Hedge Fund Pain Compounded as Surprise Tax Hit Awaits Investors

(Bloomberg) -- A surprise tax blow could be looming for investors in hedge funds such as Point72 Asset Management.

President Donald Trump’s tax law curbs the coveted deductions that most businesses were allowed to take for the interest they pay on loans. During the tax overhaul debate, private equity firms were the fiercest critics of the provision, arguing it would change the calculus for their deals that often rely on debt.

But buried in 439 pages of proposed regulations released by the Internal Revenue Service last month was an unfortunate surprise for investors in so-called trader hedge funds like Point72, which trade stocks or other assets frequently: Their tax bills might increase as a result of the deduction limit.

“The rules create the worst possible situation,” said David Miller, a tax lawyer at Proskauer Rose LLP.

The impact on hedge funds is among the curve balls taxpayers are dealing with as the one-year anniversary of the tax overhaul nears and the IRS issues thousands of pages of regulations implementing the law. The cap also represents another hit for the industry from the GOP tax law. The overhaul eliminates the deduction for management expenses investors previously qualified for, and many New York managers are hurt by the new cap on state and local tax deductions.

In contrast, the private equity industry was able to preserve one of the most widely reviled tax breaks for carried interest -- still, the law extended the period required for managers to qualify for a lower rate on their investment profits instead of killing it, as Trump has promised.

Hedge fund investors will notice the deduction change when they start to receive their tax forms to record fund investments early next year, with new lines for calculating interest expense deductions, according to Joe Pacello, a tax partner in the asset management group at accounting and advisory firm BDO USA.

Trader funds that borrow money to make their wagers could be hit hardest. Here’s how it works: Those funds can now only deduct a certain amount of the interest they pay on that borrowed money (previously they could deduct it in full). Any remaining interest costs get passed to fund investors.

Investors can only deduct those interest costs along with any of the fund’s investment interest expenses on their 2019 tax returns if the fund has had relatively strong performance and generated enough interest income against which to take the deductions.

Expense ‘Double Whammy’

With hedge funds overall down 3.62 percent this year through November, many funds won’t meet that hurdle -- and wind up saddling investors with a “double whammy” of non-deductible fund expenses, said Simcha David, a tax partner at accounting and advisory firm EisnerAmper, which works with investment funds.

Hedge funds that buy and hold assets -- so-called investor funds that aren’t engaged in quick trading -- aren’t affected by the deduction cap. And businesses with average annual gross receipts of less than $25 million are also exempt.

The proposed rules on interest deductions are top of mind for many hedge funds that belong to industry trade group the Managed Funds Association and could significantly affect a broad swath of investing strategies and industries, according to a spokesman for the association. Some are arguing that the IRS’s rules are unclear.

Flat Fund Performance

Investors in billionaire Steve Cohen’s Point72 are potentially at risk. It had $13 billion in client assets and $71 billion in regulatory assets under management, according to regulatory filings and the firm’s website. Last month, the fund declined about 5 percent, largely wiping out its 2018 gains, a person familiar with the returns has said. Tiffany Galvin-Cohen, a spokeswoman for Point72, declined to comment.

Trader funds that use leverage and have positive returns for the year, such as Citadel and Renaissance Technologies, will likely be able to balance interest income and expenses so investors won’t be affected. Funds that use short positions to achieve leverage are also less likely to be affected since they don’t borrow as much and don’t have as many interest costs.

Most hedge fund managers have lost money this year after suffering their worst month since 2011 in October. The $3.2 trillion industry has been hit by years of mediocre performance and fund closures, with investors pulling $68.8 billion since the start of 2016. Several managers have announced plans to shutter in anticipation of year-end withdrawals.

‘Destroyed Brain Cells’

The blow from the deduction change may get worse for investors in a few years. Under the new tax law, companies can deduct interest costs up to 30 percent of earnings before interest, tax, depreciation and amortization, or Ebitda, until 2022. After that, the cap narrows to 30 percent of earnings before interest and taxes, or EBIT -- since that number includes depreciation and amortization, it’s lower, making the potential deduction amount even smaller.

Before the IRS released its rules, many tax professionals thought the law’s curb applied only to a trader fund’s managers, not to its individual outside investors, known as limited partners, Pacello said.

“A lot of tax brain cells were destroyed” trying to figure it all out, said Barbara de Marigny, a corporate tax partner at law firm Orrick.

The IRS also said the limits apply to debt instruments and transactions that don’t take the official form of a loan but have the same “substance,” which are often used by some hedge funds.

“It’s really the limited partners that seem to get screwed here,” EisnerAmper’s David said. “I was completely shocked.”

©2018 Bloomberg L.P.