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Special Considerations -- Tax Audit Risk Shifts for Passive Foreign Investment Company ("PFIC") Shareholders
US Tax-exempts and Foreign Domiciled Shareholders of Hedge Fund Foreign Feeder Companies owning master hedge funds have special tax concerns because certain contingent U.S. tax risks follow the company not the shareholder. In certain important circumstances such as where the foreign feeder owns a master fund and the master fund is determined by the IRS to be conducting a U.S. trade or business, all of the assets of the PFIC can be at risk to the unpaid U.S. tax.
Therefore, when a foreign feeder shareholder is redeemed the company retains certain contingent tax liability. For example, if two years after the fact the IRS determined that the Hedge Fund Master Fund was previously engaged in a US Trade or Business without filing a US tax return or paying any US tax a gross income tax the IRS would assess tax interst and any penalties against the Hedge Fund Master Fund.
Any shareholder redeeming shares after the year of the tax audit event but before the IRS audit problem was discovered by the Hedge Fund Foreign Feeder Company would have redeemed without having to share in the IRS tax audit liability or legal fees.
So who pays the tax bill to the IRS? Answer the remaining shareholders in the Hedge Fund Foreign Feeder will suffer the net asset reduction when the Hedge Fund Master Fund
pays the IRS.
Lesson to US Tax-exempts and Foreign Domiciled Shareholders of Hedge Fund Foreign Feeder Companies:
BE AWARE OF CONTINGENT TAX RISK!
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