IRS Tells Auditors to Look at Loans by Offshore Funds

Date: Friday, September 25, 2009
Author: Ryan J. Donmoyer, Bloomberg

The Internal Revenue Service told its auditors in Manhattan to develop cases against offshore hedge funds and foreign companies it said are trying to avoid taxes on income from loans they make in the U.S.

The agency, in a Sept. 22 directive, urged the Manhattan field director of the IRS financial services section to pursue a transaction the agency says seeks to improperly take advantage of an otherwise legal tax break. The agency also urged the official to be watchful for similar techniques.

“We understand that foreign corporations and non-resident aliens may have used other strategies to originate loans in the United States, giving rise” to tax obligations, Steven Musher, the top lawyer in the IRS’s international department, wrote in a memo to Kathy Robbins, the Manhattan field director.

“We encourage you to develop these cases and we stand ready to assist you in the legal analysis,” Musher wrote.

It is unusual for IRS lawyers to recommend audit targets to field investigators, said Robert Willens, founder of Robert Willens LLC, which advises investors on accounting and tax rules.

The IRS is “obviously incensed about this and intends to pursue the strategy quite vigorously,” Willens said in an interview.

Hedge Fund Risks

The IRS memo signals new tax risks for hedge funds and foreign investors making and refinancing loans to Americans after the financial system crash, lawyer Roger Lorence, a partner at Sadis & Goldberg LLP in New York, said in an interview.

“Anything that doesn’t involve buying a loan in the secondary market is arguably affected by this IRS action,” said Lorence, who advised clients in a letter today to “consider their structure in light of the IRS’s conclusions.”

“Who knows how far they’ll go,” Lorence said.

IRS spokesman Bruce Friedland said Robbins and Musher weren’t immediately available for comment.

According to HedgeFund.net, a provider of information on the industry owned by Channel Capital Group Inc., assets in mostly U.S.-based hedge funds focused on lending totaled $15.6 billion worldwide at the end of February. Vice President Peter Laurelli said HedgeFund.net can’t quantify how much additional money is lent through other funds that don’t focus solely on lending.

Lorence said that amount may be more than $1 trillion. “There is a gigantic amount,” he said. Lorence called the IRS memorandum “very ominous” because it signals the agency is increasing activity in this area.

Broad Inquiry

The IRS said in November 2007 it had begun an inquiry into suspected tax abuses at hedge funds and private-equity firms. IRS Commissioner Douglas Shulman also has said he is redirecting enforcement resources to focus more on cross-border transactions.

Most hedge funds set up offshore corporations in the Cayman Islands or similar low-tax countries that don’t have full tax treaties with the U.S. to shield foreign and U.S.-based non- profit investors such as pension funds from taxes.

The law says these companies can buy and sell U.S. loans on the secondary market without triggering U.S. tax obligations. If they start originating loans within the U.S., the income they generate can trigger what the IRS calls “effectively connected income.”

This week’s memo described a scenario in which an overseas company, entirely owned by foreigners, hires a U.S. firm to solicit U.S. borrowers, negotiate terms, perform credit analyses and all other loan origination activities. Employees of the foreign-based company only approve the loans and sign the loan documents at the offshore location.

Final Approval

Musher, associate chief counsel in charge of international matters at the IRS, concluded in the memo that the foreign company can’t deny it made the loan in the U.S. Therefore, he wrote, the income from the loan creates an obligation to file tax returns and pay taxes. The memo didn’t identify any specific fund carrying out such transactions.

“The IRS said, ‘no, forget it, the agent is your agent, and the activities of the agent will be attributed to you,’” said Ken Werner, a partner at the New York law firm Richards, Kibbe & Orbe. Even so, he said the circumstances of other cases may be less clear.

“It sounds like they’re really going to start looking very hard at this whole area,” Werner said.

To contact the reporter on this story: Ryan Donmoyer in Washington at rdonmoyer@bloomberg.net