On March 2, 2009, Senator Carl Levin (D.-MI) introduced the Stop Tax Haven Abuse Bill of 2009 (the Bill). A similar bill was introduced in the Senate in 2007 (co-sponsored by then-Senator Barack Obama), but was not acted upon. The Bill, like its 2007 predecessor, contains numerous provisions generally intended to prevent US taxpayers from holding assets in accounts of financial institutions located in so-called tax havens without disclosing the existence of those accounts to the Internal Revenue Service. The Bill, however, also contains an onerous provision (Section 103) which would cause hedge funds incorporated outside the United States, but managed from within the United States, to become subject to full US corporate income tax.
Effort to Reduce Tax Evasion
Much of the Bill is aimed at combating tax evasion by US taxpayers who use offshore bank accounts to hide assets from the IRS. Senator Levin, in a release accompanying the Bill, noted that offshore secrecy and the use of secret bank accounts are major impediments in enforcing US tax laws. In order to cut down on this kind of tax abuse, the Bill allows the Secretary of the Treasury (the Secretary) to cut off a foreign financial institution’s access to the US financial system if the Secretary determines that such financial institution or the jurisdiction of such financial institution is impeding US tax enforcement. The Bill would also impose requirements on US financial institutions and certain non-US financial institutions that either establish US accounts on behalf of non-US entities or set up non-US accounts or entities on behalf of their US clients, to report such transactions to the Internal Revenue Service. Penalties would be imposed on withholding agents and financial institutions that fail to properly file such returns.
Effect on Hedge Funds
These secrecy provisions, standing alone, would not necessarily affect the use of Cayman and other offshore structures in the US-managed hedge fund industry. The Bill, however, contains an important addition to its predecessor which, if enacted, would significantly affect hedge funds, many other businesses operated through non-US entities and investors in those entities. This provision would treat certain non-US corporations that are managed and controlled from within the United States as domestic corporations for US income tax purposes, causing them to become subject to full US corporate income tax.
Who Invests in Cayman Hedge Funds?
The Cayman Islands is a popular jurisdiction in which to organize a hedge fund due to the fact that the Cayman Islands generally does not impose income or withholding taxes. A US-based hedge fund manager will therefore often organize a Cayman hedge fund to attract investment by non-US and tax-exempt investors. A Cayman hedge fund that elects to be treated as a corporation for US tax purposes can generally ensure that non-US investors will not need to file US tax returns with respect to their interests in the hedge fund thereby providing them with the anonymity they desire. The Cayman hedge fund can also allow US tax-exempt investors to invest without the risk of tax that is normally imposed on income from debt-financed investments (UBTI), including investment on margin. As to this last point, it is instructive to note that Senator Levin did not list the avoidance of UBTI by tax-exempt entities as a reason for this new provision.
US taxable investors typically would not invest into a Cayman hedge fund that is organized as a corporation as such an investment would generally subject them to undesirable tax consequences. Similarly, US managers and sponsors of hedge funds would not invest directly into a Cayman corporate hedge fund; instead, they may invest into a parallel vehicle or into another tax-efficient vehicle that is typically treated as a partnership or other pass-through entity, organized in Delaware or elsewhere.
Current Law Applicable to US-Managed Hedge Funds
Under current law, non-US investors in stocks and securities of US issuers are not subject to US income tax upon a sale of those stocks and securities. The US tax law contains a safe harbor (Safe Harbor) which expressly excludes non-US investors from tax on gains from the sale of US stocks and securities for their own accounts, whether or not such sales are effected through the use of an agent within the United States (and for this purpose, a hedge fund manager sitting in Greenwich, executing trades on behalf of a Cayman hedge fund would be such an agent). Proposed regulations extend the Safe Harbor to gains realized from derivative transactions.
Thus, under current law, hedge funds organized as Cayman companies (or Cayman partnerships that elect to be treated as corporations for US tax purposes) generally pay no US tax on gains from stocks or securities, just like any other non-US investor (they may, however, be subject to withholding taxes on dividends from US stocks and certain interest payments). Indeed, if a non-US investor invested directly into stocks and securities, or into a Delaware partnership that invested into stocks and securities, that non-US investor would typically be able to benefit from the Safe Harbor and avoid US tax on its investment gain. Consequently, the Cayman hedge fund structure results in no tax avoidance by non-US investors under current law. The proposed Bill drastically changes current law, targeting a tax abuse that simply does not exist.
Treating Non-US Corporations as Domestic Corporations
Under the Bill, a non-US corporation that is managed and controlled from within the US would be taxed as a domestic corporation if either its stock is regularly traded on an established securities market or the corporation holds gross assets (including assets that it manages for investors) worth $50 million or more.
