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.
Different Investor Requirements
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. An “accredited investor” is one who has earned at least $200,000 for the past two year ($300,000 with a spouse) or has at least $1 million in net worth.
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.
Hedge funds are not subject to all of the same regulations as other investment vehicles. Based on the amount of assets in the fund, some hedge fund managers may not have to register with the SEC. However, hedge funds are subject to fraud prevention measures, and managers have a legal obligation to to act in the best interest of their investors.
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.
Tax Considerations for Hedge Funds
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.
- Tax Havens: How Globalization Really Works; Ronen Palan, Richard Murphy, Christian Chavagneux
- Hedge Fund Market Wizards: How Winning Traders Win; Jack D. Schwager, Ed Seykota
- The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds; Maneet Ahuja, Myron Scholes, Mohamed El-Erian
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.