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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

Flashback: How Donald Luskin Earned His Title

Max Sawicky, on his Twitter feed, sends us to this classic piece from Donald Luskin

Believe me, if we raise taxes on hedge-fund managers we’ll get fewer hedge-fund managers. Today, with lots of hedge-fund managers trading all the time and keeping markets efficient, stocks are at record highs around the globe and markets are deeper, more liquid and less volatile. With fewer hedge-fund managers, markets would shrink, become more volatile and more costly, and tumble from their present highs.

The date on the piece is 20 July 2007. Just over three months later—pretty much exactly three years ago—the IB-sponsored MBS origination market effectively died, having taken much more value than was produced by the underlying property and placed it firmly into the pockets of traders and originators who knew that the present value they were claiming was—let us be nice—overoptimistic.

Does anyone wonder why Brad DeLong designated Donald Luskin “the Stupidest Man Alive Emeritus“?

I Was Wondering When This Would Come Down

Tom Bozzo

A fund of fund(s) that funneled money into the Madoff scam is in Big Trouble:

Massachusetts regulators have sued the Fairfield Greenwich Group, one of the earliest of these so-called feeder fund managers, for fraud, saying it had repeatedly misled investors about how diligently it checked out Mr. Madoff’s operations over the years.

“Fairfield’s complete disregard of its fiduciary duties to its investors and its flagrant and recurring misrepresentations to its investors rises to the level of fraud,” [said the complaint].

Henry Blodget had nicely ripped Fairfield Greenwich’s marketing claims a while back (Fairfield Greenwich also apparently forgets that the Internets remember all). If the rap can be beaten with a claim that those were mere puffery rather than outright fraud, then the law surely is an ass: performing rigorous analysis of investment managers’ strategies is one of the (few) ways a fund-of-funds can justify its fees-on-fees [*]. An interesting question is why this is being handled as a state matter; maybe now that the Ted Stevens debacle is over, some Justice Department resources can be liberated.

One thing this points to is that the “accredited investor” concept — the “safe harbor” that allows hedge funds to escape much regulation by limiting their services to high-income, high-net-worth investors — deserves a place (however minor) on John Quiggin’s growing rubbish heap of refuted ideas. Merely being rich (or at least upper-middle class) didn’t make the Madoff suckers and suckers-of-suckers sophisticated (in U.S. securities regulation, sophisticated investors is a more restrictive category such that few funds apparently use it), and there’s really little more (if not much less) reason to think they can evaluate complicated investment strategies than that they can reliably complete their own taxes. Ultimately there’s a reliance, possibly at a couple degrees of separation (part of the fraud that I leave to the sociologists), on actual expertise.


[*] That is, substantively justify, as opposed to charging what convention and apparent market failure allows the market to bear.

Shiela C. Bair Tries to Save the World–Again

Via Felix, we discover Joe Nocera at the NYT reporting that securitization professionals are not as stupid as they would have had us believe:

What [the FDIC] has discovered, said [Michael H. Krimminger, the F.D.I.C.’s special adviser to the chairman for policy], is that the contracts are rarely as constricting as investors and servicers have been portraying them. They do not allow principal reduction, for sure, but they almost never disallow interest rate reduction — or delaying principal payments for a short time. What’s more, Mr. Krimminger said, the servicer agreement simply says that the servicer’s job is to maximize the investment — which often means avoiding foreclosure.

Buyers of a security want the best return they can get. Foreclosure stops that cash flow, and bankruptcy procedures—at their best—impede those flows.

This is the rational position. So what had Nocera written that caused Bair and Krimminger to call him?:

I have quoted a number of experts and people in the securitization business who have told me repeatedly that it is nearly impossible to modify mortgages that are trapped in toxic mortgage-backed securities. The contracts, they say, don’t really have provisions for preventing foreclosures. And the servicers face terrible conflicts if they try to modify mortgages, because inevitable some of the bond investors will do better than others — depending on where they stand along the risk continuum — and under those same contracts, servicers are obliged to treat all investors alike. Finally, I’ve heard, servicers have been unwilling to lift a finger for homeowners because they have no financial incentive to do so — and they face the prospect of being sued by one of their investors if they do.

Servicers have been unwilling to lift a finger, and as such are not following the fiduciary responsibility of ensuring investors an appropriate return.

