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Hedge Fund Tax Avoidance Schemes–using (purported) offshore reinsurers

by Linda Beale

Hedge Fund Tax Avoidance Schemes–using (purported) offshore reinsurers

It seems that billionaires think they are entitled to it all and think they should be able to run their speculative games without paying much of anything at all in taxes to the government they depend on. And none of this is good for the economy or good for the taxpayers not in “the 1%”.

Case in point–John Paulson, the notorious hedge fund manager who got a CDO built to his desires with a bunch of iffy subprime mortgages and then took the short side of the bet, making a fortune off the bet against subprimes in the mortgage crashes underlying the 2007-8 Great Recession.  See, e.g., Zuckerman, Trader Made Billions on Subprime, Wall St. J. (Jan. 15, 2008).

What has Paulson done?  He established a new “reinsurance company” in Bermuda in April, that turned around in June and put the money invested in it  back into Paulson’s hedge funds in New York, as a portfolio of insurance “reserves” to be held to pay off insurance risks that go bad.   The result is tax deferment for Paulson and other executives of his hedge fund along with re-characterization of ordinary compensation income as preferentially taxed capital gains.

For a discussion of the hedge fund reinsurer gambit, see , e.g., any of the following.  The story at Bloomberg has reinvigorated media attention to this issue.

Barile notes that these hedge funds are using reinsurance premiums and investing in a very aggressive way, compared to traditional reinsurers”.  This aggressive position produces a downside if there are low investment returns, especially if there are catastrophes for which they have to pay claims when their investment strategies have produced losses.  He says that “it remains to be seen” whether hedge-fund reinsurers are in it for the long haul, since they have a shorter time frame on making greater returns on their money.

Looking at this as a global concern, Baker ultimately suggests that the Basle Capital Accord rules should be extended to hedge fund reinsurer operations,  “Another area in which the BIS should take a leadership position,” he says, “is the role in which reinsurance firms play in hedge fund operations.  The tax implications of hedge funds using reinsurance firms in their funds for tax advantages points to the need for more government regulation of this activity.”

He describes the basic problem as follows:  “wealthy individuals invest in private placement offerings of offshore reinsurance companies.  These companies, many headquartered in Bermuda, buy insurance policies written by name-brand insurers…and “may then invest its stock issue returns in a hedge fund.  …[That reinsurer] pays no taxes on the trading profits until it sells the fund shares and then the reinsurer is taxed at a lower capital gains tax.  The tax savings are passed on to the individual investor.

He goes on to say that “The problem … is that insurers are exempt from registering as investment companies….These reinsurers do not have to make annual distribution of profits as mutual funds do and they are not taxed by the Internal Revenue Service as investment vehicles.  …In short, the activity … is a method for wealthy investors to reduce their tax burden as a result of a tax loophole.  Since these insurance companies are mixing insurance business with investment business, they need more supervision.

This is especially true when hedge funds are involved.  “[H]edge funds work with reinsurers to reduce tax liabilities for their wealthy clients.  …U.S. hedge fund managers and investors form a tax-advantaged reinsurance company offshore in…Bermuda, which has no corporate income tax.  The Bermuda-based reinsurer sends investment assets to the hedge fund to invest.  Investors return to the United States with shares of the reinsurer and pay no taxes until the company goes public.  At that time, investors [and managers] sell their shares in the reinsurer company and are taxed at a lower capital gains rate.
These schemes are worrisome from both tax and insurer regulatory perspectives.  “Aside from the tax loophole problem, the real issue in these cases is the added underwriting risk incurred in the process. … [Hedge funds acting as reinsurance companies] have insufficient insurance expertise…. Much of this activity has stemmed from financial engineering and deal making of the 1990s. … [W]ithout the bailout of LTCM [Long-term Capital Management hedge fund] by national bank regulatory authorities, many banks and reinsurers might have collapsed as well.”

So why do it and how does the hedge fund reinsurer gambit work?  Remember that these hedge fund execs get a ridiculous amount in compensation in the form of a “fee” (usually 2% of assets under management) and a “carry” (usually 20% of the profits).  (The fee and carry are often represented as 2 and 20, but can be much higher for some firms with status, rising to as much as 5 and 50.)  Without more, hedge fund managers don’t get as much benefit from the claimed treatment of a “profits” partner as private equity fund managers do.  Though the managers claim classification as “profits” partners whose taxation is based on their share of the partnership’s gains and ordinary income and not as payments of (ordinary) compensation, hedges mainly yield ordinary income so don’t act directly as “converter” entities.   Private equity fund managers also claim they are “profits” partners whose income should not be classed as compensation but as pass-through shares of the  partnership items:  in their case, most of the private equity fund’s gains will be deferred anyway (for several years at least until the partnership sells the leveraged company) and they claim those deferred gains should be characterized as pass-throughs characterized by the partnership rather than being characterized as ordinary compensation income to them.  

