Tax Considerations for Sovereign Wealth Funds’ Investments in Hedge Funds (Part Two of Two)

Although sovereign wealth funds (SWFs) are an important source of capital for hedge funds, preservation of their preferential tax treatment under Section 892 of the Internal Revenue Code of 1986 can prove quite tedious for managers. Unless blockers and other intermediate vehicles are properly deployed, income from certain commercial investments can improperly flow through to SWFs. There is a catch, however, as those same intermediate vehicles can also inadvertently cause worse tax treatment for SWFs. Thus, managers need to walk a narrow and fraught line to optimize their funds for SWF investors. In a two-part guest series, Troutman Pepper attorneys Steven D. Bortnick and Morgan L. Klinzing outline material tax factors for hedge fund managers to weigh when structuring their funds for SWF investors. This second article analyzes risks that a fund’s commercial activities pose to the tax-exempt status of SWFs and certain structuring approaches that can be taken. The first article described the tax benefits, limitations and exemptions available to SWFs in the U.S. tax code. For more from Bortnick and Klinzing on tax issues, see our two-part series “How Recent and Proposed Interest Limitations Under Section 163 of the Internal Revenue Code Apply to Private Funds”: Part One (Apr. 14, 2022); and Part Two (Apr. 21, 2022).

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