Last year, about $450 million belonging to top executives at billionaire hedge fund manager John Paulson’s New York firm took a quick round trip to Bermuda. In April, the executives sent the money to a reinsurance company that they’d set up on the island 650 miles off the North Carolina coast. By June, the Bermuda company, which has no employees and sells far less reinsurance than the industry norm, had sent all the cash back to New York, to be invested in Paulson & Co. funds.
By recycling the funds through Bermuda-based Pacre Ltd., the Paulson executives are positioned to legally exploit a little-known tax loophole, reduce their personal income taxes and delay paying the bill for years. “These types of reinsurance companies are permitting U.S. taxpayers to defer -- indefinitely -- U.S. tax,” said David S. Miller, a tax lawyer at Cadwalader Wickersham & Taft LLP. For some, he said, it’s “an unjustified benefit.”
A decade after the IRS threatened to crack down on what it said were abuses by hedge-fund backed reinsurers, more high-profile money managers are setting up shop in tax havens. ... Because reinsurers, which sell coverage to other insurers, manage large pools of capital, they’re a handy way to funnel a U.S. hedge fund investment through a tax haven.
At a time when the Obama administration and Congressional leaders of both parties are calling for a corporate tax overhaul that includes eliminating some loopholes, the reinsurance tax dodge is gaining popularity among hedge funds. The three new reinsurers backed by U.S. hedge fund managers put a combined $1.7 billion back into the managers’ hands. ...
By setting up reinsurance companies there, money managers can take advantage of a loophole in IRS rules. Ordinarily, when hedge fund managers invest in their funds, they pay either the 39.6% rate for ordinary income or the 20% long- term capital gains rate, depending on how frequently securities are traded, plus an extra 3.8% health-law surcharge. If they were to move the hedge funds to tax havens, they would incur IRS penalties on earnings from what the agency calls “passive foreign investment companies.”
Here’s the catch: The IRS doesn’t penalize earnings from insurance companies, which it considers to be “active” businesses. As a result, by routing money through a Bermuda reinsurer, which in turn puts its assets back into their own hedge funds, fund managers can defer any taxes until selling the stake. They then pay only the lower capital gains tax rate.
In the meantime, the money grows tax-free, and the savings add up. Investing $100 million in a hedge fund that returns 15% annually, and paying the top marginal ordinary income rate on profit, results in a $50 million profit after taxes after five years. If the investment is taxed like a Bermuda reinsurer, the gain is $77 million.
To qualify as an active company and avoid the tax penalty, the IRS says firms can’t have a pool of capital that’s far greater than what they need to back the insurance they sell. But the IRS has never specified exactly how much is too much. ...
The IRS in 2001 disclosed plans to clarify its definition of insurance companies, a move that might prevent abuses by hedge funds, Cadwalader’s Miller said. He said it never followed through.