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Alternative Investment Management Association Representing alternative asset managers globally

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Transparent, Sophisticated, Tax Neutral - The Truth About Offshore Funds

We are often asked to explain why a significant proportion of the world’s alternative investment funds, including hedge funds and private equity funds, are set up in offshore jurisdictions such as the Cayman Islands. Is it to evade tax or hide assets? This brief note seeks to provide the answers. For further information, contact us at info@aima.org.

Executive Summary
  1. Collective investment is good for investors. Investors such as pension funds, sovereign wealth funds, not-for-profit organisations, charities and other similar entities (often called “sophisticated investors”) can either make alternative investments directly or invest via a collective investment scheme - a fund that pools monies from a number of sophisticated investors and then manages those monies on their behalf. The use of such a collective investment scheme gives investors significant benefits including (i) professional management with specific industry expertise, (ii) the ability to diversify their portfolios across a broad range of alternative investment strategies, (iii) sharing of investment expenses and (iv) access to alternative investment types which are outside the scope of even sophisticated investors acting alone. However, collective investment can also bring legal, regulatory and tax complications, which sophisticated investors wish to minimise in order to maximise returns to their stakeholders.

  2. Offshore funds are “tax neutral”. Tax neutrality essentially means that the country where the fund is formed, such as the Cayman Islands, does not impose its own duplicative layer of taxes on the fund. However, that does not mean that investors in tax neutral funds registered in offshore jurisdictions such as the Cayman Islands do not pay taxes – see the table below. Tax neutral status is not unique to offshore funds. There are tax neutral fund categories in the UK and the USA, for example. What sets offshore funds - and particularly, offshore alternative funds - apart is the combination of tax neutrality, investment flexibility and sophistication allowed by offshore alternative fund structures. This is what makes offshore alternative funds so attractive to sophisticated investors. As funds are often set up as a company or a partnership, those companies and partnerships can be subject to a separate tax charge in the place where they are formed. This means that investors could effectively (and unfairly) be taxed twice on the same income and capital gains. Such double taxation would render most funds uneconomic and defeat their purpose of assisting investors. Tax neutral funds provide an answer to this problem by removing this unfair “Layer 2” of tax (see the table below). Tax neutrality in the jurisdiction where the fund is established - whether onshore or offshore - ensures that such duplication of taxation does not occur, preserving the attributes that an investor would have if investing directly in the underlying assets rather than through an alternative fund. A fund should be seen as an aggregation of capital rather than a discrete taxable entity and such characterisation underpins many of the rules allowing exemption for funds in general. 

  3. Offshore funds are transparent. As regulation has evolved, particularly since the global financial crisis of 2008, the scope of “know your customer” (KYC) rules and standards has been expanded. Today, the identity of investors in Cayman funds and other offshore funds is reported to international tax authorities such as the IRS and HMRC. As a matter of US and Cayman law implementing FATCA, the alternative fund must register and provide this data. If it does not, it will face penalties but also in practice will not be able to trade with market counterparties (who are required to confirm the FATCA compliance of firms or funds they deal with). Ultimately, funds will likely expel investors who refuse to disclose sufficient information about their identity.
  4. Offshore funds are designed for sophisticated investors. Offshore alternative funds are primarily designed as investment products for sophisticated investors. Such sophisticated investors usually employ experienced internal teams, or external consultants, who know how best to navigate the more flexible environment that offshore alternative funds operate in. Simply put, managers of offshore alternative funds face fewer restrictions - for instance, in their ability to leverage investments with borrowed money, to hedge  their positions by going ‘short’ as well as ‘long’, or to impose restrictions on withdrawals (redemptions) – than managers of onshore funds authorised to raise money from retail investors. Some onshore fund locations, including Ireland and Luxembourg, do have fund regimes with similar flexibility aimed at certain types of sophisticated investors, but the Cayman Islands remains the leading alternative fund jurisdiction because a Cayman Islands alternative fund is what US sophisticated investors in particular expect to invest in.
Table: Why any fund should be tax neutral – the three layers of tax

Investment through any alternative fund or other collective investment scheme adds a potential layer of tax over and above that which would be payable were the investors to own the underlying assets themselves. Ideally, alternative funds will be established with tax neutral status to prevent “Layer 2” tax being applied to the fund in addition to the taxes incurred (i) by the investors at “Layer 1” and (ii) on the investments at “Layer 3”, as illustrated in the table.

Table for offshore funds guide

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    1. AIMA Research
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      1. 2016 Global Hedge Fund Survey with KPMG and the MFA
      2. Private Credit
  2. AIMA Journal
    1. Recent issues
    2. Search AIMA Journal articles
    3. AIMA Journal archive: 2010-2012
  3. '25 Years in Hedge Funds'
    1. Introduction - AIMA's global mantra
    2. How the hedge fund industry has evolved over the last 25 years
    3. How the regulatory landscape has changed for hedge funds
    4. Separating fiction from reality: The most common and persistent hedge fund myths
    5. The next five years - where is the hedge fund industry headed?
    6. Virtual roundtable - Leading figures from the hedge fund industry look ahead to 2020
    7. Learning the lessons from the past
    8. Accessing hedge funds: how ‘solutions’ are the new FoHFs
    9. 'Big data': The growth of the global hedge fund industry
  4. "The Case for Hedge Funds"
    1. Global Hedge Fund Industry Paper: The value of our industry
    2. The Value of the Hedge Fund Industry to Investors, Markets and the Broader Economy: Research commissioned by AIMA and KPMG
    3. The Evolution of an Industry: KPMG/AIMA Global Hedge Fund Survey
    4. Contributing to Communities: A global review of charitable and philanthropic activities by the hedge fund industry
    5. Beyond 60-40: The evolving role of hedge funds in institutional investor portfolios
    6. The Cost of Compliance: Global hedge fund survey by AIMA, MFA and KPMG
    7. Capital Markets and Economic Growth: Long-term trends and policy challenges
    8. Apples and Apples: How to better understand hedge fund performance
    9. The Extra Mile: Partnerships between hedge funds and investors
    10. Key articles by AIMA on the case for hedge funds
  5. AIMA Guides to Sound Practices
  6. AIMA guides for institutional investors
  7. Transparent, Sophisticated, Tax Neutral - The Truth About Offshore Funds
  8. CAIA Association pages
    1. Fundamentals of Alternative Investments
  9. Regulatory Compliance Association pages
    1. About the Regulatory Compliance Association
    2. RCA Curricula and initiatives for alternative investment firms
    3. Meet the regulators and Sr. Fellows
  10. Certified Investment Fund Director programme
  11. Services to Start-up Managers
  12. Glossary
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