Hedge funds structured under foreign law, or located outside the U.S. are designated as “offshore hedge funds.”  Managers who desire to start a hedge fund offshore can enjoy several advantages over their domestic contemporaries. One advantage is that the fund and its investors are not subject to United States taxation. Another advantage is that since the number of accounts in a U.S. hedge fund is limited, offshore funds are a way to raise additional capital from non-U.S. investors.  Offshore hedge funds are not registered in the United States or with the SEC, and therefore offer privacy benefits as well as tax advantages.

So who can invest in an offshore hedge fund? Generally, non-U.S. citizens and non-U.S. residents who are present in the United States fewer than 180 days a year. However, many tax-exempt investors, such as not-for-profit institutes, retirement funds, and endowments may invest in offshore hedge funds. Both foreign investors and U.S. exempt investors will invest in either a parallel fund of an existing U.S. fund, or they will invest in a foreign-feeder fund which is set up as a corporation.

A lucrative reason for being offshore is that gains are either untaxed or very lightly taxed in the country where they were originated. With respect to the tax implications for the hedge fund manager, the manager may want the offshore fund to allow deferral of management and incentive fees. This will allow the manager to defer his or her fees for a specified period and allow them to accrue with the fund on a tax-deferred basis.

While most investors set up offshore funds in the Caribbean and British Virgin Islands, a high number of new hedge funds are springing up all over the globe. This includes places like Gibraltar, Hong Kong, Isle of Man, Jersey, Switzerland, Luxembourg and Liechtenstein. Offshore financial centers are attractive to U.S. investors since they adhere to the privacy of their clients, and anonymous transactions can be made easily.

Though the number of U.S. hedge funds far exceed the number of offshore funds, the money tied up in offshore funds is of far greater magnitude. Because voluntary information is scarce, we estimate that the number of dollars invested in offshore funds exceeds $1.4 trillion.

Because of the nature of the U.S. tax and securities laws, it is easy to see why non-U.S. investors typically will not invest in hedge funds that are based in the United States. Many hedge fund managers do maintain both U.S. and non-U.S. components. Given the global complexity of the investment community, hedge fund managers want to have both types of investment vehicles so that they attract all kinds of investment dollars. The laws and regulations of the United States are directed not just to limit the behavior of its citizens, but also to prevent money-laundering and other improper uses of offshore investment vehicles.

While regulation may be light, it’s not a good idea to set up an offshore fund just to avoid taxation. In the past few years, amidst pressure from anti-money laundering firms and a heightened priority on security after 9/11, the U.S. is tightening up its grip on offshore funds.

Both tax evasion and money laundering can warrant long sentences, although the latter can be much more brutal. However, if you have a plan that can benefit foreign investors, along with yourself, it’s not a bad idea to look into creating an offshore hedge fund.