Investor demand for exposure to lending strategies continues unabated, as allocators seek investment strategies with attractive yields and lower correlation to the broader markets. Much of the demand comes from pension plans and foreign institutions, which often seek to invest through offshore funds. However, an offshore fund originating loans to U.S. companies runs the risk of being deemed to be engaged in a trade or business in the U.S., thus potentially subjecting its investors to an effective tax rate of more than 50 percent. See “IRS Memo Analyzes Whether Offshore Fund That Engaged in Underwriting and Lending Activities in the U.S. Through an Investment Manager Was Engaged in a ‘Trade or Business’ in the U.S. and Subject to U.S. Income Tax
” (Jan. 29, 2015). To mitigate this risk, hedge fund managers have taken advantage of various strategies and structures. This article, the second in a three-part series, examines how direct lending can constitute engaging in a “U.S. trade or business” and explores options available to minimize this risk to investors in an offshore fund. The first article
discussed the prevalence of hedge fund lending to U.S. companies and the primary tax considerations for hedge fund investors associated with direct lending. The third
article will provide an overview of the regulatory environment surrounding direct lending and a discussion of the common terms applicable to direct lending funds. See also “Key Tax Issues Facing Offshore Hedge Funds: FDAPI, ECI, FIRPTA, the Portfolio Interest Exemption and ‘Season and Sell’ Techniques
” (Jan. 22, 2015).