The Bill sets forth two tests to determine whether the non-US corporation is managed and controlled from within the US. The first test looks at the geographic location of the corporation’s executive officers and senior management. If substantially all the executive officers and senior management who have the day-to-day responsibility for making management decisions are located primarily within the US, then the non-US corporation is considered managed from within the US. (The Bill treats employees who make day-to-day decisions that would normally be made by executive officers or senior management as executive officers or senior management for this purpose.) The second test treats a non-US corporation as a domestic corporation if that non-US corporation’s assets consist primarily of assets being managed on behalf of investors and the decisions about how to invest the assts are made in the US. It is this test which squarely captures offshore hedge funds. The Bill provides the Treasury Department with broad regulatory authority to determine whether a non-US company is considered to be managed from within the US.
If the Bill is enacted into law in its current form, this provision would cause many, if not most, non-US hedge funds that are managed and controlled within the US to be subject to US corporate income tax on their net income. This would mean a 35% corporate income tax on the net income of the hedge fund.
This would clearly be disastrous for investors in offshore hedge funds managed by US managers. One can imagine that this result would cause non-US investors to take their money out of US-managed hedge funds and hire non-US managers instead. Consequently (and perversely), the Bill could very likely result in a net loss of revenue to the US Treasury (taking into account the US income taxes US managers pay on their management fees and incentive fees from offshore hedge funds they manage).
Perhaps with this possibility in mind, Senator Levin included in this provision of the Bill a delayed effective date – the provision would be effective for the taxable year that begins after the second anniversary of the Bill’s enactment. Thus, if the Bill is enacted in its current form, non-US corporations would have an opportunity to restructure or alter their methods of operation prior to the effective date.
Senator Levin's Reasons for Change
Senator Levin’s reason for including this provision in the current version of the Bill appears to stem from a belief that hedge fund managers (and their investors) are escaping tax through the use of these Cayman Islands structures. It appears that belief is grounded in the proliferation of Cayman Islands companies registered at a single Cayman Islands address. In the release that accompanied the Bill, Senator Levin discussed his discovery of Ugland House, a building on Grand Cayman Island. Ugland House happens to count among its registered addressees 18,800 different companies, only one of which is physically present there – Maples and Calder, the Cayman Islands law firm. Many of the other companies registered at Ugland House have business addresses within the United States – these are the Cayman Islands corporate vehicles that facilitate investment into the United States by non-US investors and many tax-exempt investors. Senator Levin claimed that the use of Ugland House and the Caymans Islands generally allow hedge funds managers “sitting in Connecticut, New York or Texas” to “escape tax even though the funds themselves are managed from within the United States.”
The Reality of Cayman Hedge Funds
This belief, however, is not rooted in the reality of the current tax law as applied to hedge funds. As noted, under current law, a non-US investor does not need a Cayman hedge fund to escape tax on its investment gains from sales of US stocks and securities. Both the non-US investor and the hedge fund itself would benefit from the Safe Harbor which eliminates US tax on investment gains of non-US investors, whether their investments are managed by US persons or not. The Cayman structure is provided almost exclusively to ensure that the non-US investor will not be required to personally file a US income tax return – the Cayman hedge fund itself would file any required US tax return.
Similarly, US investment managers do not typically use Cayman hedge funds to escape US tax. This is particularly true since the enactment of Section 457A in October, 2008, which eliminates the ability of US managers of offshore hedge funds to defer their compensation from their offshore hedge funds. Most US investment managers typically pay US tax on their investment gains as they receive them.
US tax exempt investors do escape tax in some circumstances by investing in a Cayman hedge fund. A US tax-exempt investor would owe tax on gains from investments made with leverage – the Cayman structure allows these investors to escape this tax. This result, however, does not appear to have any connection to Senator Levin’s introduction of the Bill.
Since the introduction of the Bill, two events have taken place that provide some hope that the Bill will not be adopted in its current form. First, Senator Max Baucus announced, two days after the Bill was introduced, that the Senate Finance Committee, which he chairs, would introduce its own Bill aimed at combating tax avoidance by US persons. The draft discussion version of that Bill does not contain a provision similar to Section 103 of Senator Levin’s Bill. Second, while Treasury Secretary Geithner endorsed the Bill in broad terms at congressional testimony in March, indicating the Obama administration’s approval of the Bill’s approach, the G20 summit, held in early April did not result in any concrete proposals for regulating hedge funds or otherwise curbing the use of tax havens.
Hedge fund and private equity fund regulation is clearly a topic of interest in Washington and it is likely that either some form of the Bill or other legislation targeted at hedge funds will be acted upon in 2009. It is imperative that the hedge fund and private equity fund industry take steps to illustrate the faults of Senator Levin’s bill so that the US-based fund industry does not suddenly find itself bidding its non-US and tax-exempt investors goodbye.