HEDGE FUNDS
FUNDS TYPES & OFFERINGS: INTERNATIONAL FUNDS
"Offshore" used to be the industry term,
but we prefer international versus U.S. funds. The hedge fund industry
has really gone global, and we are setting up funds in every corner of
the world. This work is right up our alley, since we are a leading international
securities (commodities and currencies) and tax firm. The combination
works great for our international and U.S. clients.
GreenTrader is not a law firm, we work on your hedge fund development
(business, registration, tax and accounting) and utilize outside indepenent
attorneys (as your liason).
If you have any questions or would like to get started, please email hedgefunds@greencompany.com
and/or call
us.
The word “offshore” has a certain mystique to many. Offshore hedge funds are investment vehicles organized in offshore financial centers.
Offshore financial centers (“OFC”) are large centers for the establishment and administration of mutual funds and hedge funds. See Investment Company Institute at www.ici.org. Hedge funds legally domiciled in an OFC hold around one-half of the hedge fund assets reported by the TASS hedge fund database, with the British Virgin Island and the Cayman Islands being the most popular locations. Management of hedge funds is often conducted in or near major international financial centers such as London and New York, but the actual fund is registered in an OFC. In many OFCs, the low costs of setting up a company, along with a kind tax environment, makes them attractive to establishing companies. It has been estimated that over one-half of the world’s international business corporations are incorporated in the British Virgin Islands.
These types of funds offer securities primarily to non-U.S. investors
and to U.S. tax-exempt investors. Money managers who have significant
potential investors outside the United States typically create offshore
hedge funds. With regard to investors, U.S. taxpayers generally prefer
to be in a domestically organized vehicle that is a flow-through entity
for tax purposes, such as a limited partnership or a limited liability
corporation.
This is an intricate area that requires experts in tax law, tax treaties,
and offshore administration. Make sure you get the right help if you decide
to create an offshore fund.
In a flow-through entity, the entity itself pays no taxes. Instead, the profits "flow through" to the investors, who are responsible for paying any taxes due. Offshore investors will prefer to invest into an offshore corporation. Most nonresident aliens (NRAs) are eligible investors. These are individuals who are both non-U.S. citizens and non-U.S. residents and who are present generally in the United States fewer than 180 days per year.
Offshore funds also are attractive to tax-exempt investors, such as certain not-for-profit institutions and retirement funds. Offshore hedge funds generally cannot be sold or solicited in the United States or to any United States citizen abroad. Not all funds are authorized for sale or exempt from registration or qualification in all countries.
Advantages
The advantage of an offshore hedge fund is that the investors in
the fund generally are not subject to United States taxation. Investment
fund managers typically create offshore funds in Caribbean jurisdictions,
although a European offshore entity may be more appropriate if
a significant number of European investors are involved.
Offshore hedge funds generally are not subject to U.S. Securities & Exchange Commission (SEC) regulations. They are not subject to U.S. income or withholding taxes on distributions received from the fund or to U.S. estate taxes on fund shares. Offshore hedge funds generally are exempt from withholding taxes because the funds are located outside the United States.
As offshore hedge funds are not registered in the United States or with the SEC, they offer privacy benefits and a variety of tax advantages.
The key reason for being offshore is that gains are either untaxed or very lightly taxed in the country where they are created. Additionally, the regulatory regime in these countries is less burdensome that that of the high-tax countries where the investors, money managers, and promoters (owners) of the fund are located.
Structuring an Offshore Fund
Correctly structuring an offshore hedge fund is of critical importance
and is a major determining factor in its overall success. There
are six major issues that must be addressed. These issues pertain
to tax issues, regulatory matters, day-to-day business management,
investment strategies, marketing, and back-office operations. Addressing
these areas prior to creating an offshore hedge fund (or funds)
eliminates problems later. It is important to understand that these
are all closely related.
The typical offshore hedge fund manager seeks to create a financial investment for high net-worth and institutional investors. The key distinction with respect to offshore hedge funds is that they are not retail, publicly offered investment products, which would be subject to more stringent regulatory requirements.
