Tags: Kleinfeld | tax | reform | fallacy

The Fallacy of Tax Reform for Hedge Fund Investors

Wednesday, 05 September 2012 08:25 AM Current | Bio | Archive

Tax reform is unlikely to help hedge fund investors.

All the presidential campaign talk of tax reform just does not seem to appreciate the utter complexity that the various Congresses have created in their myriad of tax reform tax laws.

Just deciding whether somebody is a “trader” or an “investor” has been the subject of some rather intense litigation. Traders get expense deductions (thereby saving tax) and investors do not (thereby paying more tax).

If President Barack Obama has his way in a second term, then those with high incomes will see even fewer deductions and, as a result, pay more taxes.

A curious part of the tax code deals with such financial contracts as regulated futures contracts, foreign currency contracts and nonequity options.

Among other mind-boggling tax provisions are those dealing with derivatives, which are viewed as straddle positions.

Then there are the short sale rules, constructive sale rules, wash sale rules and constructive ownership rules.

If anybody actually wanted to “reform” the income tax provisions that impact American hedge fund investors, is it even possible?

Clearly, the answer is no.

Quite simply, Congress has passed tax reform acts almost every year, but the income tax has never been reformed.

This is certainly true in the taxation of investors in hedge funds, where the only other choice is repeal.

Many U.S. taxpayers do their hedge fund investments through offshore structures.

It makes sense that, for example, U.S. taxpayers reside outside the United States or have wealth preservation planning use foreign structures.

The United States likes this money coming into the American investment markets.

But, Congress has, over the years, enacted such an enormously complex foreign tax system that it is not possible for foreign tax professionals to explain it to their domestic counterparts.

Even foreign tax specialists have a hard time understanding the foreign tax rules.

Controlled foreign corporations, passive foreign investment companies and qualified electing funds are just a few of the layers of tax law that come into play.

Then comes the Foreign Account Compliance Tax Act (FACTA), which got enacted into law, but implementation is seriously in doubt. No one — not the Internal Revenue Service, foreign financial institutions (FFIs) or U.S. financial institutions (which will be treated by other countries as FFIs) — has yet figured out how to do it.

The uncertainty and serious risks surrounding FACTA is expected to severely impact investments in U.S. hedge funds by foreign investors.

Those who hold hedge fund investments should be aware that as much as hedge funds are attractive investment opportunities, they come at a significant tax risk and, if nothing else, significant costs in retaining tax professionals to figure out the income tax consequences.

Tax reform might make for a good campaign slogan, it always has in the past, but for investors whose money is on the line, tax reform is just a fallacy.

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Wednesday, 05 September 2012 08:25 AM
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