Hedge funds are pooled investments that provide alternative investment opportunities for affluent investors. Hedge funds can invest in derivatives such as options and futures. They can take unlimited short positions -- selling borrowed securities -- and they can use leverage, or debt, to magnify rewards and risk. An onshore fund serves residents of the fund’s country, whereas an offshore fund serves everyone else. The two fund types differ in significant ways.
U.S. onshore hedge funds are used by U.S. individuals and institutions. Individuals investing in U.S. onshore funds must be “accredited,” according to the Securities and Exchange Commission, meaning they must have $1 million in wealth or annual income of at least $250,000. Offshore funds are open only to investors who are not subject to home country taxes. Offshore funds assume that all assets under management are not taxable and therefore not subject to reporting.
Structure of Onshore Funds
U.S. onshore hedge funds are usually organized as limited partnerships. This type of structure passes income through to the investor partners so the partnership is not subject to taxation. The structure confers limited liability on partners, meaning they cannot lose more money than they invest. The fund is run by a general partner, who may also be the head trader. Due to the Wall Street Reform and Consumer Protection Act of 2010, nearly all U.S. hedge funds are now registered with the SEC and banks can no longer have any relationship with these funds.
Structure of Offshore Funds
Most offshore funds are LLCs based in low tax jurisdictions. Hedge funds that wish to accommodate onshore and offshore investors use a structure called a "master feeder": The onshore and offshore funds act as “feeders” that invest in an offshore master fund. In this arrangement, U.S. tax-exempt entities and non-U.S. investors can remain anonymous to government regulators and still benefit from the expertise of an onshore fund manager. The total assets of the master fund are the sum of the onshore and offshore fund assets, providing economies of scale and unified administration.
Onshore funds notify their local governments of the income they pass through to partners, but only if such governments levy income taxes. The attraction of offshore funds is that they are usually set up in no-tax domiciles such as the Cayman Islands, a territory that has no direct taxes. The lack of currency exchange restrictions allows offshore investors to convert and repatriate their money at will. Offshore jurisdictions often have strong privacy laws; it is a crime in the Cayman Islands to even inquire about a person’s bank accounts.
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