Rich, offshore, taxable?

Now that lucrative tax break may be endangered by legislation moving through Congress.

Ironically, in an era when offshore-tax crackdowns are hot topics in Washington, no politician appears to have been intentionally targeting this lucrative Wall Street perk. The potential threat to this little-known tax play seems to be pure accident.

In July the Senate Finance Committee unanimously approved a bill that would strengthen pension protections for workers. The National Employee Savings and Trust Equity Guarantee Act, or Nesteg, proposed in February by Republican Senator Charles Grassley of Iowa, is primarily designed to prevent the type of catastrophic pension losses suffered by Enron employees.

But tucked into the bill are provisions that would limit the ability of U.S. executives to defer income if those assets are held in trusts or in other arrangements located outside the U.S. In part, the sponsors are trying to prevent wealthy corporate officials from putting sizable pension holdings beyond the reach of any possible future creditors by moving the money offshore.

For many of the largest U.S. hedge fund managers, however, the broad language of the bill is potentially monumental. "It's the equivalent of dynamite," says an executive at one hedge fund group. "It is huge."

Here's why. Hedge fund managers receive most of their compensation from performance fees, usually 20 percent of the profits they generate for investors. Managers earn those fees every year, but they typically avoid paying personal taxes on the income for up to ten years by arranging to automatically reinvest their fees back into their offshore funds. As a result, managers can attempt to compound their personal income tax-free for years. Some individual managers have deferred hundreds of millions of dollars in performance fees -- essentially personal income -- in just one year. Thus, some of the largest U.S. fortunes in the financial services industry these days are parked offshore. "The money involved is clearly in the billions," says offshore hedge fund expert Antoine Bernheim. "There are individual managers who have deferrals that exceed $100 million or $200 million."

It is perfectly legal for anyone to defer income for tax purposes. In practice, the technique is a much bigger bonanza for hedge fund managers, who operate in the U.S. but run money in offshore funds, than it is for most U.S. citizens. When a U.S. brokerage firm defers income for its employees, company shareholders must essentially shoulder the employees' immediate tax bills. But if a U.S. hedge fund manager defers income, no one picks up the tab, because the fund's limited partners -- foreign investors or tax-exempt U.S. institutions -- don't pay U.S. taxes.

Some tax experts insist that the Senate Finance provision, while coming close to covering the hedge fund deferral technique, would only prohibit deferrals that use a specialized structure called a "rabbi trust," which creates additional protections for deferred income. (The first such trust was created for a rabbi by his congregation.) But several tax lawyers say that until Treasury writes specific regulations on this issue, as mandated by the legislation, the fate of these hedge fund deferral arrangements will remain in limbo. More generally, hedge fund and tax experts worry that as these hedge fund arrangements become better known, they will become a tempting target for tax writers. Says a manager at a large hedge fund organization, "The industry always figured it would get killed one day."

And ongoing revelations about how scandal-tainted companies like Enron used offshore arrangements to avoid taxes and boost income, coupled with the patriotic backlash against U.S. companies that reincorporate in Bermuda to cut their U.S. taxes will certainly make lobbying on the new rules tricky. "The legislation is not directly aimed at hedge funds," says Catherine Creech, an attorney with Washington-based Davis & Harman. "But I believe that congressional staffers have become aware of the deferred compensation arrangements hedge funds use. And anything that is offshore has a negative implication to it these days."