The Internal Revenue Service has released an internal memorandum indicating that it will give close audit scrutiny to offshore hedge funds that engage in lending activities with U.S. residents. A number of hedge funds have relocated to the U.S. Virgin Islands to take advantage of the Territory’s Economic Development Commission (EDC) Program which exempts such funds from 90% of the federal income tax liability. Although owner of EDC beneficiary companies can similarly exempt their income from the company from federal income tax if they are Virgin Islands residents, past practice has led to the hedge funds providing loans to owners who are not Virgin Islands residents.
Hedge funds that engage in direct or indirect lending activities involving U.S. borrowers are impacted by this IRS action and should immediately review their lending practices in light of the IRS’s indication that it will pursue vigorous enforcement in this area.
The IRS is specifically targeting offshore hedge funds and foreign corporations that, instead of purchasing loans on the secondary market, hire a U.S. company to solicit U.S. borrowers, negotiate terms, perform credit analyses and other loan origination activities. In such situations, the IRS is inclined to regard the U.S. firm soliciting borrowers as an agent of the offshore hedge fund, regardless of whether the U.S. firm is an independent contractor or has authority to conclude contracts on behalf of the hedge fund.
On this basis, the memorandum concludes that the agent’s lending activities (and U.S. office) are attributed to the hedge fund and cause the hedge fund to be conducting a U.S. trade or business. Accordingly, under these circumstances, the interest income earned by the offshore hedge fund from U.S. borrowers is considered income which is effectively connected with a U.S. trade or business, and this triggers a U.S. tax filing obligation on the part of the hedge fund. The memorandum did not specify that it would be reviewing U.S. Virgin Islands hedge funds in particular.
Top international IRS officials, however, are encouraging examining field agents to diligently identify and scrutinize these transactions and have offered full support of the IRS national office in developing such cases.