Many believe that creating and managing an offshore investment vehicle is an extremely complicated and expensive process. It can be both, but it doesn't have to be. Our goal is to make offshore hedge funds accessible to money managers.
Offshore Hedge Fund Locations
There are many areas of the world that are considered primary offshore
centers for forming hedge funds. The most widely used places are
Bermuda, the Cayman Islands, Guernsey, Hong Kong, the Isle of Man,
Jersey, Luxembourg, the British Virgin Islands and Dublin. These
low-tax areas provide a welcoming environment for hedge funds.
Bermuda
www.bma.bm
Bermuda is geared more towards the corporate than the retail world. It boasts the largest
captive insurance industry in the world, but only three banks offering
banking and wealth management services to expatriates. Bermuda also boasts
an experienced trust industry, is growing as a fund management domicile
including hedge funds, and is pushing itself as an e-commerce hub. It has escaped
the wrath of the OECD, et al., thanks to strong regulation – it is
thought of highly.
British Virgin Islands
www.bvi.gov.vg/
Made its name via low- tax International Business Company legislation
in 1984. Over 300,000 IBC's have since been established and similar legislation
is adopted throughout the offshore world. More than 2,000 mutual funds
worth an estimated $55bn are currently incorporated in the BVI, while
several hedge funds are here. In all, 11 banks operate on the BVI, catering
mainly for high net-worth wealth and trust management for expats. The
government launched new laws to placate the international community’s
concerns over financial regulation.
Cayman Islands
www.cayman.gov.ky
It's hard to believe that palm-fringed Georgetown is the world’s
fifth biggest financial centre - with 580 banks, 520 insurance companies
and a mighty 3,000 mutual funds with assets of $215bn. It’s developing
as a hedge fund domicile too. The Cayman Islands is one of the world’s
lowest ta x domiciles with no personal or corporate taxes. Deposits, banking,
wealth and fund management, and trust and company administration comprise
the bulk of financial services geared towards expats. The Cayman Islands
has suffered from an image crisis for many years, borne from weak financial
regulation. A negative KPMG report into offshore centres and general ill
sentiment throughout 2000 and 2001 has forced the Caymans to tighten its
financial services industry. Continues to be monitored by the OECD.
Cyprus
kypros.org/Government/
Since 1974, the island of Cyprus has been split 70:30 between the Greek
Republic of Cyprus and the poorer Turkish-run north. Business and general
economic standing have suffered over the continued and sometimes bloody
antagonism between the two sides. All financial services take place in
the Republic and focus primarily on low- tax International Business Company
legislation and offshore banking. Over 50,000 IBCs have been set up since 1976,
many of them Middle Eastern or Russian in origin looking for a regional
business hub. Offshore banking is the second most important activity,
with assets of just under $11bn. The Republic was severely criticized
during 2000 and 2001 for lax financial regulation by both the OECD and
the FSF. Cyprus has begun to tighten its legislation, and the IMF has given
the island a nod of approval. Ultimately, the Republic is dropping offshore
finance by 2005; its main priority, much like Malta, is accession into the European Union.
Dubai
www.uaecb.gov.ae
Dubai and Abu Dhabi vie as the United Arab Emirates’ main financial
centre. Eighty percent of revenues are non-oil. Expatriates are well catered
to via banking, asset, and investment management. The popularity of Dubai
as a regional and international business hub, attracting skilled expatriate
labor, continues; many banks and financial institutions have set up
shop there, including HSBC and Skandia. Since September 11, financial
regulation in the Middle East region has been questioned, especially Dubai’s use as a conduit for terrorist and criminal funding.
Gibraltar
www.fsc.gi/fsc/home.htm
Financial services have suffered due to on-going political squabbles among
Spain, the UK, and Gibraltar since 1713. Nonetheless, this centre will do all it
can to avoid being subsumed back into Spain and to protect its low- tax
financial services industry. Gibraltar makes much of its prestigious EU
membership; jurisdictions such as the Isle of Man and the Channel Islands
are not members. Gibraltar caters mainly to the banking, fiduciary, and
wealth management needs of expatriates in southern Spain and Portugal. Gibraltar
is a small jurisdiction (bank deposits total $3.5bn) and has no real fund
management industry. In the past, it suffered from lax regulation and a
bad reputation but has now received good endorsements from the OECD et
al.
