Taxation of U.S. Investment Partnerships and Hedge Funds

NAVENDU P. VASAVADA, PHD, has held the positions of investment manager of large institutional investors, manager of private hedge funds, an economic analyst, and writer-at-large. He was formerly a senior investment manager at Aetna Inc. for over a decade, serving as head of quantitative research, risk manager, mortgage securities analyst, and equity/fixed income derivatives quant. He holds a PhD from Wharton, preceded by an engineering MS from the University of Pennsylvania and PGDBA from IIM-A, India.

Preface xiii

Chapter 1 The Arcane World of Hedge Funds and Investment Partnerships 1

What Is a “Hedge Fund”? 1

U.S. Venture Partnerships 3

Types of U.S. Hedge Fund Entities and the U.S. Tax Code 4

Organizing a Typical U.S. Hedge Fund 6

Investor Clienteles in Hedge Funds 10

Foreign Investors in a U.S. Hedge Fund 14

Offshore Funds 14

U.S. Investors in Offshore Funds 17

U.S. Investors in Swiss Bank Accounts 19

U.S. Investors in Madoff-Like Managed U.S. Trading Accounts 23

Size of the Global Hedge Fund Industry 25

Fund-of-Funds 28

Incentives of the Hedge Fund Manager and Investors 30

Valuation of a Hedge Fund Management Company 31

Economies of Scale in Hedge Funds 33

Chapter 2 The Structure of Hedge Funds 35

Organizing a Typical Offshore Hedge Fund 35

Master-Feeder Structuring of Onshore/Offshore Arms: Organizing a Hedge Fund for Clienteles 39

U.S. Withholding Agent for U.S. Withholding Taxes on Foreign Investors 44

Chapter 3 Hedge Fund Fees 47

Starting Point: The Partnership Agreement 47

Fund Valuation at Discrete Opening Time Points 48

Calculation of Fixed Fees 49

Calculation of Performance Fees 55

Claw-Back Provision: Performance Fee Returned to Limited Partners 66

Representation of a Fund’s Net Asset Value (NAV) per Share 71

Black-Scholes Formula Valuation of Performance Fees 74

Chapter 4 Hedge Fund Accounting and Tax Filing 79

Partnership Accounting for U.S. Funds 79

IRS Tax Return Filings for U.S. Hedge Funds 80

Financial Statements for Hedge Funds and Venture Funds 85

Interim Valuation: The Core of a Hedge Fund’s Accounting Operation 93

Books of Account and Financial Statements for Hedge Funds 96

Audit of an Offshore Fund 97

Audit of a U.S. Fund 98

Capital Account Audit for Both Offshore and U.S. Funds 99

Chapter 5 Partner Tax Allocations in U.S. Partnerships 101

U.S. Tax Allocation Rules Governing U.S. Partnerships 101

Tax Components of U.S. Investment Partnership Income 103

Fixed Fees: Income to the General Partner and Expense to the Limited Partners 107

Generalizing the Allocation Formula to Other Components of Income 108

Tax Basis of Partner’s Investment in a U.S. Partnership 109

Accountants’ Terminology 113

Tax Allocations of Realized and Unrealized Income to Partners 113

The Tax Allocation Method of Layering 115

Tax Allocation of Interest 118

Tax-Exempt Interest Income, Line 18a 120

Similar Calculation for Tax Allocation of Dividends, Investment Expense, Foreign Tax Paid 121

Tax Allocation of Fixed Fees Paid by Limited Partners 121

Tax Allocation of Guaranteed Payments (of Fixed Fees) to the General Partner 122

Reporting Subcomponents of Interest Income and Dividends 122

Tax Consequences of Shorting 123

Short Positions: Tax Treatment of Equity Dividends or Bond Coupons Claimed as Interest Expense 123

Distributions from Partnerships Owned 124

Chapter 6 Tax Allocations of Realized Gains by Layering 127

Tax Allocation of Unrealized and Realized Capital Gains Using the Method of Layering 127

Ignoring Ambiguity #1 with Layering 132

Work-Around to Fix Ambiguity #2, the Fatal Flaw with Layering 133

Chapter 7 Partial and Full Netting Methods 137

The Methods of Aggregation or Netting 137

Partial Netting 138

Full Netting 141

Measures of Book-Tax Disparity across Partners 142

Formulating the Problem for Optimal Partner Tax Allocations under Full Netting 143

Formulating the Problem for Optimal Partner Tax Allocations under Partial Netting 146

Solving the Convex Optimization Problem of Tax Allocation 148

Chapter 8 Comparative Tax Consequences of Layering and Netting Methods 153

Which Is the Better Method for Allocation of Realized Gains: Layering, Full Netting, or Partial Netting? 153

Layering Examples Showing Earlier Tax Payment 154

Full Netting Examples Showing Tax Postponement 158

Chapter 9 Tax Efficiency of Hedge Funds 161

Tax Efficiency Considerations for Offshore Hedge Funds 161

Tax Preference Ordering for U.S. Investors 163

More Attractive Tax Items to U.S. Investors 167

Less Attractive Tax Items to U.S. Investors 169

An Exception: Special Tax Preference for Gains from U.S. Exchange-Traded Futures Contracts 170

Ambiguities in Tax Preference 170

Tax Efficiency Steps for U.S. Hedge Funds 170

A Structure for Tax-Exempt U.S. Entities to Recover Foreign Taxes 173

Chapter 10 Hedge Fund Performance and Risk Presentation 175

Performance Presentation: CFA Institute GIPS Verification 175

Calculation of Hedge Fund Returns for Performance Presentation 179

Facilitating Historical Risk and Return Review for Investors Using GIPS Guidelines 183

Chapter 11 Mutual Funds and Venture Funds Compared to Hedge Funds 191

Tax Return Filing of U.S. Partnerships Is an Involved Task 191

Comparison with Tax Allocations Made by Mutual Funds 191

U.S. Venture Partnerships (Silicon Valley Venture Funds) 196

Chapter 12 Epilogue 203

Economic Accounting Is a Common Denominator for U.S. and Offshore Funds 203

Tax Return Filing of U.S. Partnerships Is an Involved Task 204

Calculating Partner Allocations Is Most of a U.S. Partnership’s Tax Accounting Effort 204

Layering and Netting Methodologies for Tax Allocation of Capital Gains 205

Example of Tax Allocation of Capital Gains by Full and Partial Netting in a 100-Partner Setting 205

Tilting Tax Allocations According to Tax Preferences 206

The Crown Jewel: Automated Tax Allocation of All Items of Income 206

The End of an Era of Layering 207

Appendix 1 Excerpts of Key U.S. Statutes Discussed in Chapter 1 That Govern U.S. and Offshore Hedge Funds Venture Funds 209

Appendix 2 Methodology and Implementation Example of Full Netting 229

Appendix 3 Methodology and Implementation Example of Partial Netting 253

Appendix 4 Nonabusive Tilting of Tax Allocations According to Tax Preferences 259

Appendix 5 Eliminating Layering Entirely, by Allocating Dividends, Interest, Capital Gains, and Expenses in One Step 267

Index 277