One of the consequences of the credit crisis that began in the summer of 2007 was the deterioration in the U.S. housing market, rendering the valuations of securitized or structured mortgage-backed assets volatile.The contracting demand for these assets — which had been dramatically overvalued by brokers who earned substantial commissions by pushing over 600 varieties of these assets to hedge fund managers through repos that were leveraged without regulatory bounds — precipitated the tightening of unsecured term funding. That led to credit downgrades, massive write-downs of MBS assets by financial institutions according to mark-to-market accounting rules, and illiquidity.

Losses mounting from forced liquidation of MBSes at low valuations triggered by redemption notices from hedge fund investors, as well as margin calls from brokers trying to make up for the difference in the value of securities used as collateral on repos, financially wounded most prominent veteran hedge funds while bankrupting others.

Many hedge fund managers were caught swimming naked when the wave of credit crises hit. Only a few survived with short positions in credit derivatives. Most of these were instituted two years prior to the credit crisis when these contracts were priced low in order to profit from the deterioration in MBS values. Some hedge fund managers transferred their poorly performing, illiquid MBS assets to side pockets and valued them separately from the remainder of the fund’s portfolio to immunize the fund’s net asset value calculation from the performance of these hard-to-value assets, effectively freezing the illiquid MBS-affected portion of the hedge fund’s portfolio.

This enabled them to avoid writing these investments down or selling them at a large loss. Less astute hedge fund managers transferred their risky MBS assets to an MBS loss fund, and then floated the MBSLF publicly on stock exchanges in foreign jurisdictions.

Call this “Transaction I.”

Next, in a move reminiscent of the 2003 mutual fund scandal, they anticipated the deterioration in overvalued MBS assets in the MBSLF’s portfolio by purchasing basket index credit swaps (contracts that simulated the credit of the MBSLF’s portfolio holdings from a U.S. broker/dealer). These were constructed based on the hedge fund manager’s non-publicly available knowledge of the loss fund’s MBS portfolio holdings held between two affiliated funds, with the MBSLF holding the risk side of the swap.

Call this “Transaction II.”

THE TAX ANGLE

While both the Securities and Exchange Commission and the Department of Justice are in the process of investigating the $2 trillion hedge fund industry for mis-valuation of MBS assets, illicit transfers of capital by hedge fund managers between onshore and offshore funds, and inappropriately billed expenses to hedge funds, the credit crisis-induced risk management transactions of a hedge fund manager ought to be evaluated for their U.S. tax consequences to the hedge fund, its investors and its managers, as outlined below.

Foreign hedge funds may be structured as limited liability partnerships or companies, unit investment trusts, corporations, insurance companies, or as master feeder funds that use a combination of an offshore master partnership with onshore and offshore feeder funds.

They avoid U.S. taxation on their trading income by relying on a trading safe harbor, which renders the act of trading in “securities” (including MBS and credit derivatives), for their own account in the secondary market to be not effectively connected income, or ECI, with a U.S. trade or business. Nevertheless, foreign hedge funds remain subject to U.S. taxation under withholding taxes on their U.S. - source FDAP — fixed, determinable, annual or periodical income.

A hedge fund manager’s entry into Transaction I and Transaction II might not fall under the safe harbor, in which case the foreign hedge fund would be deemed a dealer that is engaged in a U.S. trade or business, subjecting it to net basis taxation on its ECI in the U.S.

If that happens:

1. Any derivative contracts based on MBS assets that a hedge fund manager transfers to a foreign hedge fund’s side pocket may be subject to mark-to-market accounting; and,

2. Any U.S.-source FDAP income of a foreign hedge fund that might have been otherwise subject to taxation (or exempted) under the U.S. withholding tax regime may be treated as U.S.-source ECI subject to net basis taxation.

3. Any expenses of a foreign hedge fund may be disallowed if the foreign hedge fund has not filed a tax return. These include a hedge fund manager’s compensation, which may be evaluated for reasonableness by the Internal Revenue Service.

A hedge fund manager’s entry into Transaction I and Transaction II or side-letter agreements as stated above may also subject a foreign hedge fund to transfer pricing adjustments, or scrutiny under the U.S. tax shelter provisions.

If the foreign hedge fund manages tax-exempt money, a hedge fund manager’s credit-crisis-induced cross-border risk management transactions may have ERISA considerations, exposing each prohibited transaction to U.S. taxation under prohibited-transaction rules.

Any foreign tax consequences of a hedge fund manager’s credit-crisis-induced cross-border risk-management transactions to the foreign hedge fund may also trigger the application of RICO penalties that apply to a taxpayer that has deprived a foreign government of tax revenue.

Finally, the U.S. tax classification of a MBSLF created by a hedge fund manager in Transaction I as stated above may be questioned under qualified foreign company rules.

When a foreign hedge fund is deemed engaged in a U.S. trade or business, any investor in the fund — either in the U.S. or abroad — is barred from relying on the trading safe harbor, and is subject to net basis taxation in the U.S. on ECI from a U.S. trade or business.

The U.S. investors of a MBSLF created under Transaction I as mentioned above by the hedge fund manager, on the other hand, may be subject to the anti-deferral rules of the passive foreign investment company provisions if the U.S. tax classification of an MBSLF is challenged under qualified-company rules.

After being scrutinized for its reasonableness for tax deductibility from a foreign hedge fund’s ECI by the IRS, a hedge fund manager’s incentive fees that are deferred offshore in a rabbi trust may not result in the deferral of income. Accordingly, a hedge fund manager with an offshore rabbi trust plan may be required to include these amounts in income.

The International Monetary Fund estimates that the credit crisis will continue to spread worldwide, with losses approaching $1 trillion, and more hedge funds are rumored to be in trouble due to their leveraged MBS asset investments. Consequently, the credit-crisis-induced risk-management transactions of hedge fund managers hidden in the shadows of hedge fund accounting improprieties should be closely scrutinized for their U.S., foreign and ERISA tax consequences.

Selva Ozelli, Esq., CPA, is a New York-based international tax attorney.

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