Guernsey
www.gfsc.guernseyci.com
The Channel Island of Guernsey fits the image of an "offshore financial
centre" well. It offers a comprehensive range of financial services
for all expatriates, including deposit taking, banking, wealth and fund management,
and fiduciary administration. It is developing as a leading private banking
hub, and the latest figures show deposit and fund levels are at an all-time high. Guernsey , like most centers, says that its regulation and
know-your-customer rules are better than most financial centers. It has started
to become more outspoken and high-profile; it recently set up the Guernsey
Promotional Agency to foster better relations with the business world.
Hong Kong
www.hkma.gov.hk
It has been tough for Hong Kong ever since the Asian financial crisis
hit hard in 1997, despite strong GDP growth in 2000 and a rising number
of firms setting up here. GDP growth for 2001 is set to be a humbling
0 per cent. Despite strong competition from Shanghai , Hong Kong is predicted
to be China’s premier "world" city and act as a link
between a developing WTO-approved China and a West eager to trade with
China’s 1.2bn consumers. Hong Kong has yet to hit its former glory
but continues to be the region’s key financial centre for banking,
asset management, and low-tax trust and company administration. Over 60 of the
world’s largest banks are here.
Ireland
www.basis.ie
Over the last 10 years, Dublin has rapidly grown into the second largest
domicile of offshore funds after Luxembourg , but many expatriates probably
don’t know they have a Dublin-domiciled fund or investment plan.
There is no offshore banking or wealth management here as there is in
places such as Jersey . The low- tax International Financial Services Centre
(IFSC), a district of Dublin that has been beneficial to Ireland’s economy,
attracts hundreds of international, blue-chip banks and businesses from
around the world. Corporate tax is 10 per cent. Irish GDP
grew 10 per cent in 2000 and its growth forecast is 8 percent in 2001.
Isle of Man
www.gov.im
The Isle of Man is still a small player but has been one of the most successful
offshore centers for growth during 2001: total net assets of investment
funds stood at $6.73bn as at June 30 2001, an annual rise of some 19.75
per cent. Corporate taxation is set to fall to 10 per cent, pitching the
island directly against Dublin as an offshore funds domicile and business
hub. Three industries are zero-rated for tax in the Isle of Man: shipping,
insurance and fund management. The island plans to become a low-tax hub
for e-commerce companies. Already, the government has awarded three online
casino licenses - to Stanley Leisure, Sportech and MGM Mirage (one of
the largest U.S. casino groups) - and will issue more in the coming months.
However, the largest area is the new, fledgling market for international and
cross-border pensions, pitching the Isle of Man against the likes of Luxembourg
- also keen to capture a market measured in trillions of dollars, not
billions.
Jersey
www.jerseyfsc.org
Jersey boasts a well-established banking, wealth management, and fiduciary
fund financial services industry for expatriates. Jersey joined Guernsey in defense
against heavy-handed attacks on financial regulation and has refused to
play ball unless other countries do so too. Around £250bn is invested
in financial institutions, and finance contributes around 60 percent of
government tax revenues.
Liechtenstein
www.bankenverband.li
Until 2001, Liechtenstein was one of the most secretive financial centers.
A series of financial scandals and intense international pressure over
secret bank accounts and low- tax company structures thrust this jurisdiction
into the spotlight. While complaining that it was being disproportionately
targeted, it has moved quickly to hire a troubleshooter from the Swiss
National Bank to clean up legislation. The new Due Diligence Authority
has been launched; its first job is to check, but not reveal, the beneficial
owners of Liechtenstein companies - some estimates suggest as many as
80,000 structures exist. The country’s 12 banks manage about $70bn.
Luxembourg
www.bcl.lu
The world’s largest offshore fund’s domicile, with $800bn, is
also one of the largest offshore banking and wealth management centers,
handling about $600bn. Luxemburg's banks operate like Swiss rivals, with strict client
confidentiality and secrecy rules.
