| By Richard Shapiro, Henry Connelly and Jonathan Ansbacher, Tax Partner, Tax Manager and Audit Senior Manager respectively with Ernst & Young LLP, New York. This article appeared in the November 1997 issue of Hedge Fund News?.
The Taxpayer Relief Act of 1997 (the "Act") contains several provisions that are of special importance and interest to hedge fund managers and investors. This article summarizes each of these provisions and examines how each could impact hedge funds.
Capital Gains Rate Reduction
The Act generally reduces the top income tax rate on capital gains for individuals from 28% to 20%. This lower rate applies to investments sold after July 28, 1997 which were held for more than 18 months. (For assets sold after May 6, 1997 and before July 29, 1997, the holding period required to obtain the 20% rate was more than 12 months.) For sales after July 28, 1997, the 28% rate will continue to apply to the sale or exchange of capital assets held for more than 12 months but not more than 18 months. The change in the long-term rate impacts "Section 1256 contracts" (e.g., futures on an S&P 500 Index, etc.) which are taxed as 60% long-term and 40% short-term. The long-term portion of a 1256 contract should be taxed at the new 20% rate, and this is confirmed in the Technical Corrections Bill of 1997 under consideration by Congress. Also, a 25% bracket was added for long-term gain attributable to real estate depreciation.
In addition, rules for the netting of capital gains and losses have been clarified, in a manner favorable to taxpayers (albeit made more complicated as well) in both the Technical Corrections Bill and via a special letter from key Congressmen and Senators issued subsequent to the Act. The letter, read in conjunction with the Technical Corrections Bill, provides that losses for a particular tax bracket will first be used to offset gains in such bracket. Excess losses from any "long-term" bracket (i.e. any holding period greater than one year) will be used to offset the net gains of the highest long-term tax rate bracket and then the next highest long-term bracket. Any remaining losses would then offset net short-term gains (i.e. holding period of 1 year or less). For example, if there is a net loss for the 20% tax-bracket, that net loss can be used first to offset net gain for the 28% bracket, then the 25% bracket, and then net short-term capital gains. Similarly, a carryover of a net long-term capital loss from a prior year would be used to first offset net gain for the highest long-term tax-rate bracket and so on. Net short-term losses are first applied against net long-term gains in the highest bracket, etc.
In general, these changes in the capital gains law will make the burden of keeping proper financial records that much more complex. Automated systems that currently track short-term and long-term positions will need to be modified to account for the various long-term holding periods as well as the netting rules. Hedge funds may want to review their overall tax position prior to year-end so as to maximize potential gain/loss offsetting benefits through trades prior to year end.
Simplified Application of the Stock and Securities Trading Safe Harbor
To facilitate foreign investment in U.S. stocks and securities through a U.S. based investment fund, the Act simplifies the application of the stock and securities trading safe harbor. Specifically, the Act eliminates the requirement, for both partnerships and foreign corporations that trade stock or securities for their own account, that the entity’s principal office not be within the U.S. Therefore, such entities will no longer be required for federal income tax purposes to perform the 10 ministerial functions provided in the current Treasury regulations, commonly referred to as the "10 commandments," from an office outside the U.S. as a condition for exemption from U.S. taxation. The provision is effective for taxable years beginning after December 31, 1997.
U.S. investment managers and advisors of offshore investment funds that currently meet the "10 commandments" safe harbor are advised to consider the non-tax business as well as state and local tax implications of transferring some or all of the administrator’s activities to the U.S. before taking such action. In particular, it should be noted that for state tax purposes, placing the principal office in a particular state may subject the foreign investors to tax in that state unless the state conforms to this federal change. This issue is of particular concern for an offshore corporate fund which conducts its own trading activity.
A "fund of funds" formed outside of the U.S. should now be able to invest directly in U.S. partnerships — those principally engaged in the business of trading securities solely for the account of their partners and members — without incurring U.S. federal income and withholding tax with respect to its share of securities trading profits. This simplified rule, coupled with the repeal of the excise tax on transfers of appreciated property to foreign partnerships, should also result in greater utilization of "master feeder" type fund structures to streamline operations for fund managers with U.S. taxable, U.S. tax-exempt and non-U.S. investors. Specific benefits to be obtained by operating a single master trading vehicle include reduction of trading costs, increased ability to obtain financing and efficiency in receiving trading approvals in emerging markets. Also, the investment manager can preserve the ability to elect deferral of fees from the foreign feeder.
U.S. investment advisors should now be able to accept foreign investors directly into their U.S. funds. However, foreign investors and foreign investment funds are likely to continue to invest in the U.S. through offshore entities both for the sake of privacy and to avoid U.S. estate taxation.
Constructive Sales/Treatment for Appreciated Financial Positions
The Act contains a provision, subject to certain exceptions, requiring taxpayers to recognize gains (but not losses) upon entering into constructive sales of any appreciated position in stock, a partnership interest or certain debt instruments. This provision applies neither to straight debt (non-contingent, non-convertible debt), nor to positions subject to mark-to-market accounting. Generally, a taxpayer is treated as making a constructive sale of an appreciated position when the taxpayer does one of the following: (1) enters into a short sale of the same or substantially identical property ("short-against-the-box"); (2) enters into an "offsetting notional principal contract" with respect to the same or substantially identical property (e.g. an equity swap); (3) enters into a futures or forward contract to deliver the same or substantially identical property; (4) to the extent provided in regulations, transactions that have substantially the same effect as any of the transactions described.
