Most Canadian hedge funds are structured as either trusts or limited
partnerships and, similar to traditional mutual funds, must distribute or
allocate their income and capital gains annually to investors. Be mindful of
some of the tax consequences of hedge funds, most of which stem from the
underlying investment strategies of the fund.
A key difference between hedge funds and mutual funds, is that traditional
mutual funds employ a "long-only" strategy, meaning they buy stocks or bonds,
hold them and ultimately sell them, generating interest or dividend income along
the way. Hopefully, at the end of the day, these investments also generate a
capital gain.
Hedge funds, on the other hand, use a variety of strategies depending on the
fund's mandate.
If the fund trades frequently, employing sophisticated arbitrage strategies,
any profits realized may be treated as income rather than tax-preferred capital
gains, which are only half taxable.
"It's a grey area," says Sharon Grosman, president of SGGG Fund Services
Inc., in Toronto, a firm of specialized accountants that offers administrative
services to more than 150 hedge funds with total assets under administration of
$5.5-billion.
"The legal offering documents always disclose and acknowledge that there is a
risk that the income generated from the ownership of units could be
characterized as being on income account and not capital account," says Ms.
Grosman.
Hedge funds use a variety of sophisticated investment tools -- buying
derivatives, engaging in short selling and writing or purchasing options.
Each of these activities could give rise to tax consequences beyond the
traditional interest/ dividend/capital gains mix.
Swaps, futures and forwards are all examples of derivatives, which get their
name, from the fact that they do not generate their own independent returns, but
rather, derive returns through reference to an underlying asset, currency or
stock index.
When hedge funds sell derivatives at a profit, such profit is not
characterized as a tax-preferred capital gain.
It is considered by the tax man to be ordinary income. Such income is
distributed or allocated at the end of the year to investors, who would then pay
tax at full marginal rates.
A similar issue may also arise with short-selling activities and the writing
or purchasing of options.
The Canada Revenue Agency generally considers such activities to be on
"income account," as opposed to capital, and thus such profits would be taxed in
the hands of investors as ordinary income.
As a result of these negative tax consequences, it may be wise to hold your
hedge fund inside a registered plan such as a RRSP or RRIF.
But this is only possible with larger, more publicly available "retail" hedge
funds, which are legally structured as mutual fund trusts.
Jamie Golombek, CA,
CPA, CFP, CLU, TEP is vice-president, taxation and estate planning, at AIM
Trimark Investments in Toronto.
Jamie.Golombek@aimtrimark.com