So for hedge fund managers,  gaining deferment (of what is clearly in substance their compensation as managers) can achieve  minimal current tax.  If the money is cycled through an offshore corporation that pays no taxes, that’s even better because it gets preferential rates as well.  The deferment is achieved by waiting to sell the stock, and the sale of the stock is reported as a capital gain.  Thus what is really current compensation income is re-characterized, through the reinsurer “conduit” scam, as a deferred capital gain.   So hedge fund and private equity managers ultimately both claim to get the best of all possible worlds–their wages from work are not currently taxed as wages at ordinary income rates, they pay no payroll taxes on their compensation, and their compensation is deferred and taxed at preferential capital gains rates.

This is so obviously unfair to the vast majority of ordinary taxpayers who pay taxes on their compensation income even before the end of the tax year through the withholding mechanism that Congress should step in with legislation.   It seems hard to justify a “profits” interest in a partnership at all: it has been created by the “Wall Street Rule” that gains credence because big-money people claim it is correct.  As usual, tax administration eventually mostly went along with it (Rev. Proc. 93-27) and a few court cases (Diamond, Hale) mostly treat the notion of a profits partner who pays no taxes on his compensation as reasonable.  Congress could easily legislate away the profits interest and define partner in a partnership for tax purposes as someone who has made a genuine at-risk equity contribution of cash or property to the partnership. There really should be no such thing as a services partner with a “profits” interest who hasn’t contributed up front for a capital interest.  And all compensation shares to what are currently treated as profits partners could be treated as ordinary income –i.e., compensation currently subject to the income tax and to payroll (Social Security/Medicare) taxation.

This use of reinsurers by hedge funds is itself a tax dodge that has been around a decade or so.  In 2007, the Senate Finance Committee held a hearing on Offshore Tax Issues: Reinsurance and Hedge Funds (S. Hrg. 110-875, Sept. 26, 2007) (179 pages).  In his introduction, Baucus described insurance tax avoidance schemes as follows:

Insurance companies make a living by doing two things: they assess premiums based on the prediction of the likelihood of events against which they insure—that is called underwriting—and they also make money by investing the premiums that they collect until they have to pay out claims. If they are good at those two jobs, they  make a profit.

Customers buy insurance from insurance companies to guard against the risk of fire, disaster, or some other calamity. In exchange for paying premiums, the customers shift some of their risk to the insurance companies. Insurance companies also buy insurance. Property and casualty insurance companies pay premiums to reinsurance companies in exchange for shifting some of their risk to the reinsurance company. Sometimes the reinsurance company is also the parent company of the property and casualty insurance company. In that case, the property and casualty insurance company shifts risk to their parent reinsurance company at something less than an arm’s length transaction.

Here is where the tax avoidance comes in. Some parent insurance companies set their headquarters in low-tax jurisdictions, like Bermuda. Subsidiary property and casualty insurance companies shift risk to the Bermuda parent. Because of Bermuda’s low tax burden, the Bermuda parent can get a greater after-tax return on their investment activities. As a result, subsidiary property and casualty insurance companies can charge lower premiums for their insurance. They get a competitive advantage over insurance companies doing business in jurisdictions that tax investments.

The second setting that we will examine today involves hedge funds. Foundations and other nonprofits are some of the largest investors in the world. The law requires a nonprofit investor that invests directly in hedge fund partnerships to pay the unrealized business income tax, otherwise known as UBIT. The policy behind the law is that tax-exempt entities should not be able to have an unfair advantage over taxpaying entities doing the same thing. To avoid UBIT, nonprofit investors sometimes invest in hedge funds through offshore entities incorporated in low or no-tax jurisdictions, such as the Cayman Islands or Bermuda. These offshore entities are called blockers.

The third setting we will examine today is the compensation of hedge fund managers. Hedge fund managers receive fees from offshore blocker corporations used by nonprofits and foreign investors.Some hedge fund managers elect to defer their income, and deferring income means you pay taxes later, which is the same as a significanttax savings.