Luxembourg is in the middle, both geographically
and politically, of the emerging Euro Zone and the European Union, so steps
to harmonize taxation may clash with its financial services industry -
if the EU is looking to tighten up the world’s financial system
it should lead by example. Then again, it’s hard to imagine what
will then become of Luxembourg ’s $1,400bn offshore assets, and it
is doubtful Luxembourg will do too much to threaten its wealth. It has
the highest GDP per capita in the world.
Singapore
www.mas.gov.sg
Despite a recessive economy, Singapore is working hard to improve its
re ta il financial services industry. The Monetary Authority of Singapore
has instigated several legislative acts to revitalize the sector. Financial
services still grew 4.1 per cent in 2000 and account for 10 per cent of
GDP. About 700 local and foreign financial institutions are here, offering
a wide range of financial products and services. Singapore competes with
Hong Kong for regional business in the Pacific Rim but has really never
threatened the latter. A large tech sector has suffered with the general
global downturn.
Switzerland
www.snb.ch
Switzerland still on top, despite continued assaults on its entrenched banking and
client confidentiality rules. Any such changes to Swiss law must be put
before the electorate, and they are less than likely to twist an industry
that brings in over SFr44bn to the economy every year. The concept of
"Swiss banking", an expensive luxury for high-net-worth individuals,
is nevertheless under fierce competition from cheaper jurisdictions, such
as the Channel Islands . Poor equity markets and general performance are
making many ask if Swiss wealth management is ultimately worth the cost.
The Bahamas
www.bfsb-bahamas.com
Originally on the FATF’s blacklist of non co-operative financial
centers, the Bahamas took off in July 2001 after passing 10 new Acts. Financial
services accounts for over 20 percent of GDP, and banking provides $300m
annually in revenue. The Bahamas is a very low tax jurisdiction. Banking and
wealth and asset management are core industries, with around $200bn under
management. The island also boasts some 700 mutual funds, with around $100bn.
Where to Domicile Your Fund: Pros and Cons for Different
Locations
Ask where a hedge fund is domiciled and you are likely to hear the name
of a hand-full of places worldwide. In the United States, domestic hedge
fund businesses tend to cluster within a few states, in particular California,
Connecticut, Illinois, New Jersey, New York, and Texas. Each state has
different tax and regulatory laws. Outside the United States, several
centers in the Caribbean and Europe present different benefits and costs
to fund managers. Regulatory burdens and expenses can be worth bearing,
depending on the nature of the investment vehicle and its clients. A key
distinction is sometimes forgotten: The domicile of the fund need not
be the same as that of its administrator and custodian. A fund's service
providers can hail from the other side of the world. Moreover, the service
providers' jurisdiction sometimes turns out to be the more important issue.
A manager planning a new fund needs to answer a few key questions in order to decide where to register - what kind of investor the vehicle is for, where those investors are and what they want in a domicile. Experienced alternatives investors typically are less worried about domicile than are first-time investors. Funds designed for mass distribution to the retail market need to have more regulation than those meant for wealthy individuals who are already in hedge funds. Some institutions may be bound by rules that limit investment to regulated jurisdictions, while others face no such requirement.
However, single-strategy managers continue to gravitate to traditional Caribbean locations and Bermuda, where costs are lower and the regulatory burden lighter than in Dublin and Luxembourg. Basic administrative fees are similar in all jurisdictions, but regulatory oversight adds to the expense in the European centers. For instance, in Dublin funds need to have a custodian, which is not the case in the Cayman Islands. While banks and large fund companies like to have regulations for their retail vehicles to reassure investors, the majority of hedge fund managers are small operators, for whom the extra costs can be a major burden, Mr. Blair noted.
