Offshore hedge funds using total return swaps on bank loans have become increasingly involved in the origination process and some market participants warn their activity may be viewed as a lending business and subject to federal income tax. This issue has been raised with the Securities and Exchange Commission a few times in recent years, but the commission found trade volumes were not significant enough to warrant a closer look, said Mark Leeds, a shareholder and tax attorney with Greenberg Traurig in New York, adding this market has now grown exponentially and may attract attention again. One official estimated the market for total return swaps on bank loans now stands at about $50 billion notional a year.
Tax advisors must be careful the trading activity of offshore funds does not look like lending, which could trip the U.S. tax alarm, Leeds said. He explained the more influence hedge funds have in negotiating the underlying bank loan, the more likely the fund is to be considered a lender. Leeds said funds must have secondary market exposure but various funds have gotten into the business of extending credit and actively soliciting borrowers. He asks the funds, "Are you buying in the secondary market, or are you so involved in negotiating that you're like a lender?"
"I think the deep policy issue is whether these vehicles are competing with U.S. lenders in the U.S. markets, thereby creating what's perceived to be an unfair tax advantage" said Mike Farber, a partner in Davis Polk & Wardwell's tax department in New York. He said offshore funds help the U.S. market with their large monetary inflows, adding well-advised offshore funds have developed guidelines to minimize risk of being considered a U.S. trade or business.
