeder fund and "feed" monies into the offshore master fund. If offshore investors exists, an offshore feeder fund can be established for them in their home country or in another country. Trading gains and losses are allocated to the feeder funds based on the percentage assets under management in each feeder fund.
Feeder Funds Can Vary Feeder funds that invest in the same master fund can differ from one another in their investor types, investment minimums, fee structures, net asset values, and other operational features. In other words, a feeder fund is not tied to a particular master fund, but rather functions as its own legal entity, a hedge fund in its own right, that can invest in any number of master funds. The converse is also true: a master fund can accept investments from any number of feeders.
Mini-Master Offshore Fund In this structure a offshore master hedge fund is formed and elects to be treated as a partnership for U.S. tax purposes. A stand-alone (i.e., feeder fund) U.S. hedge fund funnels its cash into the offshore master hedge fund. All trading takes place in the offshore master hedge fund, which is more efficient. The offshore master hedge fund is structured as a limited partnership and its general partner is itself another partnership. The general partner is allocated the performance allocation and receives the allocation of performance fee. This allows the hedge fund manager to receive what would normally be a currently-taxed performance fee a partnership allocation in the form of tax-favored, long-term capital gains and qualified dividends. This allows the hedge fund manager to defer current taxation of the entire performance fee (as a performance allocation typically include an element of unrealized gain).
U.S. Feeder Hedge Fund with Offshore Master Hedge Fund If you are a U.S. based fund manager, consider setting up an offshore fund if you manage money for foreign and/or U.S. tax-exempt individuals and businesses. Under U.S. income tax laws, a tax-exempt organization (such as an ERISA plan, a foundation, or an endowment) engaging in an investment strategy that involves borrowing money is liable for a tax on "unrelated business taxable income" (UBTI), notwithstanding its tax-exempt status. The UBTI tax can be avoided by the tax-exempt entity by investing in offshore hedge funds.
When U.S. investors are involved, the master feed hedge fund structure typically includes a U.S. limited partnership (or a limited liability company) as the U.S. feeder hedge fund for U.S. taxable investors. A foreign corporation is established as the offshore feeder hedge fund for foreign investors and U.S. tax-exempt investors. A master hedge company is formed offshore as well.
If an offshore feeder corporate fund is set up for U.S. tax-exempt investors (i.e, a UBTI blocker company is set up in the form of an offshore feeder fund), it then makes sense to elect to have the master fund taxed as a partnership for U.S. tax purposes. This election will simplify tax issues for investors in the U.S. feeder fund.The master hedge fund should file Form 8832 with the Internal Revenue Service. This form allows the check-the-box election allowing the master hedge fund to be treated as partnership for U.S. tax purposes only and this should be done before engaging in trading activity on behalf of the U.S. feeder hedge fund.
Some investment managers try to skip the offshore master fund to save money and attempt to use the offshore feeder hedge fund as the master hedge fund. However, If U.S. taxable investors invest in or effectively control the offshore hedge fund, complex U.S. tax rules applicable to controlled foreign corporations, foreign personal holding companies, or passive foreign investment companies (PFIC) may become problematic for the U.S. investors.
Advantages and Disadvantages of Master-Feeder Funds
In general, depending on the objectives of the fund and its target markets, the advantages of setting up a hedge fund with a master-feeder structure can outweigh the disadvantages.
The advantages of a master-feeder structure include the following:
• A master-feeder fund reduces trading costs because it has no need to split tax lots (trading in portfolios designed to mirror each other). • A master-feeder structure eases the administrative burden of maintaining multiple portfolios (pari passu). • The master fund general partner’s performance fee will be able to maintain the underlying tax attributes from onshore feeders. • The fund’s combined assets can be used to obtain greater financing benefits (for example, greater leverage or lower interest rates on borrowed securities).
Disadvantages of a master-feeder structure include the following:
• An offshore fund is generally subject to 30% withholding tax on U.S. dividends. If a fund tries to avoid such transactions, it incurs increased costs that it otherwise would not experience. • The different investment strategies available to a master-feeder do not offer advantages to all investors at all times. For example, long-term capital gains are beneficial for U.S. limited partners, but taxes are not a concern for offshore investors. Therefore, if the master fund holds a security longer to receive favorable tax treatment, strategy conflicts may result. • Some investment types, such as REITs and mutual funds, can be appropriate for U.S. investors, but inappropriate for offshore investors due to various regional restrictions. • Uneven allocations of profit and loss (such as hot issue versus non-hot issue) and tax accounting can become cumbersome, negating the time and/or cost savings gained from easier trade administration.
It may appear at first glance that the advantages of a master-feeder structure are outweighed by the disadvantages, but the balance depends on the individual fund. Fund structures and strategies must be evaluated on a case-by-case basis to determine whether and when any obstacles are likely to present themselves.
