Hedge Fund Managers Using “Mini-Master Funds” to Retain Favorable Tax Treatment of Performance-Based Revenue from Offshore Funds

With the passage last year of legislation eliminating the ability of U.S. hedge fund managers to defer taxes on fee income from their offshore funds, managers are increasingly employing so-called “mini-master funds” to obtain a different kind of favorable tax treatment for the same revenue.  Traditionally, in a master-feeder structure, managers would enter into an investment management agreement with the offshore fund, which in turn would invest substantially all of its assets (from non-U.S. and U.S. tax-exempt investors) in a master fund.  The investment manager would charge the offshore fund a “performance fee” of 20 percent of the gains on its investment in the master fund.  Before last year, managers were able to defer tax on the performance fee by reinvesting it in the offshore fund.  However, Internal Revenue Code Section 457A, adopted as part of the Emergency Economic Stabilization Act of 2008, disallows such fee deferrals and requires hedge fund managers to take all existing deferrals into income by 2017.  Mini-master funds seek to circumvent this rule by converting the performance “fee” into a performance “allocation.”  We explain precisely how mini-masters can accomplish this, and in the course of our discussion explore traditional fee deferrals, the operation of Section 457A, the tax effect of mini-masters, jurisdictional issues and what proposals relating to the taxation of carried interest may mean for the continued utility of mini-masters.  See “IRS Releases Further Guidance Affecting Offshore Hedge Fund And Other Pooled Investment Vehicle Deferrals,” Hedge Fund Law Report, Vol. 2, No. 6 (Feb. 12, 2009).

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