Conversely, for a taxpayer that has entered into a short sale, notional principal contract, or futures or forward contract, the taxpayer is treated as making a constructive sale if it then acquires property that is the same or substantially identical to the underlying property for the position. Upon a constructive sale event, gain is recognized as if the position were sold at its fair market value on the date of sale and immediately repurchased. The basis of the appreciated position is increased by any gain realized and a new holding period begins as if the position had been acquired on the date of the constructive sale.
There are a number of exceptions and a generally favorable grandfather provision. One such exception from constructive sale treatment exists for certain closed transactions during a taxable year that meet three conditions: (1) the transaction is closed before the end of the 30th day after the close of such taxable year; (2) the position is held throughout the 60-day period beginning on the date such transaction is closed; and (3) during such 60-day period the taxpayer does not enter into certain transactions that would diminish the risk of loss during that time on such position. A special rule applies where the closed transaction is re-established within a 60-day period. The constructive sale provision is generally effective for constructive sales entered into after June 8, 1997. Transactions that merely reduce risk of loss or only opportunity for gain, but not both, generally do not result in a constructive sale of an offsetting position.
It is hoped that the IRS will issue prompt guidance, including safe harbors, with respect to common transactions entered into by taxpayers. In particular, the legislative history to the Act recommends that regulations provide standards for determining which "collar" transactions result in constructive sales. It is anticipated that Treasury regulations with respect to collars will be applied prospectively, except in cases to prevent abuse.
There appears to be some opportunity to reduce the impact of these rules by hedging less than "substantially all" of the risk of loss and opportunity for gain with respect to an appreciated financial position. Financial products will no doubt be introduced that capitalize on such opportunities. The meaning of "substantially all" has been left intentionally vague and will require clarification. In general, merger arbitrage transactions, if properly structured, should avoid triggering the constructive sale rules.
Mark-to-Market Election for Traders in Securities or Commodities
The Act now allows hedge funds classified as traders in securities or commodities to elect the mark-to-market method of accounting with respect to any security held in connection with their trade or business. Special rules will apply to electing taxpayers to make inapplicable the wash sale, straddle, short sale, and certain other provisions of current law. Thus, investment funds with very active turnover that are currently burdened and adversely affected by the wash sale and straddle provisions may want to consider making this election. The disadvantages of the election are (1) gain or loss realized will be ordinary in character; (2) income recognition will generally be accelerated; (3) it will be difficult to identify any positions held as not subject to the election. This election provision is generally effective for taxable years ending after the date of enactment and is a permanent election.
Mark-to-Market Election for PFICs
The Act allows shareholders of passive foreign investment companies ("PFIC") with "marketable" stock to mark their PFIC shares to market annually. Amounts included in income pursuant to a mark-to-market election, as well as gain on the actual sale or other disposition of the PFIC stock, are treated as ordinary income. An investor who cannot otherwise make a Qualified Electing Fund ("QEF") election with respect to a PFIC investment may find the mark-to-market election helpful. Additionally, the mark-to-market election could be made with regard to an investment in a PFIC for which a QEF is available. This may be done in order to avoid the sometimes burdensome reporting and record-keeping requirements associated with a QEF which are imposed on a partnership and each partner. However, in making such election, any potential tax advantage which may be obtained from a QEF (e.g. long-term capital gain on annual flow-through or on disposition) would be foregone. This provision is generally effective for taxable years beginning after December 31, 1997.
Regulated Investment Company (RIC) Reform Provisions
Under current law, to avoid entity taxation, a regulated investment company ("RIC") must derive less than 30% of its gross income from the sale or disposition of certain investments (including stock, securities, options, futures and forwards contacts) held less than three months (the "short-short test"). The short-short test has restricted the investment flexibility of RICs (for example, limiting a RIC’s ability to hedge its investments, such as with options). This provision repeals the short-short test effective for taxable years beginning after the date of enactment. In the absence of the short-short rule, we can expect some mutual fund managers to become relatively more active in trading their securities portfolios.
Magnetic Media Filing Required for Large Partnerships
For partnerships which have more than 100 partners such as those subject to the new SEC "(3)(c)(7) rules", partnership returns and Schedule K-1’s will need to be filed via magnetic media. Resolving some contradictory statutory and Committee Report language, the Technical Corrections Bill provides that this provision applies to partnership tax years beginning after December 31, 1997. Hedge funds (or their tax return preparers) will need to obtain the technical resources by which to comply with this provision.
Death of a Partner
The Act provides that the tax year of a partnership will close with respect to a partner who dies. This is a cumbersome rule for hedge funds as it will generally cause an additional "break-period" at the date of death whereby the partnership will need to determine the deceased partner’s share of taxable income through such date. (Under prior law, income for the entire year with respect to such partner’s interest would be taxed to his successor). This rule applies for partnership tax years beginning after December 31, 1997. The scope of this problem might be reduced by amending the partnership agreement to provide that a pro-rata allocation for the year of death will be made between the deceased partner and the estate.
Overall, the Act presents a mixed bag of changes. While the reduction in the capital gains rate is certainly favorable and "ten commandments" repeal should facilitate investor structuring, many of the provisions are lacking in detailed guidance and will require significant additional record-keeping and reporting burdens. Hopefully, finalization of the Technical Corrections Bill and issuance of regulations by the Treasury will provide clarification and possibly reduce some of the burden created by the Act.