Tax Planning for Offshore Hedge Funds - 
  The Potential Benefits of Investing in a

By Philip S. Gross
Originally published by the Journal of Taxation of Investments, February 2004. 

U.S. investors are often confronted with the issue of investing in an offshore investment vehicle and hedge fund managers are often confronted with the issue of whether to set up a domestic fund, an offshore fund or both. Generally, U.S. tax-exempt investors and foreign investors invest in a manager's parallel offshore hedge fund or offshore feeder fund which is classified as a corporation for U.S. federal income tax purposes. Conventional wisdom is that U.S. taxable investors invest in the manager's parallel domestic fund or domestic feeder find which is classified as a partnership for U.S. federal income tax purposes. But conventional wisdom is not always wise. This article discusses the tax issues that a U.S. investor should consider when investing in an offshore fund (and as a corollary what a hedge fund manager should consider when structuring his or her funds) with a particular focus on the various PFIC (i.e., passive foreign investment company) elections potentially available to a U.S. investor and highlights the potential affirmative tax benefits, although somewhat counterintuitive, of U.S. investors investing in offshore funds rather than in domestic funds.

What is a PFIC?

A PFIC is a non-U.S. entity classified as a corporation for U.S. federal income tax purposes under IRC Section 7701 and Reg. 301-7701.3 and which meets a gross income test or an asset test set forth in Section 1297(a). The gross income test is met if 75% or more of the entity's gross income for the taxable year is passive income; the asset test is met if 50% or more of the entity's assets produce passive income or are held for the produc­tion of passive income.

A hedge fund is a private pooled investment vehicle that is generally not registered with the Securities Exchange Commission and is geared to institutional investors and high net worth individual investors. A hedge fund generally buys and sells securities for its own account. These private investment funds have various investment or trading strategies and for historical reasons are generally referred to as "hedge funds" although their strategies may not include hedging. Most offshore hedge funds (other than master funds in a master-feeder structure) are PFICs and this article assumes that any offshore funds discussed herein are PFICs. This article also assumes that the offshore funds discussed herein are not considered to be engaged in a trade or business in the U.S. for U.S. federal, state and local income tax purposes. For this purpose, U.S. managers generally rely on a "safe harbor" under Section 864 for trading stocks and securities for one's own account or for trading certain commodities for one's own account. When considering the use of a PFIC, it is crucial that a fund not be considered to be engaged in a U.S. trade or business and any risk concerning this needs to be weighed against the benefits of utilizing a PFIC.

U.S. Tax-Exempt Investors

U.S. tax-exempt investors include, for example, public charities, private foundations, individual retirement accounts, university endowments, and pension plans. U.S. tax-exempt entities are generally not subject to U.S. federal income tax, except that they are subject to U.S. federal income tax on unrelated business taxable income (UBTI), which is defined in Section 512. UBTI includes unrelated debt-financed income, which is defined in Section 514. If a U.S. tax-exempt investor invests in a domestic hedge fund (i.e., one classified as a partnership for U.S. federal income tax pur­poses) and the fund uses leverage (i.e., borrows money), some portion of the U.S. tax-exempt investor's income from the fund would be UBTI. In contrast, if a U.S. tax-exempt investor invests in an offshore hedge fund (which is classified as a corporation for U.S. federal income tax purposes), none of the U.S. tax-exempt investor's income from the fund would be UBTI even if the fund uses leverage (except if the investor uses leverage to invest in the fund).

This article assumes that any investment by a U.S. tax-exempt inves­tor is not itself a leveraged investment (where the investor borrows money and then invests in the fund). A leveraged investment would cause some of the income from a domestic or offshore fund to be UBTI even if the fund itself does not use any leverage. Because of UBTI and because many hedge funds use leverage, U.S. tax-exempt investors generally invest in offshore funds in order to not have an investment in a fund create any UBTI. Assuming a U.S. tax-exempt investor's investment in the fund would not result in UBTI, the PFIC issues discussed below would not be applicable to a U.S. tax-exempt investor.

Also, a fund manager generally prefers that a U.S. tax-exempt investor invest in the offshore fund because he or she often can defer compensation with respect to an offshore fund but not with respect to a domestic fund. For this reason, many hedge fund managers would prefer that their foreign and U.S. tax-exempt investors (and possibly their U.S. taxable investors) invest in their offshore fund. There have been recent legislative proposals that might restrict whether or how a manager can defer compensation and any fund manager that is considering deferring compensation needs to explore this topic in further detail with his tax advisors.

