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An offshore fund is a collective investment scheme domiciled in an Offshore Financial Centre such as the British Virgin Islands, Luxembourg, or the Cayman Islands; it is typically sold exclusively to 'foreign' investors (those not of the domestic fund sponsor's country of origin). Thus, a common example could involve an offshore fund managed or sponsored by a U.S.-based money manager, organized under the laws of the Cayman Islands and sold exclusively to non-U.S. investors. For the purposes of the Income and Corporation Taxes Act 1988 of the UK, an offshore fund is one which is governed by the Offshore Fund Rules set out in that Act. The vast majority of offshore funds are organized under the laws of the Cayman Islands, with the British Virgin Islands being the second most popular domicile.
Offshore funds offer eligible investors significant tax benefits compared to many high tax jurisdictions such as the United States. For example, U.S. domestic investment products such as mutual funds are at a tax-disadvantage to non U.S. investors since dividends from such a fund are typically subject to high rates of U.S. non-resident alien withholding and taxes – typically as high as 30% on certain income paid by the U.S. fund (lower by treaty). An offshore fund can be managed similarly however without the high taxes otherwise involved with a similarly managed U.S. organized fund. Where income is repatriated (paid or transferred) to high tax jurisdictions, however, such income is usually taxed at normal rates as foreign sourced or arising income.
Many of these tax-haven locations are considered investor-friendly and are internationally regarded as financially secure.
Many offshore jurisdictions, notably the British Virgin Islands, offer a zero-tax regime for investment funds which are domiciled there, which allows the fund to reinvest that part of its investment portfolio's gains which would otherwise have been lost to tax. In addition, the regulatory regime in these offshore jurisdictions is deliberately light, with emphasis placed on the importance of balancing effective regulation for the benefit of the protection of investors on the one hand, with the establishment of a regime in which the conduct of investment business is fast and simple. A number of offshore jurisdictions have recently tightened the regulation of offshore funds.
Typically, the regulatory regime will take a two tier approach, making a distinction between funds which are offered generally to members of the public, which require a high degree of regulation because of the nature of potential investors, and non-public funds on the other (for example, in the British Virgin Islands, see the Mutual Funds Act 1996, which applies a three-tier regulatory approach in this manner). Non-public funds are usually either categorised as private funds or professional funds. Typically, investors in non-public funds can be assumed to be sophisticated because of the nature of the offering – there may, for example, be a high minimum initial investment, say US$100,000, and/or a requirement that investors establish that they are "professional investors". Or the fund will be designed for a small and select group of investors and the constitutional documents will limit the number of investors, say to no more than 50. Although most offshore jurisdictions permit funds to obtain licences to operate as public funds, the onerous regulatory requirements associated with such licences usually means that only a small minority of offshore funds are available for subscription by the general public.
The tax advantages of the funds encourage high tax countries to apply some draconian laws to limit their distribution. Nonetheless, the vast majority of offshore funds operate primarily in investor markets in the United Kingdom and the U.S.A., although they are usually subject to ordinarily taxation in those jurisdictions as they apply to distributions of income arising from foreign sources.
Most offshore domiciling of funds tends to be regulatory driven rather than tax driven. The relative absence of regulation relating to leveraging and investment strategies in offshore jurisdictions encourages higher risk funds, such as hedge funds, to form themselves in those jurisdictions. The vast majority of the world's estimated 9,000 hedge funds are formed in Cayman Islands, British Virgin Islands, Luxembourg or Bermuda.
Critics, such as ATTAC (an NGO), alleged that they are a main player of the underground economy, allowing legalized tax evasion, in particular through the usage of shell corporations practicing transfer pricing.