Comment: IRS tackles hedge fund investors' deduction of interest expenses and fund of funds management fees

Comment: IRS tackles hedge fund investors' deduction of interest expenses and fund of funds management fees

Steven M. Etkind and Roger D. Lorence of US law firm Sadis & Goldberg argue that two recent rulings by the US tax authorities on deduction of hedge fund expenses may not have pleased the industry but at least provide clarity on points that have been shrouded in uncertainty for some time.

Two recent IRS rulings consider the treatment of investors' deductions of two types of domestic hedge fund expenses: interest expense, where the fund has borrowed to acquire long securities, and management expenses in funds of funds. These rulings come after long periods of uncertainty on the part of tax practitioners about these two categories of expenses, and although unfavourable, at long last provide guidance.

Deduction of investment interest by a taxpayer that is not a corporation is limited to the amount by which investment interest expense for the year, paid to acquire long securities in a margin account at the broker, did not exceed investment income such as dividends, interest, or certain gains.

The term 'investment' can be confusing because all hedge funds are classified as 'investors' for these purposes, no matter how active their trading strategy is. The excess of investment interest over investment income is carried forward to future years. What was unclear prior to the issuance of Revenue Ruling 2008-38 was the treatment of investment interest expense in partnerships that were active traders, or both active traders and investment partnerships (that is, buy-and-hold strategies).

The recent ruling considered the case where a hedge fund that is an active trader in securities generated more investment interest expense (USD200) than it did investment income (USD150) for a partner that was not a corporation. The ruling concludes that USD150 of the investment interest expense was deductible in computing the partner's adjusted gross income, which is helpful, because the higher the adjusted gross income, the more limitations can apply to the taxpayer. The remaining USD50 of interest expense is carried forward to future years.

In a second case, the ruling considered the consequences when the hedge fund is both an active trader and an investor (buy-and-hold) partnership, generating USD200 of interest expense from its active trading and USD100 from its investment activities, with only USD150 of investment income. The ruling applies a 'split-the-baby' approach and holds that USD100 of the interest expense is from active trading and USD50 is from the investment activities.

The investment activity-generated interest expense is categorised as an itemised deduction, because it is not generated in a trade or business, which would be subject to limitations in the hand of the typical hedge fund investor to make it unusable in many cases. The remaining USD150 of interest expense is carried forward, and is again divided into two-thirds from active trading and one-third from investment activity.

The second ruling, Revenue Ruling 2008-39, analysed the treatment of expenses paid by investors in funds of funds. First, the management fees and operating expenses reported by the lower-tier funds in which it invests are reported to the fund of funds investors as an active trading partnership (generating business expenses) or investment partnership (generating investment expenses whose deductibility is subject to various limitations), according to how they are reported below.

This is not news. However, the ruling concludes that the fund of funds management expenses and other expenses generated by the fund of funds are treated as investment expenses, effectively killing the deduction of these expenses for many investors.

The fund of funds ruling contains its own memorandum of law, citing many authorities to support the IRS's position. Its view is that a fund of funds is a passive investor in other partnerships whose activities are not treated as being engaged in derivatively by the fund of funds.

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