Answers to Questions and Problems

13.4
The IRS does ask the courts to look through the business structure of
sham transactions as if the structures did not exist. It is plausible that
the IRS might argue that an investment in a derivative was an artificial
way to avoid having to report interest expenses that could require the
investor to pay UBIT.
For several reasons, the tax-free investor could argue that a
hedge fund derivative was not a sham trade. First, the tax-exempt in-
vestor is permitted to consider taxes in making investment decisions
and could argue that there was a business purpose and an economic
motive for investing in the instrument. Second, the derivative invest-
ment could differ materially from a direct investment in terms of
downside protection, leverage, or even in the extent that the deriva-
tive replicated the direct investment. Third, the tax-free investor can
invest in offshore hedge funds that do not pass through interest ex-
pense. Tax-free investors can invest in banks that also have large in-
terest expenses. Although the tax code can trigger a UBIT situation,
the IRS doesn't view the hedge fund industry and the tax-exempt in-
vestors as abusive tax shelters. Finally, tax-exempt investors do invest
in a variety of other derivatives and the IRS does not methodically
look through these derivatives to see if they can find a way to tax oth-
erwise tax-exempt investors.
13.5
The fund earned 4 percent after a 20 percent incentive fee, which was
calculated after a 1 percent management fee (0.25 percent per quar-
ter). A gross return of 5.25 percent reduces to 4 percent net of a quar-
terly 0.25 percent management fee and 20 percent incentive fee.
On a notional investment of $10 million, this means you receive 80
percent of 5.25 percent on $10 million or $420,000. You pay LIBOR
on $10 million at 5 percent (1.25 percent per quarter) or $125,000.
You net the two payments and receive $295,000.
13.6 Because the gross return is given, it is not necessary to make calcula-
tions involving the management and incentive fees. The investor re-
ceives a payment of 80 percent of ­2 percent on a notional balance
of $10 million (a loss or negative receipt of $160,000). The investor
also pays the $125,000 interest calculated in the answer to question
13.6. Therefore, the investor makes a payment of $285,000.
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