A hidden beneficiary from the border-adjustment tax could be hedge fund managers, who might see a savings of tens of billions of dollars a year, according to tax experts.
Here’s why hedge funds also could benefit: A large number are domiciled abroad — in places such as the Cayman Islands or Bermuda — with most of their investment professionals in the U.S. Under the new rules, which have not been finalized, both exported goods and services are expected to be exempt from taxation.
Because the investment professionals could be exporting their “service” of managing a portfolio to the foreign fund, they, too, would receive the benefit. Hedge fund fees, which were previously taxed as income at rates as high as 45 percent, could be exempt from taxation.
“Part or all of the services the managers render to a hedge fund I would expect to be exempt from U.S. taxes under the border-adjustment tax,” said Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, and a former tax lawyer advising financial institutions. “How large those services are depends on the drafting and how clever the investment managers are at restructuring their operations.”
Rosenthal said it is unlikely that the drafters of tax reform would enact a border-adjustment tax while exempting services, such as those rendered by hedge funds.
One way the government could decrease the benefit to hedge funds would be a so-called look-through test, he said. This would require the hedge funds to show the origin of ownership.
If a large portion of their limited partnerships are from the U.S., then the benefit would be muted. But if they are from outside of the U.S., then managers could receive quite a substantial tax exemption, he said.
The trick is that foreign-based hedge funds may be unwilling to turn over details to the U.S. government of who invests in their funds, and it may be difficult for the government to administer a look-through test on its own.
Either way, funds that are currently organized in the U.S. may seek to reorganize abroad to take advantage of the border-adjustment tax if the rules are written in a way that would benefit them.
“There will be a whole industry developing of tax experts advising people on how to manage their foreign source income and minimize their domestic source income,” said Robert Willens, an independent tax consultant.
Currently, most hedge funds are set up like partnerships and therefore pay about a 45 percent tax rate on much of the income they generate, he said.
“Income from rendering services which historically have been taxable, because of the fact that (they are) rendered to a foreign party, could be excluded,” Willens said of the potential border-adjustment tax proposal.
While many members of the House have indicated that a border-adjustment tax is likely, the exact rules have yet to be written. Lawmakers could still find a way to dilute the benefit the tax would have to hedge funds and other money managers, although it would be difficult to do, tax experts say.
“The axiom is the more detailed the rules, the easier they are to manipulate,” Willens said. “If as I’m expecting there will be very detailed and specific rules, the easier it will be to manipulate them.”