Bloomberg reports today that the United States Internal Revenue Service (the "IRS") is about to begin an inquiry into the tax affairs of hedge funds and individual hedge fund managers. In an e-mail to Bloomberg, the IRS states that "the Service seeks to identify any areas of possible non- compliance in the income tax reporting of hedge fund and private equity fund investors and managers, as well as possible non- compliance in the reporting of withholding obligations."
Bloomberg adds that, from the outset, there are seven tax issues under review:
"-- suspicions that hedge funds and private equity funds are failing to file or improperly filing tax and information returns;
-- cases where funds are structuring cross-border loans to get around requirements that taxes be withheld on the proceeds (this refers to the process of holding US equities through total return swaps which thereby avoids the 30% withholding tax which would otherwise be paid on dividend income);
-- evidence that managers aren't paying tax on all of their income;
-- improperly classifying ordinary income that should be taxed at the 35 percent rate as capital, where gains are taxable at 15 percent and losses can be claimed more liberally;
-- the flow of funds between onshore and offshore entities;
-- how inventive payments and other income is timed and allocated;
-- improper accounting methods that minimize income."
Tax raises a multitude of issues (as an aside, the new accounting standard FIN 48 requires hedge funds, including offshore vehicles, to make accruals for taxes if it is more than 50% likely that the fund may have to pay). When we read this article, we had two immediate thoughts:
- Wall Street loves to innovate and create new financial products, and Wall Street particularly loves to invent structures which avoid tax. The risk here is that the IRS could look at particular structures and decide to reclassify their treatment for tax purposes - the ripple effects from such a change could be widespread. New products and structures regularly come into vogue and are ever more quickly adopted by managers eager to save a few basis points which would otherwise go to the taxman. However, just because "everyone else is doing it", doesn't mean that the authorities may not eventually catch up and decide that all was not OK after all. That's the lesson of mutual fund timing.
- Our second comment is to highlight Bloomberg's remark that, "unlike corporations, which are likely to have in-house tax attorneys, hedge funds and buyout firms are often smaller partnerships less likely to have staff lawyers to prepare filings for the IRS and the Securities and Exchange Commission."
The law of unintended consequences comes into play here. A hedge fund which has sailed a bit too close to the wind in their tax planning could face an enormous distraction if subject to a full blown IRS audit. The IRS, of course, makes an SEC inspection look like a casual evening out with friends. While aggressive tax structuring may have boosted returns in the short term, pulling the manger away from the portfolio to deal with a tax audit could create a far greater hit to performance. That's before we get to interest, fines and penalties.
Overall, there is probably a quick litmus test for investors: hedge funds which spend more time explaining their tax planning that they do talking about their investment ideas are, we expect, in line for some bumps in the road.
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