No Tax
Bermuda, which imposes no corporate income tax, is the global center of the reinsurance industry. Since it emerged in the 1980s, the reinsurance business has lifted Bermuda’s economy, creating jobs for underwriters, actuaries, lawyers and accountants.
The companies backed by hedge funds -- lightly regulated funds available only to institutions and wealthy individuals -- are no less welcome. A 2001 presentation by a group of business leaders to encourage development in Bermuda touted the tax benefits of what it called “reinsurance wrapped around a hedge fund.”
After Paulson set up the Pacre venture last year, Wayne Furbert, then the minister of business development, called it “a strong vote of confidence in Bermuda as a leading financial jurisdiction,” according to the local newspaper, the Royal Gazette.
IRS Rules
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 percent rate for ordinary income or the 20 percent long- term capital gains rate, depending on how frequently securities are traded, plus an extra 3.8 percent 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 percent 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.
$64,000 Question
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.