Feb

2013 20

A growing trend in tax avoidance is the practice of hedge funds setting up reinsurance companies in Bermuda, funneling money to the tax haven and then back to the states. This takes advantage of an IRS loophole the agency knows needs to be closed but has been reluctant to act on.

This gaping hole in our tax code is being newly publicized this week with the discovery that $450 million belonging to top executives of the New York firm run by hedge fund manager John Paulson took a round trip to the tropical paradise last year alone.

In April, the executives sent the money to a reinsurance company that they’d set up on the island 650 miles off the North Carolina coast. By June, the Bermuda company, which has no employees and sells far less reinsurance than the industry norm, had sent all the cash back to New York, to be invested in Paulson & Co. funds.

By recycling the funds through Bermuda-based Pacre Ltd., the Paulson executives are positioned to legally exploit a little-known tax loophole, reduce their personal income taxes and delay paying the bill for years.

“These types of reinsurance companies are permitting U.S. taxpayers to defer — indefinitely — U.S. tax,” said David S. Miller, a tax lawyer at Cadwalader Wickersham & Taft LLP. For some, he said, it’s “an unjustified benefit.”

Over a decade ago, the IRS threatened to crack down on tax abuses in the hedge fund industry but nothing has materialized. Today, hedge fund managers are exploiting the system to new degrees to avoid paying the agency rightful rates. Bloomberg explains how the Bermuda-based reinsurance companies are getting around the IRS:

By setting up reinsurance companies there, money managers can take advantage of a loophole in IRS rules. Ordinarily, when hedge fund managers invest in their funds, they pay either the 39.6 percent rate for ordinary income or the 20 percent long- term capital gains rate, depending on how frequently securities are traded, plus an extra 3.8 percent health-law surcharge. If they were to move the hedge funds to tax havens, they would incur IRS penalties on earnings from what the agency calls “passive foreign investment companies.”

Here’s the catch: The IRS doesn’t penalize earnings from insurance companies, which it considers to be “active” businesses. As a result, by routing money through a Bermuda reinsurer, which in turn puts its assets back into their own hedge funds, fund managers can defer any taxes until selling the stake. They then pay only the lower capital gains tax rate.

In the meantime, the money grows tax-free, and the savings add up. Investing $100 million in a hedge fund that returns 15 percent annually, and paying the top marginal ordinary income rate on profit, results in a $50 million profit after taxes after five years. If the investment is taxed like a Bermuda reinsurer, the gain is $77 million.

Read more on tax avoidance by hedge fund managers in Zachary Mider’s article.