Vexed issue of ethics: investing in hedge funds in tax havens

If the aim of Labor’s attack on Prime Minister Malcolm Turnbull and his wife Lucy for using hedge funds domiciled in the Cayman Islands tax haven was to damage his credibility with the public, it appears to have missed the political mark.

But it’s worth working through whether investing in hedge funds in tax havens is both legal and ethical.

Advantages of offshore funds in tax havens

If Australian individuals and organisations want to invest in US companies via a hedge fund. it enables investments to be made over a much larger, more diverse, and more frequently changed portfolio.

If an Australian invests in a US-domiciled hedge fund then the Australian investor (under the Australia - US Double Tax Treaty) would be subject to 15% US withholding tax on dividends the fund received from US companies.

Australian tax rules mean the Australian investor would pay Australian tax on those dividends equal to the excess of their average rate over 15%. The investment would also be subject to Australian capital gains tax on any capital gains the fund made on its US investments when they were sold. The Australia - US Double Tax Treaty will mean that normally no US capital gains tax will be payable..

The position changes when an Australian investor uses a hedge fund domiciled in a tax haven such as the Cayman Islands.

Let’s assume the fund invests in US shares. Normally the fund will be organised as a Cayman Islands company. The fund will structure its US share investments so that the investments are not regarded as the conduct of a US trade or business. Hence capital gains the fund makes on realising its US investments will not subject to capital gains tax in the US. This is because the capital gain will not be regarded as being “effectively connected” with a US trade or business.

Any dividends received by the Cayman Islands will be subject to US withholding tax at the US non-treaty rate of 30%. There is no double tax treaty between the US and the Cayman Islands.

There will be no Cayman islands capital gains tax payable on a realisation of the investment, no Cayman Islands income tax will be payable on dividends received on the shares, and no Cayman Islands withholding tax will be payable on distributions by the fund to the Australian investor.

The real tax advantages Australian investors gain by investing via the Cayman Islands hedge fund rather than via a US domiciled hedge fund, are in terms of the ability to defer tax.

Although no Cayman Islands withholding tax will be payable on a distribution by the fund to the Australian investor, a higher level of US withholding tax is payable on the dividend paid by the US company to the fund. So looking at the dividends in isolation there seems to be no advantage in investing via a Cayman Islands hedge fund.

A real difference exists with capital gains the fund makes on underlying investments. In the case of an investment via a tax-transparent US hedge fund, the capital gain will be subject to Australian tax as soon as the investments are sold. But in the case of the investment via the Cayman Islands hedge fund, the capital gain will only be taxed in Australia when the fund makes a distribution.

The time value on the money will mean the real cost of the tax the investor pays on the capital gain falls for as long as the fund defers distributions to the investor.

Over time in real terms, less Australian tax will be paid. Admittedly the investor will not have benefited from receiving the distribution in that time and will not have control of the time of distribution. But an investor can use the appreciation in value of the investment as security against other financial transactions.

Is it legal?

The legal question is the easiest to answer. Australia used to have rules which sought to neutralise the deferral advantages described. Those rules were repealed in 2010. In 2011 the Gillard Government proposed more targeted rules for foreign funds but the Abbott Governmemt in 2013 announced that it would not be proceeding with these and other related changes. So currently deferring Australian tax through the use of foreign hedge funds is not caught under current Australian law.

Is it ethical?

How about the ethical question? This answer is harder. An investment via a Cayman Islands hedge fund results in more US tax and more Australian tax being payable on dividend distributions than investment via a US domiciled hedge fund organised.

If we assume an ethical obligation to pay taxes both in the source and residence country, then deriving dividends indirectly via a Cayman Islands hedge fund meets that obligation.

But the position is different in relation to capital gains the funds make on shares in US companies.

Neither fund will be paying US tax on the capital gains but, in the case of investment via a US domiciled tax transparent fund, Australian tax will be payable on the capital gain as soon as it is realised, while Australian tax will only be payable on the capital gain derived by the Cayman Islands domiciled fund when that fund distributes it to the Australian investor.

So back to the ethics of this. If everyone did this, there would be seriously adverse revenue consequences for Australia. But of course, not everyone can. Investing in Cayman Islands hedge funds is largely the preserve of the financially astute or those with the resources to seek advice from the financially astute.

That could raise another ethical question – is it unethical to use your own financial acumen, or that of others, to derive tax advantages unavailable to those without this access?

It depends on whether we regard taxes as a payment for the benefits a taxpayer receives from society. If so then it is arguable that those with greater financial resources receive greater benefits from society. They benefit from having their greater resources protected by law and by domestic law enforcement. As they have more assets they benefit more by having them protected by the defence force.

They derive greater benefit from infrastructure through which business can be deducted. To use your financial resources or financial acumen to pay less tax than is proportionate to the benefits you receive from society is unethical.

John Taylor has been a consultant to the Commonwealth Department of the Treasury. Owns shares in CBA, IAG, Medibank. Member of Unisuper and SASS.