U.S. Law Favors Offshore Hedge Funds Despite the U.S. government's continuing crackdown on illegal offshore accounts, offshore hedge funds remain preferred by upper-income U.S. investors when faced with a choice between an offshore hedge fund and its U.S. onshore version. For hedge funds that use leverage, an offshore fund is preferable because of its tax advantages. For U.S. investors, the tax savings flow from the opportunity to be taxed on net (and not gross) income and the chance to deduct state-tax and other itemized deductions thwarted by the alternative minimum tax. In addition, investing in the offshore fund allows a U.S. investor to avoid some or all of the ever increasing Medicare tax on investment income. Moving assets abroad is especially useful to U.S. investors living in high tax states.
U.S. Tax Issues for Offshore Funds Whenever, U.S. taxable investors invest in or control an offshore hedge fund, some complex U.S. tax issues are in play. Key U.S. tax issues encountered by any hedge fund with U.S. taxable investors include: passive foreign investment company (PFIC) rules, controlled foreign corporation (CFC) rules, U.S. tax reporting rules, effectively connected income (ECI) rules, withholding tax rules and income tax treaties; and unrelated business taxable income (UBTI) rules. However, these rules are manageable when knowledgeable tax advisors are on board.
PFIC ruleswork as an anti-tax deferral mechanism. A offshore hedge fund taxed as a corporation is classified as a PFIC when either (i) at least 75% of its gross income is “passive income;” or (ii) at least 50% of the average value of its gross assets are “passive.” These rules can just creep in. For example, a U.S. taxable investor in a U.S. fund of funds (FOF) may have tax issues if the U.S. FOF invests in a PFIC because the U.S. investor is treated for U.S. tax purposes as investing directly in the foreign fund. If the foreign fund also invests in a foreign fund, it's treated as a subsidiary PFIC and the U.S. taxable investor is treated as owning a pro rata share of the subsidiary PFIC. The upshot of all this is that taxable gain from sale of the PFIC interest is converted from capital gain to ordinary income. Making of a Qualified Electing Fund Election (QEF Election) can avoid these tax issues but then a U.S. taxable investor is required to include in income annually its pro-rate share of the PFIC's annual income and gains. The QEF election also triggers an annual income inclusion for the U.S. taxable investor even though there is no actual cash distribution (i.e., phantom income).
Controlled foreign Corporation (CFC) Rules work as anti-deferral mechanisms. CFCs require greater than 50% ownership by U.S. shareholders each owning more than 10% of the voting stock of the foreign hedge fund. This is not a common scenario and for this reason it is important that U.S. shareholders or U.S. persons do not own the voting stock or management shares. Stated otherwise, the U.S. promoter of the fund should not serve as a Director and should not control the Fund's ,\management/voting shares. However if the U.S. fund or an underlying hedge fund owns a CFC then U.S. taxable investors include in income a ratable share of the investment income of the underlying CFC. Gain from sale of the CFC interest is converted from capital gain to ordinary income (usually in part). If an underlying investment is both a CFC and a PFIC, the CFC rules apply if the U.S. hedge fund owns more than 10% of the CFC.
U.S. Tax Reporting In any year that a U.S. fund has a 10% percent or greater interest in a foreign fund, either directly or indirectly through an underlying hedge fund that is a partnership for U.S. tax purposes, IRS form 5471 is completed for that year. Much information is needed from the foreign fund to complete the Form 5471.
ECI Foreign investors and foreign funds are taxed on income that is effectively connected to the conduct of a U.S. trade or business (ECI). An offshore fund is subject to U.S. tax if it is engaged in a U.S. business. An offshore fund is then taxed as the regular corporate tax rate on its allocable share of U.S. income. In addition, the 30% branch profits tax applies, subject to a reduced tax treaty rate, if applicable. An offshore fund engaged in a U.S. Business, is required to file U.S. federal income tax returns and failure to file a U.S. tax return within 18 months of its due date causes the offshore fund to be taxed on its gross income as U.S. ECI without any deductions allowed.
Although investing in or trading U.S. stocks, securities and commodities is not considered to be the conduct of a U.S. business, certain activities or investments by an offshore hedge fund formed as a partnership may give rise to it being engaged in a U.S. business, including: investment in a U.S. pass-through entity (e.g. a U.S. LLC) that is engaged in an active operating U.S.business, loan origination activities, distressed debt investment, investments in U.S. real property interests and being a dealer in securities.
U.S. SEC Offshore AlertThe U.S. SEC's 134-page report published in 2003--The Implications of the Growth of Hedge Funds--presents the status of the hedge fund industry as viewed in the United States. What is interesting about this SEC Report is that articles and web content authored by our very own hedge fund attorney Hannah Terhune, JD, LLM (Taxation) (when she was the Chief and only Attorney at GreenCompany.com) on offshore hedge funds was cited on page 10 of the U.S. SEC Report as providing information the SEC Staff found to be valuable in its understanding of the hedge fund industry. For a decade, hedge fund attorney Hannah Terhune has been counted on by the U.S. government and hedge fund organizers worldwide as a source of cutting edge and practical information on hedge fund formations.
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