(Bloomberg) Last year, about $450 million belonging to top executives at billionaire hedge fund manager John Paulson’s New York firm took a quick round trip to Bermuda.
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In April, the executives sent the money to a reinsurance company that they had set up on the island 650 miles off the North Carolina coast. By June, the Bermuda company, which has no employees and sells far less reinsurance than the industry norm, had sent all the cash back to New York, to be invested in Paulson & Co. funds.
By recycling the funds through Bermuda-based Pacre Ltd., the Paulson executives are positioned to legally exploit a little-known tax loophole, reduce their personal income taxes and delay paying the bill for years.
“These types of reinsurance companies are permitting U.S. taxpayers to defer—indefinitely—U.S. tax,” said David S. Miller, a tax lawyer at Cadwalader Wickersham & Taft LLP. For some, he said, it’s “an unjustified benefit.”
A decade after the Internal Revenue Service threatened to crack down on what it said were abuses by hedge fund-backed reinsurers, more high-profile money managers are setting up shop in tax havens. Paulson, SAC Capital Advisors LP’s Steven A. Cohen and Third Point LLC’s Daniel Loeb have started Bermuda reinsurance companies since 2011, following a similar Cayman Islands venture by Greenlight Capital Inc.’s David Einhorn.
Because reinsurers, which sell coverage to other insurers, manage large pools of capital, they’re a handy way to funnel a U.S. hedge fund investment through a tax haven.
At a time when the Obama administration and congressional leaders of both parties are calling for a corporate tax overhaul that includes eliminating some loopholes, the reinsurance tax dodge is gaining popularity among hedge funds. The three new reinsurers backed by U.S. hedge fund managers put a combined $1.7 billion back into the managers’ hands.
Other top money managers, including some in London, are hiring advisers to explore setting up reinsurance companies in Bermuda, said Timothy Faries, an insurance lawyer at Appleby, one of the island’s largest law firms.
Fund managers are “trying to find a way to have a vehicle that can go offshore and avoid paying taxes,” said William Berkley, founder of W.R. Berkley Corp., a Greenwich, Connecticut-based insurer. “You have one company that does it and nobody pays attention. You now have four or five and it’s likely to get more people’s attention.”
Those involved in establishing reinsurers defend the strategy. “Given the world we’re in, it’s just good tax management,” said Robert Cooney, who served as chief executive officer of one of the first hedge-fund-backed reinsurers from 1999 to 2006.
Tax avoidance isn’t the only advantage to establishing a Bermuda reinsurer, insurance executives said. It means creating a large, fee-paying client that is unlikely to take its money out of a hedge fund after a bad year. Moreover, insurance companies get to invest customers’ premiums for months or years before they pay out claims.
Cohen’s, Loeb’s and Einhorn’s reinsurance firms are better designed to reap those non-tax benefits than Paulson’s company, Pacre, which has just one outside investor. The white, steel- and-glass complex overlooking Bermuda’s capital of Hamilton, which is listed as its legal address, is the office of another reinsurer to which it outsources its underwriting.
Pacre sold about $8 million of reinsurance coverage from April to December, or 1.6 percent of its $500 million in initial shareholders’ equity. That’s far below the average of 47 percent for 15 publicly traded Bermuda insurers during their most recent nine months.
Cohen’s and Loeb’s reinsurers employ underwriting staff and have set targets of insurance sales equivalent to 30 percent and 19 percent, respectively, of their equity in their first full year, according to disclosures to reinsurance brokers.
Paulson, 57, declined to say whether he plans to get a tax benefit from Pacre.
“That’s never been a portion of the business we’ve ever commented on,” said Armel Leslie, a spokesman for Paulson’s hedge fund.
The companies set up by Paulson, Cohen and Loeb are located within a half-mile of each other in the narrow streets ringing Hamilton. The pastel-hued business district overlooks a harbor where Russian billionaire Roman Abramovich docked the world’s largest luxury yacht last month.
Bermuda, which imposes no corporate income tax, is the global center of the reinsurance industry. Since it emerged in the 1980s, the reinsurance business has lifted Bermuda’s economy, creating jobs for underwriters, actuaries, lawyers and accountants.
The companies backed by hedge funds—lightly regulated funds available only to institutions and wealthy individuals—are no less welcome. A 2001 presentation by a group of business leaders to encourage development in Bermuda touted the tax benefits of what it called “reinsurance wrapped around a hedge fund.”
After Paulson set up the Pacre venture last year, Wayne Furbert, then the minister of business development, called it “a strong vote of confidence in Bermuda as a leading financial jurisdiction,” according to the local newspaper, the Royal Gazette.
By setting up reinsurance companies there, money managers can take advantage of a loophole in IRS rules. Ordinarily, when hedge fund managers invest in their funds, they pay either the 39.6 percent rate for ordinary income or the 20 percent long-term capital gains rate, depending on how frequently securities are traded, plus an extra 3.8 percent health-law surcharge. If they were to move the hedge funds to tax havens, they would incur IRS penalties on earnings from what the agency calls “passive foreign investment companies.”
Here’s the catch: The IRS doesn’t penalize earnings from insurance companies, which it considers to be “active” businesses. As a result, by routing money through a Bermuda reinsurer, which in turn puts its assets back into their own hedge funds, fund managers can defer any taxes until selling the stake. They then pay only the lower capital gains tax rate.
In the meantime, the money grows tax-free, and the savings add up. Investing $100 million in a hedge fund that returns 15 percent annually, and paying the top marginal ordinary income rate on profit, results in a $50 million profit after taxes after five years. If the investment is taxed like a Bermuda reinsurer, the gain is $77 million.
To qualify as an active company and avoid the tax penalty, the IRS says firms can’t have a pool of capital that’s far greater than what they need to back the insurance they sell.
But the IRS has never specified exactly how much is too much.
“The $64,000 question is how big a reserve can you have?” said Robert Cudd, a tax lawyer at Morrison & Foerster LLP in San Francisco. “There’s no easy answer to that.”
The IRS in 2001 disclosed plans to clarify its definition of insurance companies, a move that might prevent abuses by hedge funds, Cadwalader’s Miller said. He said it never followed through.
The fact that Pacre and the other startups trust virtually all their assets to one hedge fund manager may allow them to argue to tax authorities that they can’t afford to take on the extra risk of selling much reinsurance, Miller said.
“Under the current law, so long as Pacre’s reserves are not excessive—and they probably aren’t—this probably works,” he said. “I think you need a change in law.”
The first prominent hedge fund to set up a large Bermuda reinsurer was Louis Moore Bacon’s New York-based Moore Capital Management LP, in 1999. He originally planned for Max Re Capital Ltd. to invest all its assets in his funds, and shares were marketed in part as a tax-efficient way to invest in a hedge fund, said Cooney, a career insurance underwriter who was Max Re’s first CEO. Forbes estimated Bacon’s net worth at $1.3 billion as of September 2012.
As it turned out, Max never invested more than 40 percent of its assets in hedge funds and now puts less than 5 percent in them. Still, the tax-avoiding aspect of Max Re was highlighted in a 2001 article in Institutional Investor magazine, titled “The Great Hedge Fund Reinsurance Tax Game.” Two years later, the IRS threatened to scrutinize the practice.