Wednesday, December 14, 2011

Industry Advances Safe Harbor for Hedge Funds as Traders under Federal Tax Code Principles

The hedge fund industry proposes a three-prong safe harbor identifying funds whose activities in the financial markets are sufficiently continuous, regular and profit-motivated to qualify them, under applicable federal tax principles, as traders rather than investors. In a letter to the Massachusetts Department of Revenue, the Managed Funds Association said that whether a taxpayer is an investor or a trader for U.S. federal income tax, and thus Massachusetts tax purposes, is also a facts and circumstances determination resting on basic tax principles. The MFA agreed with the Department that it would promote good tax administration to have an objective safe harbor in the professionally managed fund context to help distinguish between investor funds and trader funds. The safe harbor is to be included in a draft Directive of the Department.

The Directive addresses tax issues with respect to professionally managed investment funds, such as hedge funds and private equity funds, that are treated as partnerships for federal and Massachusetts income tax purposes. If a professionally managed fund is determined to be engaged in the business of trading in securities, fund expenses are determined to be ordinary and necessary business expenses under Internal Revenue Code § 162. If the professionally managed fund is determined not to be a trader fund and instead is characterized as an investor fund, certain expenses flow through to the partner investors as IRC § 212 expenses. Massachusetts personal income tax law does not allow a deduction for investment-related IRC § 212 expenses and does not allow a deduction for IRC §163 investment interest expenses attributable to investor funds.

Under the safe harbor, a professionally managed hedge fund would qualify as a trader fund if the fund engages in trading activity with continuity and regularity, the primary purpose of that trading activity is to earn income or profit, and the fund’s tax disclosure and federal income tax filings do not reflect an intent that is inconsistent with trader status. A fund that does not meet one or more categories of the safe harbor test may still qualify as a trader fund based on the relevant facts and circumstances. In such cases, the application of the facts and circumstances test may take into consideration particular reasons why a fund does not meet the safe harbor test, such as unusual market conditions or unusual portfolio situations.

For example, certain events external to a fund may impact its trading strategy at a particular time, such as disruptions in one or more financial markets that result in increased costs to borrow and wide bid/ask spreads, which may limit trading opportunities for a particular fund. Circumstances internal to a fund may also impact its ability to meet the safe harbor. For example, certain tax rules, such as wash sales, straddles, original issue discount and similar rules that impact timing and character of income recognition may produce tax results that do not fully reflect the economic trading activity of the fund and skew the results under one or more of the safe harbor tests.