A U.S. person or entity (including a U.S. hedge fund) that has a financial interest in, or signature or comparable authority over, any foreign financial account must annually file a Report of Foreign Bank and Financial Accounts ("FBAR") if the value of such account exceeds $10,000 at any time during the year. The FBAR for a particular year must be filed by June 30th of the succeeding year with the U.S. Department of Treasury. FBARs for 2008 must be filed by June 30, 2009.
A U.S. person or entity is considered to have a financial interest in a foreign account if that U.S. person or entity is the owner of record or has legal title, or if that account is owned by (i) a corporation in which the U.S. person owns more than 50% of the vote or value; or (ii) a partnership in which the U.S. person owns an interest in more than 50% of the profits or capital of the partnership.
A financial account includes any bank, securities, securities derivatives or other financial instruments accounts, and generally includes any accounts in which assets are held in a commingled fund, and the account owner holds an equity interest in the fund, such as a mutual fund.
During a June 12th teleconference discussing FBAR rules, three panelists from the IRS stated their position that an offshore hedge fund is a foreign financial account for FBAR purposes and that, therefore, every U.S. investor in an offshore hedge fund should file an FBAR.
During a June 17th follow-up telephone call with one of the IRS panelists seeking clarification, the panelist reiterated the position expressed during the teleconference and added that, in the IRS's view, hedge funds are like mutual funds in that they are investment vehicles. The IRS panelist did, however, note that each hedge fund is different and that the IRS will consider whether a particular offshore hedge fund is qualitatively similar to other "financial accounts" specified in the FBAR instructions in determining whether the FBAR rules are applicable with respect to such hedge fund. If a hedge fund is being used as an investment vehicle, then the IRS would likely take the position that it is a "financial account" for FBAR reporting purposes.
The IRS's position could affect any person or entity falling into one of the following categories:
- U.S. investors, including U.S. taxexempt entities, that invest in a stand-alone offshore hedge fund, an offshore feeder fund in a master/ feeder structure, or directly in an offshore master fund;
- U.S. feeder funds that invest in offshore master funds;
- U.S. investors that own more than 50% of the profits or capital of a U.S. feeder fund that invests in an offshore master fund; and
- Investment managers that have a financial interest (for example, through a carry from an offshore master fund) in any offshore hedge funds.
Failure to file an FBAR on a timely basis may potentially result in civil penalties, criminal penalties, or both. In general, the civil penalty is $10,000, but it may be waived if (i) any income from the account was properly reported on the person's federal income tax return; and (ii) there was reasonable cause for the failure to report. If the failure to file is considered willful, then the penalty increases to the greater of $100,000 or 50% of the balance in the account at the time of the failure to report. As for criminal penalties, a willful failure to file can result in a fine of up to $250,000 and/or imprisonment for up to five years, and a willful failure that is part of a pattern of illegal activity can result in a fine of up to $500,000 and/or imprisonment for up to ten years.
From now through September 23, 2009, taxpayers with unreported foreign accounts for years prior to 2008 can voluntarily disclose their accounts to the Criminal Investigation division of the IRS. By coming forward during the voluntary disclosure period, noncompliant taxpayers can resolve any outstanding tax liabilities and generally eliminate the risk of criminal prosecution. Generally, taxpayers coming forward voluntarily will be subject to reduced penalties.
We believe that the IRS's position that an offshore hedge fund is a "financial account" is questionable.