New Rules for Hedge Funds

Terry Flanagan

The industry-wide movement to put an end to the Wild Wild West days of hedge funds continues with new rules about offshore activity.

Compliance is an unmovable part of being in the markets, and often a costly thorn in the side for many hedge funds. Its presence has been growing among the alternative investments industry, which emerged from the 2008-2009 financial crisis with an amplified sense of scrutiny from regulators and more importantly, investors.

Most market participants have heard of the Dodd-Frank Act, an overhaul financial regulatory law, which notably includes the Volcker Rule, a call to end proprietary trading. More recently, regulators have signed into law the Foreign Account Tax Compliance Act (FACTA) on March 18, 2010. FACTA is aimed at foreign financial institutions and other financial intermediaries to prevent tax evasion by U.S. investors through use of offshore accounts.

Tax evasion via offshore accounts is not an unfamiliar concept to many hedge funds—and the practice doesn’t stop with just hedge funds. Swiss banking giant UBS admitted to helping people evade U.S. taxes, and in 2009, paid $780 million and disclosed the names of more than 4,500 U.S. taxpayers with secret accounts at the bank. The scandal was in-part a catalyst for FACTA.

Naturally, when there is a greater need for compliance, there are more opportunities for hedge fund service providers.

“There will be a wealth of opportunities for those that service hedge funds not relying on internal vendors,” said David Richardson, managing director of international tax at global auditing tax and advisory firm, KPMG.

“FACTA will bring in a great amount of new processes, and it’s important for hedge funds, and other financial institutions, to remain cognizant that they alone are responsible for complying and doing things right.”

The basic premise of FACTA is that foreign financial institutions that are not reporting offshore activity to the IRS (Internal Revenue System) will be subject to a 30% withholding tax on all relevant U.S.-sourced payments, such as dividends and interest paid by U.S. corporations, and underlying U.S. investments carried abroad. Similarly, the same 30% withholding tax will apply if such assets are sold for a profit.

Compliance with FACTA is “economical” for most hedge funds, according to Richardson. Yet, implementation is not “economical” or cheap. In fact, it may be a very expensive process to comply.

“The scope of the affected parties by new FACTA rules is very wide,” said Richardson. “Implementation will be costly and complicated.” He expects that FACTA regulators will require a long lead time from the beginning stages of implementation to effective date. The target effective date is January 1, 2013.

Will FACTA make it more difficult for hedge funds to evade taxes of their winnings offshore? Richardson believes so, but has faith that hedge funds are primarily playing in offshore funds due to other reasons.

“FACTA is definitely going to making offshore investing less attractive for those that want to hide assets,” he told Markets Media. “But, investors invest through offshore funds primarily for other reasons, such as foreign tax, legal and regulatory reasons. I don’t think FACTA will have a chilling effect for hedge funds in the sense that it will dissuade sponsors from using offshore vehicles.”

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