U.S. Taxable Investors and PFICs

A U.S. taxable investor would generally invest in a domestic fund, which is classified as a partnership for U.S. federal income tax purposes, and would be taxable on his distributive share of income from the fund. A taxable investor would include, on a current basis, his distributive share of the fund's income in his income for federal income tax purposes and for state and local income tax purposes in the state and local jurisdictions where he is a resident. Because the fund itself, which is taxed as a partnership, is not itself subject to income tax, this structure results in one level of tax, at the investor level, on the fund's income.

If a taxable investor invests in an offshore fund, the PFIC rules would apply with respect to that investor's investment.[1] U.S. taxable investors often fear the PFIC rules. The PFIC rules are generally designed to discourage investing offshore and to recoup the time value of money for the deferral of the payment of income taxes on an offshore investment. The PFIC rules provide various tax elections that can be made with respect to investments in PFICs.

No Election Made. If a U.S. taxable investor invests in an offshore fund and makes no PFIC elections, then distributions or redemptions with re­spect to that investment would trigger ordinary income and, under com­plex rules, an interest charge would be imposed on the benefit of deferring tax on income from the investment in the fund.[2] For example, if a U.S. individual invests $I million in an offshore fund and receives no distribu­tions from the fund until his shares are redeemed in year 5 at which time he receives $2 million, then the $1 million return on his investment is spread equally over the 5 years of his investment ($200,000 per year) and interest is imposed on tax on income allocated to prior years. All income from the PFIC investment allocated to the current year or allocable to prior years would be ordinary income, taxed at ordinary tax rates, even if the underlying income was capital gain income.

The interest imposed on the deferred tax is not deductible by an indi­vidual investor since it is viewed as personal interest. The interest rate for the calendar quarter that began on October 1, 2003, is 4%, which is the interest rate on underpayments under Section 6601 and is, on a relative basis, historically low.[3]

PFIC Elections

QEF Election. The qualified electing fund election (the "QEF Election") is an election under Section 1295 whereby an investor includes income from the PFIC on a current basis. The election is made on an investor-by­investor basis and causes the investor to include his portion of the fund's current earnings and profits in income and the income is long-term capital gain income to the extent of his pro-rata portion of the fund's net capital gain (i.e., net long-term capital gain less net short-term capital loss) and ordinary income to the remaining extent. Losses (i.e., negative earnings and profits) are not passed through. Earnings and profits of the fund are determined on a basis similar to taxable income. A negative factor in de­termining earnings and profits is that, as with determining taxable income, deferred compensation (i.e., the fee payable to the fund's investment man­ager which is deferred by the manager) is not deductible until paid (it is, however, deductible if paid within 2-1/2 months after the end of the taxable year). One solution, if it is determined that it is preferable for U.S. taxable investors to invest offshore, as discussed below, is to have an offshore fund solely for U.S. taxable investors and another offshore fund for U.S. tax-exempt and foreign investors, so that U.S. taxable investors are not hit with tax on deferred compensation.

Another negative factor is that underlying qualified dividend income (QDI), which is taxable to noncorporate U.S. investors at a 15% federal rate, does not pass through as QDI. Further, the fund is subject to 30% U.S. withholding tax on U.S. source dividend income, including QDI.

QEF Election Plus Election to Defer Payment of Taxes. This election, under Section 1294, enables a person that makes the QEF election to pay his taxes when he receives distributions from the PFIC or disposes of some or all of his shares in the PFIC. The tax would be paid with interest but this election allows the taxpayer to benefit from the underlying net long-term capital gain and allows the taxpayer to realize capital gain on the disposi­tion of his shares to the extent his gain exceeds his portion of the PFIC's ordinary earnings and profits.

PFIC Mark-to-Market Election. This election, under Section 1296, allows a person to elect to mark-to-market his investment in certain PFICs; that is, to recognize the increase in the value of his PFIC shares at the end of each taxable year as ordinary income and, to the extent prior gains were recognized, to recognize the decrease in the value of his PFIC shares at the end of each year. This election, while causing the income to be ordinary, avoids the interest charge. This election is only available with respect to PFIC shares that trade on a market and, therefore, it would generally not be available with respect to most hedge funds. This election is a different election than the mark-to-market election under Section 475. In general, the Section 475 election allows a trader in securities to mark-to-market his securities at the end of each year, except securities specifically identified as held for investment. The Section 475 election would apply to invest­ments in PFICs to the extent they are held by a trader in his trading secu­rities business.

