Taxation of hedge funds

Q – In B.C. we are able to get into a hedge fund with $25,000 which I have done. I understand the fee structure (2% with 1/12 taken off each month) and the performance incentive (20% of gains above 10%) What I don’t understand is how hedge funds and taxation work.

1. Is the performance incentive taken off each year and I pay tax on the remaining gain or do I pay tax before the incentive is taken off?

2. There is generally a lot of trading that goes on in a hedge fund. I’m used to mutual funds and distributions but don’t know how hedge funds trading is handled for purposes of taxation.

Thanks for your answer. – P.L.

A – The tax treatment of hedge funds is normally no different from that of an ordinary mutual fund unless the hedge fund has some unusual structure, such as a limited partnership. If that’s the case, you should consult a tax professional for advice.

Assuming the hedge fund is set up as a trust, then the Canada Customs and Revenue Agency would see it as no different from a mutual fund trust held outside a registered plan. Specifically, this means:

1) You are not liable for any for tax on anal gains in the unit value of the fund until you sell. At that time, a capital gain or loss will apply for tax purposes. Remember, when you sell you can deduct all costs associated with the sale (such as brokerage commissions) from your profit for tax purposes.

2) Net profits earned within the fund from dividends, interest, call writing, and trading must be distributed to unit holders at least once a year. You will receive a T3 reporting slip from the fund’s administrators (assuming it is set up as a trust) that details the amount of income allocated to your units and shows a break-down of the various types of income. This is essential because different tax rates apply to capital gains, dividends, etc.

3) Any costs associated with the fund, such as management fees and performance incentives, are normally deducted by the administrators before distributions are made. The effect will be to reduce the amount of distributions actually paid (and therefore taxable).

4) Even if distributions are reinvested and not received in cash, they are still taxable in the year received. This is true for all mutual funds. – G.P.