Tax blocker

Many tax-exempt U.S. investors want to avoid or limit their exposure to . To achieve this, they invest through non-U.S. entities that are classified as corporations for U.S. tax purposes. These entities are commonly known as .

A operates as a . This means that investors are treated as if they directly conducted the fund's UBTI-generating activities. In contrast, an offshore hedge fund intercepts such income at the fund level. This prevents the problematic income from flowing through to investors and being taxed at the individual investor level.

The Internal Revenue Code provides a statutory exemption from U.S. net income tax for non-U.S. persons, including offshore hedge funds. This exemption applies when these entities engage in securities, commodities, and related derivative transactions solely for their own account. This provision is often called a "."

However, if an offshore hedge fund fails to satisfy this safe harbor requirement, it may be deemed engaged in a U.S. trade or business. When this happens, the fund itself becomes the taxable entity subject to U.S. income tax, rather than its individual investors. Through this mechanism, the offshore hedge fund effectively blocks non-U.S. investors from being directly exposed to U.S. tax liability. Those investors continue to bear the economic burden of any taxes the fund pays, but they avoid direct tax obligations.

Tax-exempt U.S. investors benefit from the corporate tax structure because it allows them to earn income in a different form. Income that would otherwise be classified as UBTI—such as income derived from or fund operating activities—can instead be received as dividends or capital gains distributed by a foreign corporation. These dividends and capital gains typically do not pass through as UBTI.

However, this advantage can be partially offset by U.S. imposed on the distributions the offshore fund makes.

Offshore funds typically pursue one of two approaches to manage their tax obligations. They either restrict their activities to those encompassed within the safe harbor provisions, or they segregate investments that fall outside the safe harbor by directing them through corporate blocking entities.

Although certain securities investments related to real estate may not automatically disqualify a fund from safe harbor treatment, they may nonetheless generate . Therefore, careful structuring remains important even for seemingly routine investments.

An offshore fund that engages in dealer activities should consider establishing those activities through a separate corporate structure. This approach isolates such activities and shields the remainder of the fund's operations from full U.S. income and .

The statutory safe harbor described above does not extend to offshore funds engaged in dealer activity, regardless of where such activity is conducted. For tax purposes, a dealer is defined as an entity that systematically purchases and sells securities, stocks, commodities, or derivatives to end customers with the purpose of generating profit. This differs from entities that engage in such transactions as investment or speculative activities.

Offshore funds that acquire may find themselves holding interests in U.S. businesses following bankruptcy reorganizations. These interests may be held directly or through pass-through vehicles such as partnerships, limited liability companies, or trusts.

In such circumstances, strategic planning should be implemented to minimize the U.S. tax burden the offshore fund bears. One common approach involves channeling these investments through U.S. corporate blockers. An offshore fund that maintains an equity position in a pass-through entity actively engaged in U.S. business activities must file a U.S. federal tax return. This filing requirement applies even in scenarios where the entity does not allocate any effectively connected income to the fund.

An offshore fund that holds an equity interest in an entity classified as a partnership for U.S. tax purposes faces specific tax obligations. For example, if the fund invests in a , it is subject to U.S. taxation on its allocable portion of the partnership's effectively connected income, if any.

Additionally, gain realized on the sale or disposition of an interest in such a partnership is treated as effectively connected income. This includes withdrawals from the partnership. The income is treated this way to the extent the partnership would have allocated such income if the partnership had liquidated all assets at fair market value.