PFIC Planning - Affirmative Tax Benefits of Investing in a PFIC

While an investment in a PFIC or structuring a fund as a PFIC generally connotes bad things from a tax perspective, surprisingly, they actually can be good tax planning vehicles in certain circumstances.

Avoid Trader v. Investor Issue. An important issue that often confronts a fund is whether a fund's trading style constitutes being a trader or an investor for income tax purposes. If a fund is deemed an investor, certain tax limitations can apply to its investors such as the 2% floor on miscellaneous itemized deductions under Section 67, the 3% phase-out under Section 68, the disallowance of a deduction for miscellaneous itemized deductions for alternative minimum tax purposes under Section 56(b), and state and local deduction limitations on itemized deductions. Many hedge funds should clearly be considered traders, but the legal standards for determining whether someone is a trader or an investor are not entirely clear. The general understanding is that a trader buys and sells securities for short-term profit swings. But how short securities must be held and how often securities must be traded are not clear. Also, the recent decrease in the tax rate applicable to long-term capital gains and qualified dividend income may put pressure on funds to recognize these types of income but these types of income would generally not be considered trader-type income.

Using a PFIC avoids the trader versus investor issue and thus avoids exposure to such limitations on deductions. This result is reached because of how earnings and profits would be determined. All expenses, including expenses which would otherwise be miscellaneous itemized deductions and including investment interest expense, which would otherwise be sub­ject to its own deduction limitations under Section 163(d), would be de­ductible in determining the PFIC's earnings and profits which is the general limitation on the amount of income included in the investors' incomes. For funds which are clearly considered investors and not traders, this could be a significant benefit to U.S. taxable investors. Such U.S. taxable investors would likely make the QEF election so that net long-term capital gains pass through, especially in light of the recently reduced rate of 15% on long-term capital gains.

For example, assume a fund, which is considered to be an investor, allocates income of $1,000,000 and miscellaneous itemized deductions of $150,000 to Investor A. If Investor A is subject to a combined tax rate of 40% and does not receive any benefit for deducting the miscellaneous itemized deductions, Investor A would incur a $400,000 tax on his income from the fund. If, instead, the fund were a PFIC and Investor A made a QEF election, he would incur a tax on his income from the fund of only $340,000 (40% x $850,000), for a $60,000 savings.

As stated above, if a manager wants to defer fees with respect to foreign and tax-exempt investors but not with respect to taxable investors because the compensation would not be deductible in determining earnings and profits until paid, the manager could have an offshore fund for foreign and tax-exempt investors and another offshore fund for taxable investors or possibly different classes of shares in the same fund. Also, with respect to U.S. taxable investors, if the manager wants to receive a special allocation of the underlying income and thus receive a flow-through of the character of the underlying income, he could set up an offshore feeder fund for the U.S. taxable investors and that fund could flow into a master fund from which the manager receives a special allocation.

Being a PFIC for which an investor can make a QEF election requires that a fund provide certain information to its investors, however, and has some complexity and adds some administrative costs. For example, electing shareholders would need to make an election on Form 8621[4] and in some cases may need to file Form 5471[5] where a U.S. shareholder owns 10% or more by vote or value of a PFIC. Also, it is crucial that the PFIC avoid being classified as a controlled foreign corporation and therefore ownership of the fund may need to be monitored. However, these concerns may be outweighed by the benefits if the deductibility limitations on investors is a big concern.

Minimize Tax Shelter Reporting Requirements. Tax shelter reporting regulations issued in February 2003 can apply to hedge funds even though hedge funds and their transactions would generally not be thought of as tax shelters. The application of the regulations to offshore funds, however, is more narrow than their application to domestic funds and therefore using an offshore fund instead of a domestic fund may minimize the tax shelter reporting requirements of a fund and its investors.

