Many hedge funds set up subsidiaries in the Cayman Islands and other low-tax locales so their investors can pay lower taxes on a certain amount of their activity. Hedge funds lobbying with stealth

Sometimes in Washington, stealth is more important than strength.

In recent years, hedge fund managers, who oversee those secretive and lightly regulated pools of billions of dollars of investment capital, have gotten increasingly worried about whether Washington will change tax rules for offshore investors.


Many hedge funds set up subsidiaries in the Cayman Islands and other low-tax locales so their investors can pay lower taxes on a certain amount of their activity. If Congress were to make a grab for that money by changing the tax rules governing the hedge funds, it could generate hundreds of millions of dollars in new taxes at the hedge funds’ expense.

Adding to their anxiety is the prospect of an unfriendly Barack Obama administration taking office in January and working in league with its Democratic allies on Capitol Hill. Lobbyists working for hedge funds feel a sense of increasing urgency to make progress now, while more sympathetic Republicans control the White House.

But how to argue their point in Washington? Typically, lobbyists would mount a large public relations campaign and aggressively push their message on the Hill. But it could be a tough political sell for often unpopular billionaire hedge fund executives to mount a high-visibility campaign to keep tax breaks in the Cayman Islands.

So instead, the Managed Fund Association, which represents hedge funds, is taking a different tack. It’s quietly pushing for a tax ruling from the Internal Revenue Service and the Treasury Department that many feel could lay an important behind-the-scenes precedent in the offshore tax fight. The ruling itself would affect the ability of offshore funds to buy distressed debt in the United States.

Another reason hedge fund lobbyists are so eagerly anticipating the ruling: “This is a canary in the coal mine,” said one lobbyist who represents hedge funds. “They figure they can get a better answer this year, as opposed to next year with either an Obama or a [John] McCain administration,” he added.

For now, their focus is on the short-term objective. In April, the MFA sent a letter to the IRS and the Treasury Department asking for written guidance on whether offshore hedge funds can negotiate with U.S. debtors without having to pay U.S. taxes at the corporate rate.

Generally, offshore entities are allowed to buy and sell U.S. securities without becoming a “U.S. trade or business” under the tax code and thus becoming subject to U.S. taxes at the corporate rate. That’s a well-established principle.

But a new gray area has emerged as offshore investors become more interested in purchasing distressed debt such as subprime mortgages, credit card debt and car loans from the current holders, such as mortgage lenders, credit card companies and auto lenders. In theory, this can be a lucrative move if the debt is sold cheaply enough, and the hedge funds can negotiate profitable payment schedules from the debtors. It could also be a good thing for the debtors, who would get a chance to restructure their payments around a reduced principal.

But would negotiating with homeowners or other debtors over revised financing terms cross the line from being a passive investor in U.S. assets to an active “trade or business” that must pay U.S. taxes at the corporate rate? The hedge fund lobby wants its members to be able to buy the debt, do the restructuring and still be considered “passive” investors for tax purposes.

The MFA, not surprisingly, argues that cutting such deals shouldn’t trigger U.S. tax liability. And what’s more, it argues that it’s in the national interest for foreign investors to be allowed to buy distressed U.S. debts and negotiate with the debtors — which could provide a way out for thousands of subprime mortgage holders under reduced payment terms.

“MFA and its members strongly believe that non-U.S. investors would be more likely to provide significant additional liquidity for distressed debt” if the administration issues written guidance, the trade association said in its letter.

What’s got the hedge fund representatives particularly on edge is that a decision could come at any time. Because there’s not likely to be a formal rule-making, only informal written guidance, there may not be any public meetings, comment periods or other activity in advance of a decision. There’s also no guarantee that President Bush’s administration will take any action at all this year.

“We’re not going to comment on whether or not we’re going to issue any guidance in this area,” said Treasury spokesman Andrew DeSouza. An IRS spokesman did not return calls for comment.

If a ruling does come, some hedge fund managers and their lobbyists plan to use it for long-term leverage into the other offshore taxation issues that will likely come up for debate again next year.

At stake for the hedge funds could be their use of certain so-called blocker entities structured to avoid U.S. taxes. Many funds set up offshore corporations in low-tax locales such as the Cayman Islands or Bermuda in order to lure investment capital from foreign investors and tax-exempt U.S. entities such as pension funds and foundations.

If nonprofit investors invested directly in the hedge funds themselves, rather than through their offshore blockers, they would have to pay what’s known as unrealized business tax. By using the offshore corporation, though, they avoid paying that levy.

Keeping the blocker setup legal is vitally important to hedge fund managers, who count on the enormous pension funds and nonprofit foundations for a significant chunk of the capital they invest. Any tax change that threatened that flow of cash could be disastrous for them.

It’s widely expected that the blockers will come under scrutiny next year, because eliminating them could be one way to raise an enormous amount of tax revenue for the government to pay for expensive initiatives or other tax cuts proposed by the new administration.

Both the House and Senate tax-writing committees have held hearings on offshore hedge fund tax issues within the past year. In such a public forum, the advocates of offshore blockers know that they’re not easy to defend, and they fear that a high-profile fight over offshore tax breaks that benefit hedge fund billionaires is bound to be politically difficult.