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In general, U.S. taxable investors (hereinafter stated as “U.S. investors”) invest in a hedge fund through a U.S. partnership. However, for various reasons, such investors may invest in a hedge fund through a foreign partnership. Recently, one of my clients asked if there is any tax implication for investing through a foreign partnership. I briefly summarized the following administrative issues you may encounter if you invest through a foreign partnership instead of a U.S. partnership.
Investing in a U.S. Partnership Could Lessen the Tax Compliance Burden if There are Many Foreign Informational Filings
For example, there could be situations in which U.S. investors indirectly invest in various Passive Foreign Investment Companies (“PFICs”) through a foreign partnership. Since a foreign partnership cannot make PFIC elections on behalf of its partners, such as the Qualified Electing Fund (“QEF”) election, (only a U.S. shareholder can make such elections), such U.S. investors would need to file Form 8621s for the indirect ownership of the PFIC investments and make any necessary elections.
In general, if such PFIC investments were held through a U.S. partnership, the U.S. partnership could make the election on behalf of its partners, such as the QEF election, and file the Forms 8621 at the partnership level, thus alleviating the filing by each underlying investor.
In most situations, the same would hold true regarding the filing of Form 5471. If investments in foreign corporations were held through a U.S. partnership, in most cases the U.S. partnership could file the Form 5471 on behalf of their investors. U.S. investors need to file Form 5471 when they make an investment in a foreign corporation (including a PFIC) and meet certain filing requirements (i.e. in brief, if you have 10% or more interest in a controlled foreign corporation, acquire at least a 10% interest in a foreign corporation, or dispose of a corporate interest that reduces shareholdings to below 10%).
Investment in a foreign partnership would also cause the potential filing of Form 8865. There are four categories of filers and most investors who invest in a foreign partnership fall under category 3. Category 3 is one in which the investor has contributed to a foreign partnership more than $100,000 or has owned, directly or constructively, at least 10% interest in the foreign partnership immediately after the contribution. If the foreign partnership has ownership in other underlying foreign partnerships, you may have additional filings on Form 8865 for your indirect ownership in such foreign partnership. If you invest indirectly in a foreign partnership through a U.S. partnership, in most cases, the U.S. partnership could file the Form 8865 on their investors’ behalf.
Additional filings under Form 8938 (Specified Foreign Financial Asset Reporting) may need disclosure as well if U.S. investors hold an interest directly in a foreign partnership and the aggregate value of the interest in the foreign partnership “that is specified foreign financial assets” exceeds $100,000 on the last day of the tax year or more than $150,000 at any time during the tax year for married taxpayers filing a joint income tax return for the 2016 tax year.
Duplicative Reporting: Prime Brokers (“brokers”) May Issue Forms 1099 to U.S. Investors Directly if the U.S. Investors Invest through a Foreign Partnership
A foreign partnership will need to provide to brokers or banks a Form W-8 IMY with Form W-9 or W-8 attachments and a withholding statement as to how the income should be allocated to each investor.
There appears to be an issue when U.S. persons are invested in a foreign partnership as brokers or banks are looking through to the U.S. investor and issuing a Form 1099 directly to such U.S. investors.
This could result in duplicative reporting as the income is reported on the Schedule K-1 and would be reported again on Forms 1099. The amounts on the Schedules K-1 may also not reconcile to the Forms 1099 due to tax adjustments and tax allocation differences at the foreign partnership level.
As such, it is important to review the subscription documentation and private place memorandums to understand the tax filing implications of investing through a foreign partnership before you make an investment decision.