The IRS has already noted that offshore arrangements using reinsurers for hedge fund managers may be shams that are subject to challenge on audit.  See Notice 2003-34 (indicating that “Treasury and the Internal Revenue Service have become aware of arrangements, described below, that are being used by taxpayers to defer recognition of ordinary income or to characterize ordinary income as a capital gain.  The arrangements involve an investment in a purported insurance company that is organized offshore which invests in hedge funds or investments in which hedge funds typically invest.”)  Although the notice says that these purported insurers may be challenged as not insurers because they are not using their capital and efforts “primarily in earning income from the issuance of insurance”, and although it states that such arrangements will be subject to close scrutiny that could result in the application of the PFIC rules (leading to current taxation), it has apparently not bothered to challenge any of the big hedge funds’ reinsurer companies.

Again, why would they be subject to challenge?  On the basis that they are not real reinsurers, since the low amount of reinsurance that many provide is the less risky part of the business and provides a buffer to the very high reserves that they retain, sometimes invested solely in a single promoter’s hedge funds.  And if they are not insurers, they are at the least “passive foreign investment companies” (PFICs) on which shareholders are subject to current taxation on profits.  (Or perhaps the IRS might go further and re-characterize the arrangement as a sham , causing the hedge fund executive to have current ordinary compensation income.)    In other words, there is good cause to think that for many of these, the tax haven corporation is acting as an offshore tax-avoidance pocketbook for the hedge fund executive, and not really as an insurer.
By the way, if you think these hedge fund managers who are making multi-millions and billions from managing other people’s assets and hardly paying any U.S. taxes on those huge compensation payments are incredibly smart people who add to the economy’s well-being and therefore merit that kind of out-sized pay or because of the returns they bring to people that then invest them in needed projects in the good ole US of A, you need to rethink that. Hedge funds typically pay out very poor returns, when all the expenses and profits to managers are taken into account.

Roughly speaking, if the typical fund manager worked for free, and if the investment firms didn’t charge, these masters of the universe would still have underperformed a balanced index since 2003, by roughly 2.5 per cent per year. Andrew Hallam, Think you’re smarter than a hedge fund manager?, The Globe and Mail (Feb. 19, 2013) (emphasis added).

cross posted with ataxingmatter

  • Chad Brick says:

    This loophole should be deemed illegal. The re-insurer must be an active company, and clearly, Paulson’s is a sham.

    Lock him and anyone else pulling this crap in a cage for tax evasion, seize everything he owns, and erase his name from the history books.

  • m.jed says:

    I’m fairly familiar with the Paulson vehicle for reinsurance. Dan Loeb’s Third Point also recently started a hedge fund with a very reputable CEO (formerly ran the reinusrance operations at Chubb), David Einhorn’s Greenlight started Greenlight Re several years ago (which is publicly traded), and over a decade ago Moore Capital founded and eventually took public MaxRe.

    Not really clear what the “loophole” is – beyond “something about the tax code that I don’t agree with”.

    Insurers need capital to support the risks they underwrite. For competitive reasons, that capital can’t be invested in cash – pricing on expected underwriting returns won’t allow for sufficient return on capital to have it invested in cash. Insurers can take risks on that capital in one of two places – on the liabilities – i.e., future losses to be paid out of the capital, or on the assets – through investment risk.

    Aside, and I think there’s probably a way, but haven’t quite figured it out yet –

    If you have an LLC with revenues of $100 and compensation of $50, general expenses of $25 with a pre-tax margin of 25% – the partners pay pass-through taxes on the 25 of residual profits and the employees pay taxes on their aggregate compensation of $50. So govt revenues are based on $75 of total compensation. Now change it so 100% of the compensation is deferred indefinitely. The income statement changes to $100 of revenues and $75 of profits, so the partners pay pass-through tax on the $75 of profits and govt revenues are again based on $75 of total compensation.

    As for the transformation to capital gains by investing in the equity of the insurer, there is risk involved, as there’s no assurance you can monetize your stake at book value – as many publicly traded insurers are valued at a discount to book.

    As for the underperformance of hedge funds – starting points matter, and measuring starting in 2003 was coming off a 3 year bear market in equities. I’d venture to guess that relative performance changes dramatically if one changed the starting point to 2002 or 2004 – and I’d also venture to guess that the risk-adjusted return of hedge funds as measured by Sharpe Ratio – dramatically outperformed a balanced account. But I guess the larger question, considering retail and institutional investors tend to chase performance, is that why are hedge fund and private equity allocations growing if their returns have been so poor?