Offshore fund

Offshore funds are usually set up in jurisdictions with no taxes or very low taxes, such as the Cayman Islands or Bermuda. For U.S. tax purposes, these funds are treated as corporations rather than partnerships. The main investors in offshore funds are people and organizations from outside the United States, as well as U.S. organizations that are exempt from taxes, like pension fundsRetirement benefit plans established by employers to provide income to employees after retirement, typically qualifying as tax-exempt organizations. and endowmentsInvestment funds established by institutions such as universities or nonprofits to provide ongoing financial support for their operations..

Non-U.S. investors benefit from this corporate structure because of how certain types of income are taxed. When the fund earns income that is "effectively connected" to U.S. business activities, that income gets taxed at the fund level rather than being passed through to individual investors. This arrangement helps non-U.S. persons avoid becoming U.S. taxpayers or having to file U.S. tax returns. However, most offshore funds still try to minimize this type of income whenever possible.

Tax-exempt U.S. investors, such as pension funds and university endowments, also find the corporate tax structure beneficial. Normally, these organizations would face "unrelated business taxable income Unrelated business taxable income (UBTI) Unrelated business taxable income (UBTI) is income that tax-exempt organizations earn from business activities unrelated to their exempt purpose. When tax-exempt organizations invest in hedge funds, certain fund activities can create UBTI, making these otherwise tax-exempt investors subject to taxation. " (UBTI) on certain types of investment returns. UBTI includes income from debt-financed investments or the fund's general operating activities, and it would typically be taxable for these otherwise tax-exempt entities.

However, when they invest through an offshore fund structured as a corporation, this income usually comes to them in the form of dividends or capital gainsProfits realized from the sale of capital assets, typically taxed at preferential rates compared to ordinary income. from a foreign corporation. This different form of income generally does not count as UBTI, helping these organizations maintain their tax-exempt status. The main drawback is that the offshore fund may still owe U.S. withholding taxesTaxes deducted from payments at the source, particularly relevant for foreign investors or entities receiving U.S.-sourced income., which can reduce the overall benefit.

In a master-feeder structure, the master fund—the central fund that actually makes the investments—is typically formed as an offshore corporation or limited partnership in the same jurisdiction as the offshore feeder fund. Fund managers usually prefer using an offshore master fund rather than a U.S.-based one for practical reasons.

If the master fund were located in the United States, it would need to examine all the underlying investors in any offshore feeder funds. This means every single investor would need to meet U.S. accredited investor Accredited investor An accredited investor refers to an individual or entity that meets specific financial thresholds set by securities regulations, qualifying them to invest in unregistered securities offerings such as hedge funds, with standards including minimum income or net worth requirements. standards and potentially even higher "qualified purchaser Qualified purchaser Qualified purchasers are investors who meet specific wealth thresholds under the Investment Company Act of 1940. These investors are required for participation in Section 3(c)(7) funds. Generally, individuals must own at least $5 million in investments, while institutions must own at least $25 million in investments. " requirements. These standards are rarely required for typical offshore hedge fund investors, making this approach impractical for most international structures.

Despite being organized as a corporation, an offshore master fund typically chooses to be classified as a partnership for U.S. federal tax purposes. This election affects how income and losses are allocated among investors.

Here's how the investment process works: When investors put money into the feeder funds Feeder fund A feeder fund is a type of investment fund that collects money from investors and then invests nearly all of that money into a larger "master fund." This structure allows different types of investors—such as U.S. taxpayers, tax-exempt organizations, and foreign investors—to all participate in the same investment strategy while using the fund structure that works best for their specific tax and regulatory needs. , those feeder funds then contribute the money to the master fund in exchange for ownership interests. Each feeder fund receives an ownership percentage in the master fund that matches the amount they contributed. The investment manager then runs one unified investment strategy through the master fund.

In some cases, the feeder funds may have the ability to make their own separate investments if this would be beneficial for tax or other reasons. However, some structures are "hardwired," meaning the feeder funds can only invest through the master fund and cannot make independent investments.

Most offshore funds are organized as corporations in the Cayman Islands and operate under documents called "memoranda and articles of association." The corporate structure provides limited liability protection for shareholders, similar to how a regular corporation works.

These funds are managed by a board of directors. Most board members are independent directorsA board member who has no material relationship with the fund or its affiliates beyond their directorship. who are not affiliated with the investment manager. These independent directors are often hired through specialized service providers located in the fund's jurisdiction. This independent oversight helps protect investor interests and meets regulatory requirements.

In the Cayman Islands, which is a popular location for master funds, most master fund limited partnerships must register with the Cayman Islands Monetary AuthorityThe financial services regulator for the Cayman Islands that oversees and regulates financial institutions and investment funds operating in the jurisdiction.. This registration subjects them to additional regulatory oversight and compliance requirements beyond basic corporate law.

Master funds that invest in "new issues"—newly issued securities as defined by FINRA (Financial Industry Regulatory Authority) rules—face additional complications. The investment manager must calculate how much new issues income each feeder fund can receive. This calculation requires looking through to the actual investors in each feeder fund and determining what percentage of those underlying investors are restricted from receiving such income under securities regulations.

The master-feeder structure itself creates other complexities. It requires additional legal documentation and higher setup costs compared to simpler fund structures. The investment manager must also ensure that both the master fund and each feeder fund maintain their regulatory exemptions under the Investment Company Act Investment Company Act of 1940 The Investment Company Act of 1940 is a U.S. law that regulates companies whose main business involves investing in securities. Hedge funds typically use special exemptions under Sections 3(c)(1) or 3(c)(7) to avoid having to register under this law, which allows them to maintain the flexibility they need for their investment strategies and fee structures. . These exemptions—known as 3(c)(1) or 3(c)(7) exemptions—allow the funds to operate without registering as investment companiesInvestment companies registered with the SEC under the Investment Company Act of 1940, such as mutual funds., but they come with specific investor limits and qualification requirements that must be carefully monitored.