By Joel A. Adler, Esq. , a partner in the New York City office of the international law firm of Sokolow, Dunaud, Mercadier & Carreras LLP. Mr. Adler, for more than a quarter of a century, has acted as legal counsel to numerous offshore funds.
Why would a U.S. person want to invest in an offshore fund? It's the 100 rule stupid! as James Carville could have said. Indeed, until 1997, all hedge funds organized as American investment partnerships or limited liability companies could not accept more than 100 investors. The National Securities Markets Improvement Act of 1996 changed the rules of the game by creating a new category of investment fund not subject to registration under the Investment Company Act of 1940: the Section 3(c)(7) Fund in which all investors need to be "qualified purchasers" - generally, individuals and family companies having at least $5 million in investments and entities having at least $25 million in investments. See Hedge Fund News? February 1997 issue.
An unregistered investment fund which does not qualify as a Section 3(c)(7) fund and which has 100 investors will have to close its doors to new investors. Its only way to grow is by additional capital contributions from existing investors or by replacing retiring investors with deeper-pocketed investors. Many successful hedge fund advisors who manage a domestic fund along with an offshore fund for non-U.S. investors face that limitation. To the extent they wish to continue to raise money from U.S. investors without violating the 100 rule, one alternative to consider is to create a category of onshore investors ineligible for the domestic fund, for instance tax-exempt investors, and open the offshore fund to that category.
An offshore fund may accept U.S. investors without losing its tax status as an offshore fund and without being subject to regulation under the Investment Company Act of 1940 or onerous CFTC regulations. Care must be taken not to run afoul of United States legislation and regulations which could lead to unexpected results by selling securities to U.S. investors. In this article, we will give a general overview of the regulations and restrictions that apply to situations where U.S. investors invest in offshore funds. U.S. investors should know that the majority of managers of offshore funds generally prohibit investments by U.S. persons. However, the increased interest in hedge funds has also led a number of managers to open the doors of their offshore funds to U.S. persons, particularly institutional investors.
Hedge funds have traditionally offered their securities in the United States in reliance upon the safe harbor contained in the Regulation D private offering exemption, in transactions which do not constitute public offerings. An offshore fund willing to sell its securities in the United States would be advised to meet the conditions contained in Regulation D, namely:
1. As in the case of a private offering of a domestic fund, the offshore fund or its advisor should not directly or indirectly engage in any form of general solicitation or advertising in the United States, except as discussed in paragraph 2 below. Cold calls, mass mailings and seminars would fall within the prohibition against general solicitation or advertising. On the other hand, general information about the offshore fund should not be regarded as general solicitation or advertising. (Directory listings of performance of U.S. investment funds, however, may not be advisable.)
2. The SEC has been grappling with issues posed by the Internet and has provided guidance through the medium of no-action letters and an interpretative release. In general, an offshore fund that does not accept U.S. investors may use the Internet to offer securities of the offshore fund without running afoul of the registration provisions of the United Stated securities laws. If the offshore fund does accept U.S. investors, any such Internet offer can be made only to pre-cleared accredited investors and a "password protected" regime must be in place in order to allow access to the site.
3. Except for offerings of less than $1,000,000 or unless the offshore fund is willing to supply certain detailed financial and other information, all U.S. person purchasers should be "accredited investors," a category which includes high net worth individuals, pension plans, up-scale professional fiduciaries and the like.
4. The offshore fund should file a Form D with the Securities and Exchange Commission no later than 15 days following the first sale of the offshore fund's securities in reliance upon Regulation D. Form D is relatively short and straightforward. It calls for non-sensitive information relating to the identity of the issuer and its affiliates and expense and other information relating to the offering.
5. In the rare case when there is a distributor of the shares of the offshore fund, SEC Rule 144A permits the private sale of securities, including those of offshore funds, to so-called "qualified institutional buyers."