Traditionally used offshore jurisdictions, while similar, are not all the same. Some involve more regulatory oversight than do others. Fees and other expenses also vary. Any fund wanting to incorporate in Bermuda has to be approved by the Bermuda Monetary Authority. The investment manager, as well as the administrator, prime broker, custodian, and auditors, are subject to BMA approval. Any change of service providers requires the prior consent of the BMA. The authority conducts due diligence on proposed service providers and investment manager personnel, including background checks in databases (e.g, to find out whether there has been any legal action or NASD or SEC disciplinary sanctions against such individuals). In addition, a Bermuda incorporated fund is required to file monthly reports with the BMA, providing financial information such as the fund's net asset value, change in NAV from the prior month, amounts of monthly subscriptions and redemptions, and number of securities outstanding. The administrator usually makes these filings.
Registering in the Cayman Islands does not involve as much due diligence by the Cayman Islands Monetary Authority during the incorporation process, but is not necessarily cheaper or faster overall. Cayman does not require monthly reports or prior consent to change service providers, but before a fund can commence trading, it has to be registered with CIMA under the Mutual Funds Law (subject to some exceptions). This means identifying all service providers to the fund and providing certain information about the fund and the offering of its securities; CIMA has to be notified of any subsequent changes. However, the Cayman Islands currently does not require a fund to file regular reports with CIMA.
Incorporation can take longer in Bermuda because of BMA approval rules, but that includes preparation of offering documents and service provider agreements that, as a practical matter, have to be ready before the fund can commence operation in any case. In Cayman, fund incorporation can occur earlier in the process, but time has to be spent preparing documentation afterwards.
The timeit takes, from when a manager instructs counsel to commence the organization of a fund, to finalizing all documents (the offering memorandum, service provider agreements, and constitutive documents), opening bank and brokerage accounts, registering the fund, and being ready to commence trading, is four to five weeks.
No comparative database is available on how many hedge funds are registered in each jurisdiction, but administrators who work with numerous managers think that there are still significantly more offshore funds domiciled in the Cayman Islands than in other island centers. There may be fewer new funds being established in the British Virgin Islands. As managers increasingly focus on institutional investors, which typically prefer more regulation, more may choose Bermuda because it is likely to satisfy such clients.
On the other hand, all offshore jurisdictions are waiting to see what happens in the United States following the much-watched SEC examination of hedge funds and the possibility of regulation of U.S. hedge funds and their managers. If that happens, it is possible that offshore jurisdictions will follow suit. The future also could bring changes in tax rules and corresponding shifts in the distribution of hedge funds across jurisdictions. Bermuda, BVI and the Cayman Islands are all British overseas territories and as such, are under pressure from the British government to impose more taxes.
Creating
an Offshore Hedge Fund
Many investment fund managers want to know when the time is right to set
up a hedge fund operation outside of the United States. Our response is
usually a series of questions: Where are the client's investors coming
from; where do they reside; and what matters to them? What special needs
might the trading strategy of the manager present? What needs might the
investment fund manager have to establish an offshore fund?
If, after careful analysis, it is determined that there is an investor base from non-U.S. sources and/or a potential investor group that is U.S.-based but of a tax-exempt nature, then forming an offshore hedge fund could be a good idea. Because of the complexity of the U.S. tax and securities laws, and in view of the many information-sharing treaties between the U.S. and other nations, it is fairly common to conclude that non-U.S. investors will not invest in hedge funds that are based in the United States. Such investors much prefer non-U.S. locales.
Many investment fund managers do, in fact, maintain both U.S. and non-U.S. operations. Given the global nature of the investment financial community, investment fund managers want to have both types of investment vehicles so that they attract all kinds of investment dollars.
Tax Exempt Investors
One popular impetus to set up an offshore hedge fund is the case of
the tax-exempt investor. Under the U.S. income tax laws, a tax-exempt organization (such as an ERISA plan, a foundation, an endowment,
etc.) engaging in an investment strategy that involves borrowing
money is liable for a tax on “unrelated business taxable
income” (UBTI). This is true even though the investor is
otherwise tax-exempt, which presents not only an income tax issue
for the plan, but also a political issue as well (i.e., the need to
explain why a tax exempt fund is paying income tax). As U.S. funds
are almost entirely made up of pass-through entities, such as the
limited partnership or limited liability company structures, the
UBTI activity passes through the entity to the tax-exempt investor,
thereby giving rise to the tax issue. Taxable investors are not
concerned because they need to pay tax in any event. However, tax-exempt
investors are quite concerned.
