Tax Haven Abuse: (Wyly Case) (Hedge Funds)

The 8/1/06 Report: United States Senate (Permanent Subcommittee on Investigations/Committee on Homeland Security and Governmental Affairs), (Wyly Case) Hedge Funds (excerpted pages 242-243):

(a) Supplying Offshore Dollars to Hedge Funds

The Wyly-related offshore entities’ invested more than $250 million in untaxed, offshore dollars in two hedge funds known as Maverick and Ranger. Both of these hedge funds were founded and managed for years by Wyly family members. By agreeing to transfer funds to the Wyly-related hedge funds, the Isle of Man (“IOM”) entities ensured that the funds would be further invested under the direction of the Wylys.

(i) Hedge Funds Generally

In the United States, hedge funds are lightly regulated, private investment funds that pool investor contributions to trade in securities or make other investments. Most U.S. hedge funds are structured as limited partnerships, in which the general partner manages the fund for a fixed fee and a percentage of the fund’s gross profits, and the limited partners function as passive investors.913 Investors generally sign a “subscription agreement” specifying the investor’s ownership interest in the fund, which may be in the form of shares, limited partnership interests, or ownership units, all of which are treated as unregistered securities.914 Many U.S. hedge funds sponsor one or more offshore funds, which are administered offshore, keep their subscription agreements and other records offshore, and minimize contacts with the United States, other than typically using the same investment manager as their U.S. counterpart.

Unlike mutual funds, U.S. hedge funds typically are not required to register their securities with the SEC. Instead, as long as the hedge fund does not offer its securities to the public, and has fewer than 100 beneficial owners or accepts only sophisticated investors, such as individuals with at least $5 million in investments, it is exempt from the Investment Company Act of 1940 and the Securities Act of 1933.915 The reasoning behind these exemptions is that “privately placed investment companies owned by a limited number of investors do not rise to the level of federal interest.”916 In December 2004, the SEC issued a regulation requiring persons who direct a hedge fund’s investments to register with the SEC as an investment advisor and disclose a minimal amount of information about the hedge fund; however, this regulation was recently invalidated by the D.C. Circuit Court of Appeals.917

In addition to minimal SEC regulation, hedge funds are currently exempt from U.S. anti-money laundering laws. They are not required to institute an anti-money laundering program, know who their customers are, or report suspicious activity to law enforcement, despite significant money laundering vulnerabilities.918 In 2002, the Treasury Department proposed a rule that would require hedge funds, among other types of unregistered investment funds, to institute anti-money laundering procedures, but four years later has yet to finalize that rule.919

With respect to U.S. taxes, most hedge funds are organized as partnerships, file 1065 informational tax returns with the IRS, and provide information about gains and losses to their partners for inclusion in the partners’ individual tax returns. Some hedge funds organized as corporations must file 1099 forms with the IRS reporting payments made to clients.920 Hedge fund clients are then responsible for including any hedge fund gains in their taxable income. If a U.S. hedge fund sponsors an offshore investment fund, however, that offshore fund is typically structured as a foreign entity outside of U.S. tax law and does not file U.S. tax returns or report payments made to offshore clients. In 1999, the President’s Working Group on financial Markets noted that a significant number of hedge funds operated in tax havens and may be associated with illegal tax avoidance.921

View complete report: Tax Haven Abuses: The Enablers, The Tools, & Secrecy