Hedge funds are generally entities that are managed by investment managers, in accordance with certain investment strategies, in order to invest in financial assets and generate returns for the hedge funds’ investors.
The common and usual formation structure for hedge funds is a limited partnership. The partnership is comprised of a general partner and limited partners, with the fund’s general partner responsible for managing the fund and executing its investment strategy and the fund’s limited partners being passive investors. The general partner, who is, as noted, the dominant party in the fund, is compensated through management fees and carried interest, and the limited partners simply benefit from the fund’s investments’ proceeds, less the afore-mentioned management fees and carried interest paid to the general partner.
From a tax perspective, a classic hedge fund, by virtue of its formation as a partnership, constitutes a transparent entity for tax purposes. This means that the fund’s profits are taxed at the partners’ level. (A taxable non-transparent hedge fund also exists under Israeli tax law, but is less common.) Consequently, funds’ partners have certain concerns as to the manner their profits and losses will be treated under the applicable tax regime.
In light of these concerns, the Israel Tax Authority (ITA), upon the request of the fund and its investors, issues tax rulings in order to set clear taxation guidelines and provide certainty for fund investors as to their applicable tax rates and the timing of their respective tax liability. Such tax rulings apply to both Israeli hedge funds and foreign hedge funds that are managed and controlled from Israel and they state as to each such hedge fund, among other matters, that:
- The fund shall be exempt from Israeli income tax and the tax liability is borne by the partners;
- The fund’s activity, in and of itself, shall not cause the limited partners’ income to be regarded as business income, and instead such income is regarded as capital income (which benefits from a lower tax rate);
- The fund’s income shall be exempt from tax withholding;
- The foreign-resident limited partners will not be required to report their income in Israel and file income tax returns to the ITA due to their investment in the fund;
- The tax rate for a limited partner who is an Israeli resident shall be 25% (as of January 1, 2019) (this is subject to the conditions set in the tax ruling, including a nine months lock-up period condition);
- An exemption for withholding tax for a limited partner who is a foreign resident for income that were it received by him directly would be tax exempt (subject to the application of tax treaties and providing the conditions set in the tax ruling are met), whereas other income of such foreign resident shall be subject to withholding tax at a rate of 25%;
- The timing of the tax liability for limited partners shall be:
- As for the fund’s ongoing proceeds – at the end of the tax year, on an accrual basis, even without a realization event occurring; and
- As for redemption proceeds, distribution proceeds and liquidation proceeds – at the time of the realization event.
It is important to understand the serious tax implications that arise from these tax rulings:
- The Timing of the Tax Event in the case of the Ongoing Proceeds of the Fund: While the taxation of capital gains of direct investments in securities (or investments through an exempt mutual fund) is based on the principle of realization, i.e. the tax event occurs only when the security is realized (e.g., sold or redeemed), in a hedge fund covered by these tax rulings, this principle does not apply and a limited partner is liable for tax on its share of the ongoing proceeds of the fund at the end of each tax year on an accrual basis. As a result, a hedge fund investor may be liable for capital gains tax at the end of each year due to the increase of value of the hedge fund, even if the investor did not realize (i.e. sell or redeem) any of the hedge fund’s interests during that tax year and/or the fund did not realize any of its investment! This would require the investor to pay out-of-pocket to fund such capital gains taxes (unless the fund manager decided to distribute monies to investors in order to fund the tax liability payment), which, prima facie, constitutes a taxation disadvantage.
In these coronavirus times, there is another aspect to this tax result, which may be viewed as the silver lining of the “coronavirus cloud”: just as taxation on an accrual basis may result in a tax liability for the investor without a realization event (e.g., a sale or redemption of interests), so too during tax years in which the fund’s investments lose value and the value of the hedge fund decreases, as is generally the case now with the coronavirus crisis, taxation on an accrual basis may create a tax “benefit” for investors. If hedge funds end the current year with decreased net asset values, their investors would be entitled to have such decreases recognized as capital losses for tax purposes and would be able to offset such losses against their capital gains during this year or during the following years, without the need to realize (e.g. sell or redeem) their interests in the hedge funds. (However, foreign-resident investors who benefit from tax-exempt status as to their income from hedge funds’ profits are of course not permitted to recognize such losses for tax purposes in Israel.)
- Lowering the Tax Rate for Israeli Hedge Fund Investors: Though more than a year has passed since the lowering of the tax rate applicable to capital gains for Israeli investors (limited partners) in hedge funds, this point is important and warrants mention here. Until the end of 2018, the tax rate paid by Israeli limited partners for capital gains in Israeli hedge funds (or foreign hedge funds managed in Israel) was set at 30% (rather than the 25% capital gains tax rate regularly applied to the sale of securities listed on the stock exchange by “non-material” shareholders holding such securities directly). The reason for this different tax rate was that due to the nature of hedge funds’ activities, the ITA viewed investors as seeking to offset their financing expenses against their income from the sale of securities and therefore, according to the ITA, should be taxed on their profits at the higher tax rate 30%.
In December 2018, the ITA resolved to lower the tax rate on capital gains of Israeli limited partners in Israeli hedge funds (or foreign hedge funds managed from Israel) from 30% to 25%. (This became effective as of January 1, 2019.) This amendment corrected the absurd situation in which the tax rate on hedge fund investors’ capital gains was greater than the tax rate on the capital gains of investors that invested directly in securities. However, the reduced rate of taxation for capital gains of 25% is still contingent upon the fund meeting certain conditions listed in the tax ruling, including that the fund must:
- avoid offsetting funding expenses for tax purposes;
- not execute short sales in the aggregate exceeding 130% of the net asset value of the fund; and
- not hold any equity position in a portfolio company representing 10% or more of the share capital of such portfolio company.
These conditions are in addition to meeting other conditions stated in the tax ruling, including the nine-month lock-up condition.
In sum, in order to avoid uncertainty arising from the possible consequences to both Israeli and foreign investors as a result of investing in Israeli hedge funds, Israeli hedge fund sponsors should consider applying to the Israel Tax Authority for a tax ruling, while exploring the possible ramifications of such application. Our firm’s capital market and taxation departments are of course available to serve and advise you as to these matters.