Avoid Doing Business in Certain States. In some states, it is not clear whether partners in a domestic fund would be subject to tax in a state where the fund might be considered doing business. Certain states, however, such as New York State, Connecticut, and California, have clear exceptions for nonresident individuals who are limited partners in a partnership which buys and sells securities for its own account and for corporations formed in other states which are limited partners in invest­ment partnerships. Unfortunately, in some states it is not clear whether limited partners are subject to state tax solely as a result of their invest­ment in a fund. Using a PFIC can avoid this issue either by there being an exception for a non-U.S. corporation (which is sometimes referred to as an alien corporation) that qualifies for the trading for one's own account safe harbor for federal income tax purposes or by there not being an ex­plicit state safe harbor for such a corporation but where the state's corpo­rate taxable income starts with a corporation's federal taxable income, which would be zero, and there is no addback for income excluded for federal tax purposes. Nonresident investors in a PFIC managed in such a state would not be subject to tax in the state and the PFIC would also not be subject to tax in the state.

Avoid State and Local Income Tax. A possibly more aggressive use of a PFIC is that PFIC income, for which no QEF election is made and which is allocated to prior taxable years, is not included in federal taxable income when received.[6] Rather, tax and interest are computed on PFIC income allocated to prior years and that amount is added to the federal income tax computed on the investor's federal taxable income! Nowhere is such income included in federal taxable income. Many states base their taxable income on federal taxable income and the PFIC income allocated to prior years would not be includible in the federal taxable income base and hence may not be includible in state taxable income. Also, some states may tax only certain types of income including dividend income but would not tax other types of income such as PFIC income which would generally flow through on the other income line, Line 21 of Form 1040.

Avoid State Partnership Fees. Another possible benefit is that a PFIC can avoid certain state taxes or fees on partnerships and limited liability companies. For example, New Jersey enacted a $150 per partner fee in 2002. For a fund with 100 partners, that is $15,000 per year. An offshore fund is not subject to the $150 per partner fee (although it might be subject to a minimum fee of $500 per year even though it is not subject to New Jersey tax on income because of a trading for one's own account excep­tion for non-U.S. corporations). Therefore, use of an offshore corporation could avoid the per partner fee, which has upset many New Jersey taxpay­ers and practitioners.

Avoid Taxes While Compounding Tax-Free At a High Return. Another use of a PFIC is where an investor believes that an investment will have an economic return significantly greater than the grossed-up PFIC interest charge. The current PFIC interest charge, which can vary over time, is 4% for the quarter that began on October 1, 2003, as mentioned above. As­suming a 40% tax rate, the grossed-up amount would be 6.66%. If an investment in a PFIC is expected to earn more than 6.66% annually, it might be worthwhile to invest in a PFIC and not make the QEF election since the after-tax return is expected to exceed the income tax carrying charge of the investment. If you combine this with the above state and local planning techniques and the tax benefits of not being subject to the limitations on deductions for investors, the expected return might not have to be very high in order to make this worthwhile.

Complexity and Planning

The PFIC regime is very complex and has many nuances but this complex and nuanced regime can indeed offer tax opportunities in certain circum­stances. The PFIC regime should be considered by hedge fund managers and advisors in certain circumstances when they are structuring their funds and as their funds mature and confront certain tax issues and should be considered by investors when they are determining where and how to invest in a fund.

[1]  Some offshore funds prohibit U.S. taxable investors from investing in them. There are U.S. securities law issues with respect to U.S. individuals investing in non-U.S. funds. This article does not discuss securities issues or any other non-tax issues that may arise in setting up, operating or investing in an offshore fund which accepts U.S. taxable investors. Obviously, these issues would need to be considered in addition to tax issues.

[2]  IRC Section 1291.

Rev. Rul. 2003-104, 2003-39 IRB636.

[4] Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund (December 2000 version posted on IRS website at­pdf/f8621.pdf).

[5] Schedule 0: Organization or Reorganization of Foreign Corporation, and Acquisitions and Dispositions of Stock (January 2003 version posted on IRS website at

[6] Section 1291(a)(1)(B).


Philip S. Gross is a member of Kleinberg, Kaplan, Wolff & Cohen, P.C., in New York where he specializes in tax planning and structuring for domestic and offshore hedge funds, their investors and their managers. He would like thank his colleagues Jim Cohen and Jeff Bonnick for their helpful and insightful comments. Phil can be reached at 212-986-6000 or

This article and other articles herein are provided for information purposes only.  They are not intended to be an offer to engage in any securities transactions or to provide specific financial, legal or tax advice. Articles may have been rendered partly inaccurate by events that have occurred since publication.  Investors should consult their advisers before acting on any topics discussed herein.



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