The UBTI tax can be avoided by arranging for the tax-exempt entity to invest in a non-U.S. corporate structure. (Offshore funds are almost entirely corporate in nature.) The UBTI gets blocked, so to speak, at the wall of the corporation and therefore is no longer problematic for that type of investor. As a result, tax-exempt investors wishing to participate in the alternative investment market understand this aspect of the marketplace and are amenable to investing offshore. Note that there also are ERISA issues that need to be considered.
Compensation Planning
With regard to the tax implications for the money manager, the manager
may want to ensure that the offshore fund has provisions to allow
deferral of management and incentive fees. This will allow the
manager to defer his or her fees for a predetermined period and
allow them to grow along with the fund on a tax-deferred basis.
It is important to understand that the election to defer has nothing
to do with the fact that the entity is offshore, but rather that
it is not a flow-through vehicle. Were it a flow-through vehicle,
the fees would not be reflected as expenses for tax purposes, and
the investors would be paying tax on profits associated with these
fees (particularly incentive fees). Deferral of compensation is
a standard tool in compensation plans in the United States and
is particularly valuable to implement in the context of an offshore
hedge fund.
USA Patriot Act Issues for Offshore Funds
Under the USA Patriot Act, signed into law on Oct. 26, 2001, the
Treasury Department is in the process of implementing several procedures
to which all hedge funds must adhere. The issues for offshore funds
are extensive, and we give you a sample here:
The regulations issued pursuant to Section 356 of the Patriot Act
will target offshore investment companies used to launder money.
Those not registered with the SEC will be subject to special scrutiny.
Please note that money-laundering investigations now are a central
element of the IRS's crackdown on abusive offshore financial arrangements,
such as monetary funds and trusts.
Defendants charged with money laundering face stiffer penalties and longer prison sentences than persons charged with tax evasion. Federal prosecutors increasingly are charging criminals on both counts. Many lawyers and prosecutors now think foreign tax evasion can be tried as a money-laundering offense.
Prior to the Sept. 11 attacks on the United States, information exchange and money laundering were topics of increasing concern and focus. The primary government initiatives, however, were in the tax administration arena.
These initiatives included the OECD harmful tax competition initiative, the proposed United Nations International Tax Organization, the proposed IRS interest reporting regulations, the IRS qualified intermediary (QI) rules, and the effective incorporation of "know your customer" (KYC) banking regulations into the U.S. QI rules. After the attacks, there was a renewed interest in money laundering statutes and regulations as a means of aiding government in its antiterrorism efforts. This was demonstrated, most notably, by the enactment of the USA Patriot Act.
The QI rules, effective Jan. 24, 2000, are designed to enforce the withholding
taxes on U.S. source income paid to foreigners, and to ensure that income
paid to foreign financial institutions with respect to assets beneficially
owned by U.S. persons is taxed. The rules are quite complex.
Summary
There is a lot of data for you to process to get your fund set up properly.
We make that as easy as possible for you by sending you a “terms
sheet” that defines most of the sections in our standard documents.
These terms change from fund-to-fund. Using this method allows us to minimize
your fees while still providing you with a customized and fully reviewed
(both by us and by our attorney) set of documents. The terms sheet includes
the following information:
A short description
of the data requested;
A sample from
a composite of hedge funds that we have helped our clients form;
A discussion
of various alternatives that you can consider;
A place for
you to define how you want your fund set up.
We review this data and consult with you regarding your choices. We will
discuss any issue we identify, answer any questions you might have, and
develop the first drafts of your documents. As we refine your choices
and finalize certain information, we generate additional drafts for your
review.
GreenTrader is not a law firm, we work on your hedge fund development
(business, registration, tax and accounting) and utilize outside independent
attorneys (as your liaison).
If you have any questions or would like to get started, please email hedgefunds@greencompany.com
and/or call
us.
