John C. Crager, VP, Global Head of Tax, HSBC Alternative Fund Services, New York, examines the ramifications of The American Jobs Creation Act.
On 22 October 2004, President Bush signed The American Jobs Creation Act of 2004 (the Tax Act) which represents a major piece of US tax legislation. The centerpiece of the law is the resolution of friction with the European Union (EU) over US tax breaks to exporters under the exclusion for extraterritorial income (ETI) regime.
The World Trade Organization (WTO) had ruled that the US tax incentives were illegal and the WTO authorized the EU to impose trade sanctions in the form of tariffs against US exports. In March 2004, the tariffs began to be applied and were set to increase unless the US changed their tax law.
After almost two years of Congressional crafting, the tax changes are finally enacted. The ETI exclusion repeal creates a large revenue increase for the US Treasury. As such, lawmakers viewed this as an opportunity to attach numerous special interest tax provisions to the tax bill.
The Tax Act includes such diverse provisions as: special rules for livestock sold on account of weather; new amortization rules on restaurant improvements the repeal of excise taxes on fishing tackle boxes and fish finders; and the opening up of wagering on thoroughbred racing to overseas bettors. In total, there are over 270 changes to the Internal Revenue Code.
The Tax Act has provisions that have a direct impact on hedge funds and fund of funds as well as the investment management industry, in general. Below are the provisions that may have a direct impact on US fund managers as well as funds with US investors and US tax reporting requirements:
Provisions Impacting US Hedge Fund Managers & Hedge Funds:
- Restrictions of deferral treatment for offshore nonqualified deferred compensation plans: The new tax law restricts the deferral benefit of certain deferred compensation arrangements. The Tax Act states that assets set aside (directly or indirectly) in an offshore trust (or other arrangement determined by Treasury) for purposes of paying nonqualified deferred compensation may be currently includible in gross income whether or not such assets are available to satisfy the claims of general creditors. The new tax law does not apply to assets located in a foreign jurisdiction if substantially all of the services, to which the nonqualified deferred compensation relates, are performed in such foreign jurisdiction.
- Limitation of the use of built-in losses on partnership interest transfers and property distributions: These provisions of the Tax Act are aimed at losses duplicated at the partner and partnership level. The new tax law potentially increases the tax accounting burden for hedge funds and their administrators as the law has the consequence of adjusting the basis of partnership assets when (1) a partner contributing built-in loss property liquidates from the partnership before the loss property is sold; (2) a partnership interest is transferred to another partner when the fair market value of partnership assets are less than the partnership's adjusted basis in its assets; or (3) assets with built-in losses are distributed to a partner in liquidation of their partnership interest. The Tax Act does provide for "electing investment partnerships" to avoid making the basis adjustments under the new tax law, however, there is a partner-level loss limitation that would apply. Additionally, certain hedge funds and private equity funds may not meet the definition of "electing investment partnerships."
- Incentive to Re-Invest Foreign Earnings in the United States: The Tax Act provides that certain dividends received by a U.S. corporation from controlled foreign corporations are eligible for an 85-percent dividends-received deduction. A hedge fund manager set up as a US corporation with a foreign subsidiary operation may consider using the one-time incentive, subject to limitations, to repatriate income.
Provisions Impacting Investments Made by Funds:
- Modification of the straddle rules: The new tax law modifies the straddle rules in three respects: (1) permits taxpayers to identify offsetting positions of a straddle; (2) provides a special rule to clarify the treatment of certain physically settled positions of a straddle; and (3) repeals the stock exception from the straddle rules.
- Suspension of the holding period with relation to dividend received deduction when an in-the-money call option is written on a dividend paying stock: In order for corporate shareholders to receive a dividend received deduction (DRD), the shareholder (or where a corporation invests via a fund, the fund) must hold the dividend paying stock for 46-days (91-days in the case of preferred stock) around the dividend ex-date. The holding period does not include time when the shares are protected from the risk of loss. The Tax Act clarifies that in-the-money written call options suspends the holding period for DRD purposes as well as for the holding period requirements of qualified dividend income (QDI).
- Requirement of a minimum holding period for foreign tax credit on withholding tax on income other than dividends: Rules that currently apply to withholding taxes on dividend income will now also apply to foreign taxes on income such as interest and capital gain.
- Information related to taxable corporate actions are required to be provided to shareholders: This law creates an additional administrative burden for transfer agents and brokers, however, it should ease the ability of funds and other investors to determine whether a corporate action should be treated as a taxable event.
- New penalties for those that fail to disclose tax shelter information: The law, which stems from the political environment created in the post-Enron era, provides for penalties ranging from USD 10,000 to USD 200,000 per transaction for failure to disclose reportable or 'listed' transactions. The Tax Act also requires "material advisors" (which some commentators believe includes fund advisors) with respect to any reportable transaction including any listed transaction to timely file an information return. Failure to furnish such information regarding such transactions may result in onerous penalties.
- Repeal of the foreign personal holding and foreign investment company regimes: Due to the overlap of these rules with those that govern controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs), the foreign personal holding and foreign investment company regimes are being repealed.
- Provision to allow Treasury to write regulations regarding stripped interests in bond and preferred stock mutual funds: In a transaction where the right to receive future income from income-producing property is separated from the property, it may be possible to generate artificial losses from the disposition of certain property or to defer the recognition of taxable income associated with such property. The Tax Act allows Treasury to write rules similar to those written for stripped bonds.
Provisions Impacting Private Equity Funds:
- Provision to ease investment by tax-exempt entities into small business investment companies: The proposal modifies the debt-financed property provisions by excluding from the definition of acquisition indebtedness any indebtedness incurred by a small business investment company. This exclusion from the calculation of unrelated business taxable income (UBTI) will not apply if any tax-exempt entity owns more than 25 percent of the capital or profits interest in the small business investment company, or exempt organizations own, in the aggregate, 50 percent or more of the capital or profits interest in such company.
Provisions Impacting US Mutual Funds:
- Provision to ease foreign investment into US fixed income/money market mutual funds: Dividends distributed by a US mutual fund that are derived from short-term capital gains and interest income, generally, may now be paid to foreign investors without the imposition of a 30% (or lower treaty rate) US withholding tax. There is also a foreign investor-friendly tax law change related to estate tax and US mutual funds that invest in foreign securities.
- Provision to ease investment into publicly-traded-partnerships (PTP) by US mutual funds: Income from a qualified publicly traded partnership would be considered to be 'good' income under the US mutual fund qualifying tests. Prior law required mutual funds to look through the PTP to determine qualifying income thus making investment in oil and gas and other natural resource partnerships unfavorable for US mutual fund managers.
Major Provisions Impacting Individual Taxes:
- Restriction on the amount that you can deduct as a charitable contribution upon the donation of car.
- US Virgin Islands residency is to be determined by a more quantitative test based on days resident.
- Deduction of state and local sales taxes.
The return of the deduction for sales taxes has a catch - you can only take the sales tax deduction if you choose not to deduct your state and local income taxes but it may help those in states that do not impose an income tax. Also note that the deduction is currently only available for the 2004 and 2005 tax years.
To find out more about the Tax Act or read the full Tax Act, visit the House Ways and Means Committee web-site (http://waysandmeans.house.gov/Links.asp?section=1559 ).
The above is designed to provide information in regard to the subject matter covered. It is provided with the understanding that it does not constitute tax, legal, accounting, or other professional service. Please consult your tax advisor regarding your specific tax situation.
John C. Crager
VP, Global Head of Tax
HSBC Alternative Fund Services
(formerly Bank of Bermuda Global Fund Services)
330 Madison Avenue
New York, NY 10017