And it takes the bloody Chair of the FDIC—not the Treasury Secretary, whose former firm made piles of money for him with such securitization procedures—to understand the situation and tell the truth.

Apparently, we have to wait for some large investor and/or hedge funds whose bonds have gone into the default to sue their servicer before someone outside of the FDIC understands that investors prefer receiving some money to none.

Update: I see, via Mark Thoma, that John Hempton is being stupid. Is this a unique situation, or is he selling something? It appears to be the latter.

Blind-Reference of the Week

Late to the party, but FelixMatthew Malone (via The Divine Bess) quotes from Andrew Lahde’s good-bye letter, the follow-up to the one in which he noted that he only plays fair games, and the Fed is currently rigging the roulette wheel, so he’s taking his 800%+ return from last year and going home.

This ‘graf in particular caught my eye, since it is Subtil as a Flying Mallet:

I was in this game for the money. The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government.

Mr. Lahde appears to be betting that this man’s father won’t hold a grudge. That has never been true before.

(Spelling of Mr. Lahde’s name corrected 31 Dec due to correct rendering in this post.)

The Price of Gas will soon be $1.50, right?

This will teach them, right?

H.R. 6377 directs CFTC to use all its authority, including its emergency powers, immediately to curb the role of excessive speculation in the energy and swaps futures markets and take other corrective actions as necessary to eliminate any market disturbance that prevents energy markets from accurately reflecting the forces of supply and demand.

And what long-term supply (h/t Mark Thoma) is that?

As has been noted elsewhere, regulation at the CFTC isn’t in itself a bad idea. Indeed, it’s long overdue. But I’ll go back to Krugman and the FT:

The case for such a policy is based on a flawed concept of how these markets work. Those pushing for restrictions argue that an artificially high demand for essential commodities such as oil and corn has been created by the institutions’ purchase of long positions in futures contracts….

Now, if it were true that pension funds, insurance companies, evil hedge fund managers etc, were all buying large quantities of physical products such as silos of grain and storage tanks of oil, then the peasants with the torches, and their leaders, would have a point. But the investors aren’t buying physical product. [Nonsense about Lieberman being a Democrat omitted; italics mine]

So, if this bill passes the Senate and is ultimately enacted, the CFTC either will prevent some people from buying futures (by some miracle, unless they’re going to do this only for crude contracts, which would mean Lieberman is even stupider than I think he is) or, more likely, change some requirements in the booking, reporting, and buying of such contracts which will make it more difficult for outright speculators.

Now, don’t get me wrong: I fully expect to be paying $1.50 for gasoline in a couple of months: but that will be C$1.50/litre. The odds of those of you staying in the States being able to pay that per gallon—well, I wouldn’t take them. Even if I were “speculating.”

Speculation, Again

Rick Newman of Useless News and World Report busts some myths. And gets to the heart of the “speculators” issue:

Many companies, for instance, want to lock in the price they’re going to pay down the road for petroleum products and other supplies they need to run their businesses. So they make agreements with suppliers on a price they’ll pay next year, or the year after, when they actually take possession of the oil. Buying and selling such “futures contracts” makes these companies speculators by definition, since they’re placing a bet on the future price of oil.

Companies doing this kind of hedging include gasoline refiners, airlines, shipping companies, and others that spend a lot on fuel or petroleum. Often they use investment banks or other intermediaries to arrange the deals. They might be gambling, but this kind of speculation actually helps companies run their businesses more smoothly, and if they guess right on future prices, it may give them a competitive advantage against other companies that don’t plan as prudently.

It’s not “gambling” that gave Southwest a competitive advantage, or nearly put Delta out of business yet again. When your largest non-fixed expense is a known quantity (how much fuel you’ll need next year, given any expansin/contraction plans), hedging in the futures market isn’t just an adventure, it’s a job.

And note that the competitive advantage isn’t just against “other companies.” A speculator who guesses wrong doesn’t stay in the market too long. Nor, not to be blunt about it, does s/he ever take delivery of the asset: they sell the contract for a gain or loss.

This is why an increase in volume in the futures market (as noted in Mr. Master’s testimony; h/t divorced one like Bush in comments here) isn’t necessarily a sign in itself of speculation. It may be a sign of corporate risk management (finally) doing its job. After all, it’s not as if the oil price trend isn’t clear.