In the wake of news that the IRS in the US and the UK's Inland Revenue are extending their tax nets to hedge funds, a leading hedge fund expert warned the move could inflict real damage to some funds.
The warning came from James Hedges, president of LJH Global Investments, who said managers are likely to redeem their own investments in offshore hedge funds in order to pay back taxes they owe.
Referring to the situation in the US, Mr Hedges told investors and journalists during a conference call last Wednesday: "This is potentially a very dangerous situation."
Hedge fund managers often defer taxes on fee income from offshore funds by reinvesting the fees back into the funds. This allows the money to compound tax-free until they repatriate the profits.
In the past, the IRS in the US went along with this practice, but it has come under increased scrutiny in the wake of accounting scandals at Enron Corp. and other US corporations.
Large scale redemptions by managers who come under investigation could hurt investors, who might be unable to withdraw their own investments from the fund. The funds' performance also could suffer if heavy sales push down the prices of illiquid holdings.
Mr Hedges said a wider clampdown on deferral of taxes on offshore income could impact some of biggest, most successful hedge funds managers, who would be forced to repatriate "hundreds of millions, if not billions of dollars" of their own interest in offshore funds.
However, US tax experts have noted that few such cases have actually come to light in the past few years, and in the recently reported case of III Offshore Advisors, which is understood to be disputing the IRS' position, it could be years before the firm has to pay back-taxes on deferred compensation, if ever.
The UK's Inland Revenue is also understood to be interested in hedge fund managers, rather than investors, focusing on the complex structures through which managers with offshore funds take their profits.