With the economic crisis creating an investor backlash against hedge funds globally the fire has been fuelled by two US bills intended to protect investors and at the same time collect much needed tax for the US government. Business Editor Lindsey Turnbull assesses the implications for Cayman and looks at whether the bills will really in practice serve the purpose for which they were intended.
Two US Senators, Carl Levin and Charles Grassley, have their sights set firmly on offshore hedge funds, which they believe have played an integral part in the global financial crisis.
Earlier this year Levin was quoted as saying that the size of hedge funds now means that they can “damage other market participants and can even endanger the US financial system and economy as a whole”, while Grassley has said, “The wizards on Wall Street figured out a million clever ways to avoid transparency sought by the securities regulations adopted during the 1930s.”
The result is two bills passing through Congress – the Hedge Fund Transparency Act 2009 introduced on 29 January of this year and the Stop Tax Haven Abuse Act, based on a 2007 bill brought in by Sen. Levin and co-sponsored by then-Sen. Obama.
Exempted vs. excluded
Campbells Attorneys-at-law recently hosted a seminar on the HFTA, bringing in two US attorneys – Keith Miller and Mitchell Nichter, partners with Paul, Hastings, Janofsky & Walker LLP – to discuss the implications of the HFTA on Cayman’s fund business.
Alistair Walters, managing partner with Campbells, explains the reasoning behind the discussion:
“The recent moves in the US to introduce draft legislation for the regulation of hedge funds and their attempts to tighten rules for taxation of US taxpayers doing business through offshore structures are a challenge to the offshore financial centres. Whatever their final form, we need to assess the impact on the Cayman Islands.”
Nichter said that under the current law (the Investment Company Act of 1940), many private investment funds are excluded from the definition of an investment company (if they are not owned by more than 100 beneficial owners or if the funds are only open to highly sophisticated investors, known as qualified purchasers). This is important because if they were to be defined as such they would be required to register with the US Securities and Exchange Commission.
The HFTA will change this scenario because investment funds could no longer be excluded, instead they would be exempted. This is a subtle but significant change, according to Nichter, who explained: “The amendment to the law would provide the SEC with broad legislative authority to regulate and supervise private investment companies.”
For example, under the proposed new law, an investment fund with assets of $50 million or more would only be exempt if it registers with the SEC, files an information form, maintains books and records as the SEC may require and cooperates with any request for information or examination by SEC staff.
Nichter argued that this about-turn flies in the face of what he termed a decade of privacy protection in the US, whereby there had been a strong movement at a state and federal level to protect personal information.
He also said the impact on offshore service providers would be to increase the cost of doing business because advisers would face “significant compliance costs and increased scrutiny”. He furthered that the HFTA may “create barriers to entry and otherwise reduce the number of new and start-up participants in the industry”.
Although Nichter did concede that the HFTA would not necessarily impose “overly draconian measures on the industry” he thought it could open the flood gates for the SEC to introduce further more substantive legislation, which could affect all aspects of the hedge fund business, from leverage to capital structure, liquidity to governance.
Roger Hanson, director with dms Management Ltd, who attended the Campbells seminar, said he did not see the harm caused by the SEC requesting more information, so long as that request extended to only the US investors of a fund.
“If they want information on investors domiciled outside the States then that is a whole different game,” he said. “I don’t see why it would be a problem for US investors to provide information to the authorities if they are acting legitimately. I do think the SEC may well be making a rod for its own back. I understand that it is already overworked and understaffed and I have yet to ever see a regulatory body prevent a fraud. With any new powers comes greater responsibility for the SEC to catch fraudsters, which I think is impossible. An individual determined to commit a fraud will commit the crime no matter what.”
Don Seymour, managing director at dms was also at the seminar and says, “HFTA, in its current form, it would not materially affect Cayman business, in fact, it would align Cayman and US interests on key issues like hedge fund registration and AML requirements that have been promoted by and mandatory in the Cayman Islands for over a decade.”
Stop Tax Haven Abuse Bill raises serious concerns
By contrast, the Stop Tax Haven Abuse Bill is considered far more threatening to Cayman and includes a wide range of provisions intended to provide the US authorities with more powers to counter tax evasion.
For example, the STHAB presumes that any transfers by US persons to an entity in a listed jurisdiction is deemed to be a taxable transfer and any distribution by such an entity is deemed to be a realisation of income. It would be up to the taxpayer to prove that the transaction did not constitute a taxable event (and check transfer into the US).
