Davis Polk & Wardwell Newsflash

Proposed Tax Legislation Affecting Hedge Funds

March 6, 2009

Bills introduced this week in both the House and the Senate contain two provisions that are of particular significance to hedge funds. One provision would materially alter the tax treatment of offshore hedge funds with U.S.-based managers, and the other provision would change the tax treatment of “dividend equivalent” payments made on notional principal contracts (or “swaps”) that reference U.S. stocks. The proposed legislation, which was introduced by Senator Carl Levin (D.-Mich.) and Representative Lloyd Doggett (D.-Tex.), contains various other provisions, including the addition of certain reporting requirements, as well as certain presumptions to be applied in judicial and administrative proceedings, with respect to amounts derived by U.S. persons from offshore entities.

Certain Offshore Corporations Treated as U.S. Corporations for Tax Purposes

Under the Levin bill and the Doggett bill, a non-U.S. corporation that is managed and controlled, directly or indirectly, primarily in the United States would generally be treated as a U.S. corporation for U.S. federal income tax purposes if (i) its stock is regularly traded on an established securities market or (ii) it has $50,000,000 or more of gross assets (including assets under management for investors, whether held directly or indirectly).  As a consequence, all of the income derived by such a corporation would be subject to U.S. federal income tax (currently, at a maximum rate of 35%), and dividends distributed by such a corporation would be subject to U.S. withholding tax at the rate of 30% (or a lower rate provided in an applicable tax treaty).[1] Under the bills, management and control of a non-U.S. corporation would be treated as occurring primarily in the United States if the corporation’s assets, directly or indirectly, consist primarily of assets that are being managed on behalf of investors and investment decisions with respect to those assets are made in the United States.  The proposed legislation would apply to taxable years beginning two years or more after the date of enactment.

Hedge funds typically organize offshore corporations (or other types of offshore entities that are treated as corporations for U.S. federal income tax purposes) as investment vehicles for non-U.S. investors and U.S. tax-exempt investors.  The proposed legislation appears to apply not only to such vehicles that invest in assets directly, but also to such vehicles that serve as “feeder” funds in master-feeder fund structures or that hold only derivative financial instruments referencing pools of assets managed by U.S.-based investment managers. Moreover, the gross asset test appears to apply to the feeder fund’s share of the master fund’s gross assets, rather than to the feeder fund’s interest in the master fund, and to the assets underlying a derivative financial instrument held by a fund, rather than to the derivative financial instrument itself.  If enacted, this provision could also cause certain offshore “blocker” entities used by private equity funds to be treated as U.S. corporations for tax purposes.

If the proposed legislation is enacted, non-U.S. investors in U.S.-managed hedge funds could invest in the underlying portfolio through an entity that is treated as a partnership for U.S. federal income tax purposes.  In that case, the non-U.S. investors would avoid the economic burden of the new tax, although their shares of the fund’s income could be subject to certain U.S. information reporting.  In addition, if any of the fund’s income were “effectively connected” with the conduct of a U.S. trade or business, the non-U.S. investor would be required to pay U.S. federal income tax, and to file a U.S. federal income tax return, in respect of that income.  If a U.S. tax-exempt investor were to invest in the underlying portfolio through a partnership, a substantial portion of its share of the fund’s income would generally be treated as “unrelated business taxable income” (“UBTI”) subject to U.S. federal income tax, because UBTI includes debt-financed income and hedge funds typically borrow to finance investments.  Legislation originally proposed in 2007 would provide an exception to the debt-financed income rule for a tax-exempt organization’s share of the income of an investment partnership, but neither the Levin bill nor the Doggett bill contains such a provision.

“Dividend Equivalents” and “Substitute Dividend Payments”

The bills include a provision that would generally impose U.S. withholding tax on a swap payment to a non-U.S. person if the payment references, or is contingent upon, dividends of a U.S. corporation (such a payment, a “dividend equivalent”).  This provision would significantly change the treatment of payments on equity swaps.  Under current law, equity swap payments to a non-U.S. person are generally not subject to U.S. withholding tax, even though dividends on any underlying U.S. stock would generally be subject to such withholding tax.  The bills, however, would treat any dividend equivalent with respect to U.S. stock as a dividend from a U.S. corporation, which is generally subject to such U.S. withholding tax at the rate of 30% (or a lower rate provided in an applicable tax treaty).

The proposed provision would require the Treasury Department to issue regulations addressing, among other things, situations in which dividend equivalents are netted against other swap payments (with the result that the non-U.S. person may not actually receive net cash from which to withhold), as well as situations in which options, forward contracts or similar arrangements achieve the same or substantially similar economic results as the swaps that are subject to the provision.  In the latter case, the provision may affect derivatives for which the return is determined, in part, by reference to an underlying dividend that is deemed to be reinvested.

The bills would also ensure that a “substitute dividend payment” that is made to a non-U.S. person pursuant to a sale-repurchase transaction, or pursuant to a securities loan, with respect to U.S. stock will generally be subject to U.S. withholding tax.  In substance, this provision revokes IRS Notice 97-66, which was designed to prevent excess withholding with respect to a series of such transactions, but has been interpreted by taxpayers as providing that no withholding is required in certain circumstances.  The proposed legislation permits the promulgation of regulations to prevent excessive withholding, but only in situations in which the underlying dividend (or, presumably, another substitute dividend payment in the chain of payments) was previously subject to U.S. withholding tax.

These changes would apply to any payments made 90 days after the date the provision is enacted, and therefore could require withholding on future payments on existing equity swaps, securities loans and sale-repurchase transactions.

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To ensure compliance with requirements imposed by the IRS, we inform you that, unless explicitly provided otherwise, any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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1. A “controlled foreign corporation” that is a member of a group of corporations affiliated through 80% ownership would be excepted from this treatment if the common parent of the group is a U.S. corporation that has substantial assets held for use in the active conduct of a trade or business in the United States.