Finally, the fund manager should make sure that a majority of the equity capital of the offshore fund is in the hands of non-U.S. persons and unless the fund is a Section 3(c)(7) fund, that there are not more than 100 U.S. resident security holders. Generally, offshore funds limit U.S. ownership to 40% or less in order to avoid subjecting the offshore fund itself to certain U.S. taxes. The 100 U.S. resident security holder limitation is derived from the response by an SEC staff member to a 1984 no-action request submitted by Touche, Remnant & Co. (U.K.) relating to the sale of securities of its offshore fund pursuant to Regulation D offerings. While there then was no judicial or administrative support for the position taken in the Touche Remnant letter, the staff member advised that if an offshore fund conducted a Regulation D offering in the United States and, after giving effect to the offering, the offshore fund had more than 100 United States resident security holders, it would be subject to regulation under the Investment Company Act of 1940.
The SEC has given nodding approval to the position set forth in the Touche Remnant letter; the 100 U.S. resident investor limitation does not apply to an offshore fund which is a Section 3(c)(7) fund.
The so-called "Ten Commandments," which once required that certain activities of offshore funds be conducted outside of the United States in order to avoid federal income tax on a net basis, have been repealed. Attention still must be paid to state and local taxation issues since the states need not follow the federal rules. Not surprisingly, New York, the capital markets center of the United States, has adopted legislation that parrots the current federal treatment of offshore funds.
Offshore, but not out of reach of the IRS
From the point of view of U.S. persons investing in offshore funds, the taxing regime under the so-called Passive Foreign Investment Company ("PFIC") rules is quite complex and an extended description thereof is beyond the scope of this article. Generally speaking, however, there are two mutually exclusive sets of rules for reporting income:
1. U.S. taxable investors may elect to be taxed on a current basis and include in their income their pro-rata share of the fund's income under a Qualified Electing Fund ("QEF") election. The QEF election is made once by the investor. The U.S. taxpayer would need to obtain annually from the fund tax information related to the nature of the fund's income and expenses in order to comply with U.S. tax regulations. In addition to the QEF election, the U.S. taxpayer may elect, each year, to defer the tax liability on undistributed PFIC earnings (subject to an interest charge).
2. If the QEF election is not made, the investor would defer taxation until profits are distributed or the investor disposes of his interest in the offshore fund. At that point, profits would be characterized as having been earned ratably over the period of the investment and taxed at the highest income tax marginal rate for each year plus an interest charge. Additionally, in the absence of a QEF election, the taxpayer's estate would not be entitled to a fair market value basis in the shares of the offshore fund.
The tax analysis depends on the situation of the investor, the nature of the fund's performance as well as tax regulations in effect in the future. The QEF election is generally easier to evaluate given the uncertainties involved if the QEF election is not made. However, the QEF election supposes that the appropriate tax information is made available by the fund to the investor.
Tax-exempt investors can be subject to United States Federal income tax on their "unrelated business taxable income," which includes income from debt financed investments. These provisions are no different than those which would apply to U.S. tax-exempt investors in U.S. funds. Generally, offshore funds limit ownership by employee benefit plans, including non-United States employee benefit plans, to less than 25% of the securities of the offshore fund, in order to avoid having the assets of an offshore fund deemed assets of a United States pension plan regulated under the Employee Retirement Income Security Act of 1974.
Ask your lawyer
Most U.S. based managers of offshore funds have not allowed access to U.S. investors (except for the managers themselves). The reasons for this have to do with their own business conditions, the desire to avoid additional provisions in the offering documentation of their offshore funds as well as to avoid additional tax preparation work every year. On the other hand, some managers who have set up hedge funds more recently have chosen to set up a single fund offshore and to admit U.S. investors (sometimes grouped in an intermediary offshore fund) in order to facilitate the administration of their business. There are indeed certain advantages in offshore funds, particularly with respect to trading certain non-CFTC regulated instruments. Some managers have established offshore Section 3(c)(7) funds that may have an unlimited number of U.S. investors. Even if a Section 3(c)(7) fund has investment objectives precisely the same as the manager's 100 U.S. investor fund, the investors in the Section 3(c)(7) fund will not be included in the computation of the 100 U.S. investor limit. As the globalization of investment opportunities and capital availability goes on, investment professionals should review continuously the way they structure their businesses, for their benefit and that of their investors.