The list of so-called tax havens with bank secrecy laws used by US citizens contained in this bill includes: Anguilla, Antigua, Aruba, Bahamas, Barbados, Belize, Bermuda, British Virgin Islands, Cayman Islands, Channel Islands, Cook Islands, Cyprus, Dominica, Gibraltar, Grenada, Hong Kong, Man, Latvia, Liechtenstein, Luxembourg, Malta, Nauru, Netherlands Antilles, Panama, Samoa, St. Kitts and Nevis, St. Lucia, St. Vincent, Singapore, Switzerland, Turks and Caicos, and Vanuatu.
The bill wants to re-classify as a US corporation any foreign corporation whose stock is not regularly traded on an established market the assets of which under management are at least $50 million, and if the corporation is managed in the US. Thus any offshore fund managed by a US advisor with assets over $50 million and managed in the US will be reclassified, subjecting it to the Internal Revenue Service’s corporation income taxation, as well as other taxes.
Harmful to the US
Some experts believe the intended effect of this is to signify the death knell for the offshore fund manager located in the US because US managers would not be able to compete in the offshore fund market.
Hanson says, “I find this bill to be far more frightening in terms of its intended reach. It will have a knock on effect that could harm legally non-tax paying entities such as US pension funds from investing, the very investors that these bills are supposed to protect. This is because they will now be required to pay tax, quite an illogical move.”
Seymour furthers, “There are absolutely no tax advantages available to US taxable investors through investing in Cayman hedge funds. Typical US investors in Cayman hedge funds are tax-exempt investors such as universities, hospitals, pension plans, private foundations and other charities. The vast majority of their investments are in traditional asset classes within the US but they do invest a small portion of their assets in hedge funds and other alternative investments as part of their diversification and alpha generation strategy.
“US tax-exempt investors are already facing severe declining returns because of severe losses in their traditional asset classes as well as reduced charitable contributions due to the economic recession, so it seems astonishing that the US government would propose to impose taxes on entities that are already tax-exempt, simply because they have a small portion of their investments in hedge funds. Overall, hedge funds have outperformed the market, although they too have lost money recently, but to penalise tax-exempt investors for mitigating their losses by investing in hedge funds is grossly unfair.”
Nichter cautioned that it was early days yet for the STHAB and that if there was a flight by investors out of US managed funds, then the US managers would certainly “chase the investors”.
Cayman Islands Stock Exchange Chairman Anthony Travers is surprised at the probable unintended consequences of the proposed legislation.
“Senator Levin’s Bill reflects an antiquated view of the role of the Cayman Islands and miscalculates the historic importance to United States institutions of the funding provided by the Cayman Islands through its access to the international capital markets,” he said. “It is also troubling that the Senator’s bill does not appear to recognise nor credit the tremendous advances made by the Department of Justice and the Internal Revenue Service in securing full transparency with the Cayman Islands on all matters including taxation.
“Senator Levin appears to confuse the Cayman Islands with non-compliant OECD jurisdictions such as Liechtenstein and Switzerland and his conclusions about lost taxation and tax scams are therefore misplaced in so far as the Cayman Islands is concerned. The concern for the United States if Senator Levin’s Bill were enacted in its current form is that further damage would be done to the United States capital markets.”
Travers goes on to say that one probable consequence is that New York fund managers would be obliged to move out of the United States completely with negative not positive results for the United States tax base as they are already fully taxable.
“Regrettably similar mistakes have been made by United States legislators in the past notably with the imposition of Excise Tax on Bond interest payments in 1962, which single-handedly established the dominance of the bond markets in the City of London. The notion that this legislation will improve the United States’ ability to collect increased levels of taxation is wholly misplaced and is based on a fundamental misunderstanding of why capital flows. We recognise that there is a limit to the extent that we are able to assist the United States with this legislative initiative but we do hope that there will be opportunity to clarify the importance of the role of the Cayman Islands and better assist United States legislators with an effective solution to their concerns,” he states. “We no doubt need to do so sooner rather than later or harm may be done to a valuable trading partner. Protectionist legislation of this sort is unlikely to assist the United States in improving its current economic condition and insofar as it overstates the attraction to the International investors of the US markets indeed it may have a further contrary effect.”
In conclusion, Walters says the bill might not harm the fund industry from Cayman’s perspective, “There is an enormous momentum of business structured in and through the Cayman Islands and the skills of its financial services industry are exceptionally high. There will always be investors looking to generate returns on their assets. From a regulatory point of view the Cayman Islands must remain the jurisdiction of choice for clients and their on-shore advisors. Provided that remains the case, with innovative and creative thought from the financial services industry, products can still be offered that provide solutions to those clients, whatever the effect of any final US legislation.”
Walters believes this will enable Cayman to recover from the current international regulatory pushes and at the same time remain at the leading edge of offshore finance. “Indeed there may be positive opportunities to attract more new business such as US investment managers to the Islands,” he says.