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Ethan W. Johnson of Morgan, Lewis & Bockius LLP is reminding U.S. hedge fund managers operating offshore vehicles on an important deadline. U.S. hedge fund advisers have long enjoyed the ability to defer receipt of fees from offshore hedge funds and only pay U.S. income tax on those fees (plus accrued appreciation on the deferred fees) in the future.

This deferral allowed the fees to be reinvested in effect in the funds and earn a return on a compounded, pre-tax basis. The U.S. Congress brought an end to that golden age when it adopted the Emergency Economic Stabilization Act of 2008 (the Act). Section 801 of the Act prohibits U.S. hedge fund advisers from deferring fee income they earn from offshore funds after 31 December 2008. This would apply as well to hedge fund advisers based outside of the U.S. but owned by U.S. taxpayers.

Accordingly, advisers will need to decide whether to retain the performance fee structure for their non-U.S. funds or non-U.S. feeder funds, which will be taxed to advisers at the U.S. ordinary income rates, or adopt an incentive allocation structure similar to the performance allocation structure that is typically used for the U.S. hedge funds or feeder fund. The incentive allocation option will result in the pass-through of the tax character of the income associated with the performance allocation so that items of income such as long-term capital gains will be taxed at the applicable U.S. lower tax rates.

If an adviser chooses......................

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