US Taxes to Offshore Funds on Credit Derivatives?

An interesting Article  * appeared in today's WSJ dealing with the uncertain tax consequences to offshore funds purchasing credit swap derivatives in the secondary markets. At stake is whether non-US investors in the funds, or in some cases the funds themselves, are liable for US taxes on any profits from the transactions.

This is an area of extreme tax law technical difficulty (kind of like a double diamond ski trail). Technically, and to simplify greatly at the risk of some inaccuracy, the issue is whether such offshore hedge funds can (i) avail themselves of the Code Section 862(b)(2) safe harbor from US taxation (for non-US persons) by characterizing credit swap derivative transactions as trades in a security  or (ii) whether the bogeyman of Reg 1.864-4(c)(5) steps in to make such transactions a US taxable event as the conduct of a US lending business by the hedge funds. A lot of complex case law is also out there on this issue which also helps to make this area technically tough going indeed.

However, even after I considered what I had learned of the "law", my knee jerk reaction was to wonder how, as a matter of fact, the purchase of a credit swap on  secondary markets could be anything other than a securities trade by the offshore hedge fund. It turns out that I needed to learn (or relearn) a little bit about how credit markets function in this day and age.

The old days when your friendly banker made you a loan (e.g your home mortgage) and then held on to it for 30 years to collect as you repaid over time are long gone. Your friendly banker doesn't hold your paper for (likely) more than a day or two after closing. Instead, it gets bundled off (with a bunch of other loans) into a security which is sold by your friendly banker into  secondary credit markets.

Financial institution loans to big borrowers (like public companies) often work the same way. In fact, from day one before the loan is even made there may well be a loan syndicate consisting of  a lead lender and a number of other financial institutions. Eventually (hopefully) terms are agreed upon, the  loan closes, and thereafter the syndicate may unload a lot (or all) of the loan paper in the "secondary market" to purchasers via loan swap agreements. Often, very big players (read purchasers) in this secondary market are offshore hedge funds.

Put differently, in home mortgages and corporate loans, banks don't really lend any more. So where does this leave the answer to the  question, for example, of who is originating the loan or at least for whom is the loan being originated?

Arguably, in many cases, the answer is the hedge funds who are sucking up the paper in the secondary markets.

It may be, for example, that the hedge fund is on a banking syndicate's "speed dial" because it is a "regular" in the secondary market and stands ready to buy loans that the syndicate wants to unload quickly. Some hedge funds (at least historically) have been alleged to do as many as 5 of these deals a month - and likely not for pocket change.

Stated in broad terms, in such cases, the banker and syndicates can be viewed as shilling these loans for the hedge funds. If so, that may well put the offshore funds involved into taxable territory on these transactions - i.e. for being in the lending business.

Indeed, I have read that - in 2005 - 20% of the secondary market for credit derivatives was hedge funds. So,  it would seem beyond peradventure that the syndicates are designing these loans and their derivatives with hedge funds in mind. Hedge funds are also regular players in the markets for collateralized debt obligations which are derivatives backed by credit derivatives.

There is more, much more, that can be mentioned if not endorsed. For example, nasty things have been written about incestuous relationships between banks and hedge funds. There are even things said (nothing I have seen substantiated) about possible abuse (e.g for arbitrage) of insider information the funds get from being "creditors" via the swap arrangements. 

Certainly,  I would be surprised to see if a rule is made extending "securities" treatment (and hence a pass from US tax) to all of these credit derivative transactions engaged in by offshore funds. However, anything can happen. In the meantime, this is going to be an area where uncertainty rules.

*My thanks to the author of WSJ article who was kind enough to direct me to some of her source material. Any mistakes in this post are mine not hers.

Comments

[rob]

I think you will see more of the same type of thinking when it comes to offshore banking, offshore corporations, offshore foundations, offshore stock brokerage accounts etc.