Friday, March 27, 2009

The subsidy to hedge funds

Hedge funds attract a great amount of suspicion. Tax is at the core of why this should be so.

A while ago, the FT published a letter by TJN Senior Adviser Prof. Sol Picciotto and a colleague, Prof.David Campbell, saying that hedge funds owe their popularity to their special tax treatment. The inevitable reply came from a hedge fund manager, David Beddington, pouring scorn on the professors’ credentials. However, he also mustered an argument. He said that hedge funds do not receive a sizeable public subsidy:

"Hedge funds are customarily set up as offshore non-distributing funds, meaning that UK tax-resident investors who invest in them are taxed on their gains as income when they realise the profit. If the same investors were in an onshore fund they would pay corporation tax within the fund or capital gains depending on the specific structure. . . definitely no subsidy."

Amid the complex language here, he has in fact confirmed that hedge funds themselves pay no tax on the profits of the funds. This is because they are treated as 'resident' and earning their income offshore. 40% of all hedge funds are formed in the Cayman Islands. This is the case even though their investment decisions are taken by advisers onshore, and the work done offshore of placing their trading orders may entail no more than providing a letter-head.

Tax authorities in countries such as the US and the UK have accepted this state of affairs, although they could challenge it under existing international tax rules. Why have the revenue authorities in the UK and the US adopted such a lax interpretation of residence and source rules? It is “for fear of offending [US] banks” in the words of tax specialists Lee Sheppard and Marty Sullivan (Tax Notes International 14 Jan. 2008).

But Beddington’s reply also said that hedge fund investors are taxed – as soon as they “realise the profit” – that is, bring them back onshore. Here is another of the big myths of the offshore system. Since the funds are treated as resident offshore, their distributions are not subject to a witholding tax because they are treated as income that is not from a UK source. The trick is to find a way to get at that money without it triggering the tax charge that would ordinarily result if the income were brought back onshore. This can be done in several ways. For example:
  1. UK residents who claim non-domicile status can avoid all taxes on this income unless they actually bring it back to the UK. But there are many ways that they can enjoy this tax-free income: for example, use a company formed in another tax haven to buy a house in the UK for their use, or a yacht, or a private plane, or even a football club….

  2. British citizens can become non-resident, and enjoy such offshore income, while continuing to keep up an active business and social life in the UK, by exploiting the residence rules. Many own houses or apartments in tax havens like Monaco - they can still come regularly to the UK and keep outside the residence rules. Many such people come in to London on Monday morning and return Wednesday or Thursday evening, and count only two or three 24-hour periods, which they can do for 30-40 weeks and keep under the 90-day limit. The Revenue tried to change the rule to count any part of a day, but had to withdraw the proposal.

  3. Of course, the offshore status of hedge funds also provides strict secrecy, so that revenue authorities are unable to identify the beneficial owners of such income. This secrecy is an open invitation to tax evasion. As the evidence from Lichtenstein last year showed, it is a temptation which even the most highly-paid and apparently respectable seem unable to resist. Now we read that the Revenue is proposing to offer a `deal’ to thousands of British `investors’ with up to £3b stashed in Liechtenstein alone.
The subsidy is there, quite obviously. The subsidy has to go. (And let's scrap the domicile rule while we're at it.)


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