Taxation of Hedge Funds in Israel – A Short Guide to the Perplexed
What Are Hedge Funds?
Hedge funds, generally, are entities managed by investment managers, in accordance with certain investment strategies. Their goal is to invest in financial assets and generate returns for the investors.
Hedge Fund: Incorporation Structure
The common and usual formation structure for hedge funds is a limited partnership. The partnership is comprised of a general partner and limited partners. The fund’s general partner is responsible for managing the fund and executing its investment strategy, while the fund’s limited partners are passive investors.
The general partner, who is, as noted, the dominant party in the fund, receives compensation through management fees and carried interest. The limited partners simply benefit from the fund’s investment proceeds, minus the aforementioned management fees and carried interest paid to the general partner.
Hedge Fund: Taxation
From a tax perspective, a classic hedge fund, by virtue of its formation as a partnership, constitutes a transparent entity for tax purposes. This means the fund’s profits are taxed at the partners’ level. (A taxable non-transparent hedge fund also exists under Israeli tax law, but is less common.) Consequently, funds’ partners have certain concerns about the treatment of their profits and losses under the applicable tax regime.
In light of these concerns, the Israel Tax Authority issues tax rulings in order to set clear taxation guidelines and provide certainty for fund investors on their applicable tax rates and the timing of their respective tax liability.
Such tax rulings apply to both Israeli hedge funds and foreign hedge funds managed and controlled from Israel.
These tax rulings state that:
- The fund shall be exempt from Israeli income tax and the tax liability shall be borne by the partners.
- The fund’s activity, in and of itself, shall not cause the limited partners’ income to be regarded as business income. Instead, such income shall be regarded as capital income (which benefits from a lower tax rate).
- The fund’s income shall be exempt from tax withholding.
- The foreign-resident limited partners do not have to report their income in Israel and file income tax returns to the ITA due to their investment in the fund.
- The tax rate for a limited partner who is an Israeli resident shall be 25% (as of January 1, 2019).This is subject to the conditions set in the tax ruling, including a nine-month lock-up period condition.
- An exemption from withholding tax for a limited partner who is a foreign resident for income that were it received by him directly would be tax exempt (subject to the application of tax treaties and provided the conditions set in the tax ruling are met), whereas the other income of such foreign resident shall be subject to withholding tax at a rate of 25%.
- The timing of the tax liability for limited partners shall be:
* As for the fund’s ongoing proceeds – at the end of the tax year, on an accrual basis, even without a realization event occurring
* As for redemption, distribution, and liquidation proceeds – at the time of the realization event.
It is important to understand the serious tax implications arising from these tax rulings.
The taxation of capital gains of direct investments in securities (or investments through an exempt mutual fund) is based on the principle of realization, i.e., the tax event occurs only when the security is realized (e.g., sold or redeemed). However, in a hedge fund covered by these tax rulings, this principle does not apply. A limited partner is liable for tax on its share of the ongoing proceeds of the fund at the end of each tax year on an accrual basis. As a result, a hedge fund investor may be liable for capital gains tax at the end of each year due to the increase of value of the hedge fund. This applies even if the investor did not realize (i.e., sell or redeem) any of the hedge fund’s interests during that tax year and/or the fund did not realize any of its investments!
This would require the investor to pay out-of-pocket to fund such capital gains taxes (unless the fund manager decided to distribute monies to investors in order to fund the tax liability payment), which, prima facie, constitutes a taxation disadvantage.
In these coronavirus times, there is another aspect to this tax result, which one can view as the silver lining of the “coronavirus cloud.” Just as taxation on an accrual basis may result in a tax liability for the investor without a realization event (e.g., a sale or redemption of interests), so too during tax years in which the fund’s investments lose value and the value of the hedge fund decreases, as is generally the case now with the coronavirus crisis, taxation on an accrual basis may create a tax “benefit” for investors.
If hedge funds end the current year with decreased net asset values, their investors will be entitled to have such decreases recognized as capital losses for tax purposes. They will also be able to offset such losses against their capital gains this year or in the following years, without the need to realize (e.g. sell or redeem) their interests in the hedge funds. (However, foreign-resident investors who benefit from tax-exempt status for their income from hedge funds’ profits may not recognize such losses for tax purposes in Israel.)
Lowering the Tax Rate for Israeli Hedge Fund Investors:
Though more than a year has passed since the lowering of the tax rate applicable to capital gains for Israeli investors (limited partners) in hedge funds, this point is important and warrants mention here. Until the end of 2018, the tax rate paid by Israeli limited partners for capital gains in Israeli hedge funds (or foreign hedge funds managed in Israel) was set at 30%. (This is opposed to the 25% capital gains tax rate regularly applied to the sale of securities listed on the stock exchange by “non-material” shareholders holding such securities directly.) The reason for this different tax rate is that due to the nature of hedge funds’ activities, the ITA views investors as seeking to offset their financing expenses against their income from the sale of securities. Therefore, according to the ITA, they should be taxed on their profits at the higher tax rate of 30%.
In December 2018, the ITA resolved to lower the tax rate on capital gains of Israeli limited partners in Israeli hedge funds from 30% to 25%. (This became effective as of January 1, 2019.) This amendment corrected the absurd situation in which the tax rate on hedge fund investors’ capital gains was greater than the tax rate on the capital gains of investors that invested directly in securities. However, the reduced rate of taxation for capital gains of 25% is still contingent upon the fund meeting certain conditions listed in the tax ruling. The conditions include that the fund must:
- avoid offsetting funding expenses for tax purposes;
- not execute short sales in the aggregate exceeding 130% of the net asset value of the fund; and
- not hold any equity position in a portfolio company representing 10% or more of the share capital of such portfolio company.
These conditions are in addition to meeting other conditions stated in the tax ruling, including the nine-month lock-up condition.
The Bottom Line
In sum, in order to avoid uncertainty arising from the possible consequences to both Israeli and foreign investors as a result of investing in Israeli hedge funds, Israeli hedge fund sponsors should consider applying to the Israel Tax Authority for a tax ruling. However, they should still explore the possible ramifications of such an application.
Our firm’s capital market and taxation departments are, of course, available to serve and advise you on these matters.