As discussed in an article last week’s issue of the Hedge Fund Law Report, life settlements offer hedge funds an uncorrelated investment category in an era when even assets heretofore considered uncorrelated have fallen in unison. That article, the first in a three-part series, provided a detailed overview of the primary legal and business considerations applicable to hedge funds when investing in life settlements. See “Hedge Funds Turning to Life Settlements for Absolute, Uncorrelated Returns
,” Hedge Fund Law Report, Vol. 2, No. 39 (Oct. 1, 2009). As in any investment, tax can have a profound effect on the economic return of life settlement investments. Accordingly, this article, the second in the three-part series, focuses on the tax considerations relevant to hedge funds, hedge fund managers and hedge fund investors in connection with investments in life settlements, including: taxation of life settlements (including income versus capital gains treatment of the “gain” on life settlements); varying tax consequences for domestic and offshore hedge funds and hedge fund investors; the impact of recent Internal Revenue Service (IRS) Revenue Rulings on the tax consequences of life settlement investments; relevant tax rules for offshore hedge funds (including “limitation of benefits” provisions, treaties, “effectively connected income” considerations, relevance of the jurisdictions of investors and “anti-avoidance” rules); the special cases of Ireland and Luxembourg, and the “double taxation” treaties between those jurisdictions, on the one hand, and the U.S., on the other hand (and the absence of such treaties between the U.S. and other jurisdictions, notably the Cayman Islands); the utility of the UCITS structure for investing in life settlements; tax consequences of premium financing arrangements; and the future of life settlement taxation in light of certain items in President Obama’s proposed budget. Part three in this series will focus in more depth on securitization of life settlements.