Domestic Hedge Funds

A domestic hedge fund is one that is organized within the United States. If the fund is organized in the U.S., all U.S. laws will apply. Domestic hedge funds are engineered to cater to U.S. investors who are liable for paying income taxes. They are structured as limited partnerships, with the general partner being the portfolio manager, and the qualified clients as the limited partners.

Offshore Hedge Funds

Funds structured under foreign law, or located outside the U.S. are designated as “offshore hedge funds”. The advantage of an offshore hedge fund is that the investors in the fund are not subject to United States taxation. Hedge fund managers typically launch offshore funds in the Caribbean, however a European/Asian offshore fund may be appropriate if a compelling number of investors are involved. Offshore Hedge Funds are not registered in the United States or with the SEC, and therefore provide privacy benefits as well as tax advantages. These offshore hedge funds are not subject to U.S. income on distributions received from the fund or to U.S. estate taxes on fund shares. Generally, offshore hedge funds are exempt from withholding taxes because the funds are located outside the United States. A lucrative reason for being offshore is that gains are either untaxed or very lightly taxed in the country where they were originated. With respect to the tax implications for the hedge fund manager, the manager may want the offshore fund to allow deferral of management and incentive fees. This will allow the manager to defer his or her fees for a specified period and allow them to accrue with the fund on a tax-deferred basis.

Because of the nature of the U.S. tax and securities laws, it is easy to discern that non-U.S. investors will not invest in hedge funds that are based in the United States. Many hedge fund managers do maintain both U.S. and non-U.S. components. Given the global complexity of the investment community, hedge fund managers want to have both types of investment vehicles so that they attract all kinds of investment dollars. The laws and regulations of the United States are directed not just to limiting the behavior of its citizens, but also to preventing money-laundering and other improper uses of offshore investment vehicles.