The ongoing credit crisis saga has taken a tremendous toll on hedge funds due to their exposure to structured mortgage-backed assets-and for those heading or parsing trades overseas to avoid U.S. taxes: Beware.

The contracting demand for mortgage-backed securities-which had been dramatically overvalued by brokers who pushed more than 600 varieties of these assets to hedge fund managers through unregulated, highly leveraged repos-precipitated the tightening of unsecured term funding.

This has resulted in credit downgrades, massive write-downs of MBS assets by financial institutions in accordance with mark-to-market accounting rules, and illiquidity.

Hedge fund investors have since redeemed mortgage-backed securities at low valuations, some even going bankrupt, while brokers have made margin calls, trying to make up for the difference in the value of securities used as collateral on repos.

Since then, only a few hedge funds with short positions in credit derivatives, have survived. Other hedge fund managers transferred their poorly performing, illiquid MBS assets to side pockets and valued them separately from the remainder of their fund's portfolio to immunize its net asset value calculation from the performance of these hard-to-value assets, effectively freezing the illiquid MBS-affected portion of the hedge fund's portfolio. Less astute hedge fund managers transferred their risky MBS assets to an MBS loss fund, and then floated the MBSLF publicly on stock exchanges in foreign jurisdictions.

But hedge funds that have engaged in foreign transactions as a way to dodge the credit crisis could now be headed for yet more turbulent subprime times. That's because, some hedge fund managers anticipated the deterioration in overvalued MBS assets in the MBSLF's portfolio by purchasing basket index credit swaps. Essentially, these are contracts that simulate the credit of the MBSLF's portfolio holdings from a U.S. broker/dealer. These are constructed based on the hedge fund manager's non-publicly available knowledge of the loss fund's MBS portfolio holdings held between two affiliated funds, with the MBSLF holding the risk side of the swap.

There are serious tax implications at issue. Both the Securities and Exchange Commission and the Department of Justice are in the process of investigating the $2 trillion hedge fund industry for mis-valuation of MBS assets, illicit transfers of capital between onshore and offshore funds, and inappropriately billed expenses.

Next, the regulators are likely to scrutinize credit crisis-induced risk management transactions of hedge fund managers for U.S. tax consequences.

Foreign hedge funds may be structured as limited liability partnerships or companies, unit investment trusts, corporations, insurance companies or as master feeder funds that use a combination of an offshore master partnership with onshore and offshore feeder funds.

Such funds effectively avoid U.S. taxation on their trading income by relying on a trading safe harbor, which renders the act of trading in securities, including MBS and credit derivatives, for their own account in the secondary market not to count as income.

This thinking is flawed. Foreign hedge funds nonetheless remain subject to U.S. taxation under withholding taxes on their U.S. fixed, determinable, annual or periodical income (FDAP).

Further, a hedge fund trading in their own account in a secondary market might not fall under the safe harbor. The government could deem a foreign hedge fund engaged in a U.S. trade or business to be a dealer, subjecting it to net basis taxation on its effectively connected income, or ECI, in the U.S.

If that happens, any derivative contracts based on MBS assets that a hedge fund manager transfers to a foreign hedge fund's side pocket may be subject to mark-to-market accounting.

In addition, any U.S.-source FDAP income of a foreign hedge fund that might have been otherwise subject to taxation, or even exempted, under the U.S. withholding tax regime may be treated as U.S.-source ECI subject to net basis taxation.

Any expenses of a foreign hedge fund may be disallowed if the foreign hedge fund has not filed a tax return. These include a hedge fund manager's compensation, which the Internal Revenue Service may decide to evaluate for reasonableness.

A foreign hedge fund manager's entry into either the first or second types of transactions, or even side-letter agreements may subject it to transfer-pricing adjustments, or scrutiny under U.S. tax shelter provisions.

If the foreign hedge fund manages tax-exempt money, a hedge fund manager's credit-crisis-induced cross-border risk management transactions may have ERISA considerations, exposing each prohibited transaction to U.S. taxation under prohibited-transaction rules.

Any foreign tax consequences of a hedge fund manager's credit-crisis-induced cross-border risk-management transactions to the foreign hedge fund may also trigger the application of RICO penalties that apply to a taxpayer that has deprived a foreign government of tax revenue.

Finally, the U.S. tax classification of a MBSLF may be questioned under qualified foreign company rules.

When a foreign hedge fund is deemed engaged in a U.S. trade or business, any investor in the fund, either in the U.S. or abroad, is barred from relying on the trading safe harbor, and is subject to net basis taxation in the U.S. on ECI from a U.S. trade or business.

The U.S. investors of an MBSLF created by the hedge fund manager, on the other hand, may be subject to the anti-deferral rules of the passive foreign investment company provisions if the U.S. tax classification of an MBSLF is challenged under qualified-company rules.

After being scrutinized for its reasonableness for tax deductibility from a foreign hedge fund's ECI by the IRS, a hedge fund manager's incentive fees that are deferred offshore in a rabbi trust may not result in the deferral of income. Accordingly, a hedge fund manager with an offshore rabbi trust plan may be required to include these amounts in income.

The International Monetary Fund estimates that the credit crisis will continue to spread worldwide, with losses approaching $1 trillion. More hedge funds are rumored to be in trouble due to their leveraged MBS asset investments.

Selva Ozelli, Esq., CPA, is a New York-based international tax attorney.

(c) 2008 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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