Non-U.S. hedge funds may be subject to two kinds of United States federal income taxes. Funds that are engaged in a U.S. trade or business are subject to U.S. federal income tax on their net income that is effectively connected with their U.S. trade or business. Funds that are not engaged in a U.S. trade or business are generally subject to a 30% tax imposed on gross payments of U.S.-source fixed, determinable, annual or periodic income (FDAP). Most offshore funds take precautions to ensure that they are not engaged in a U.S. trade or business. However, all funds that invest in U.S. debt and equity – as well as in derivatives that reference U.S. debt and equity – may be subject to withholding tax on FDAP. In this two-part series, John Kaufmann of Greenberg Traurig discusses certain ways in which final and temporary regulations recently promulgated under Internal Revenue Code Section 871(m) increase the scope of FDAP withholding, and lists traps for the unwary created by these regulations. This article addresses the current law and the issues that the new Section 871(m) regulations are intended to address. The second article
will explain the scope of the new regulations and the potential complications that they have created. For insight from Kaufmann’s colleague, Scott MacLeod, see “Tax, Structuring, Compliance and Operating Challenges Raised by Hedge Funds Offered Exclusively to Insurance Companies
” (Oct. 30, 2014).