Comprehensive Guide to Master-Feeder Fund Structures

The Master-Feeder structure is an essential tool in the hedge fund industry, allowing fund
managers to pool capital from diverse investor bases while achieving operational efficiency and
tax optimization. Here’s a detailed explanation, using examples and highlighting legal and
regulatory requirements.

1. Understanding Feeder Funds and Master Fund

The Master-Feeder structure consists of multiple Feeder Funds that gather investments from
different types of investors, which are then pooled into a single Master Fund. The Master Fund
manages and invests all the assets, while the Feeder Funds cater to specific investor needs
based on tax treatment.

Feeder Funds

● U.S. taxable investors typically invest through a domestic feeder fund (like a limited
partnership in the U.S.), which is structured to optimize U.S. tax compliance.
● Non-U.S. investors and U.S. tax-exempt investors (e.g., pension funds) generally
invest via an offshore feeder fund (often set up in tax-neutral jurisdictions like the
Cayman Islands or Bermuda). Offshore feeders allow these investors to avoid U.S. tax
complications like the Unrelated Business Taxable Income (UBTI).

Master Fund

The Master Fund is usually based in a tax-neutral jurisdiction and holds all the capital from
the various feeder funds. It is responsible for all trading, investing in securities, and managing
the pooled assets. By consolidating assets in a single fund, the Master Fund improves
economies of scale, reduces operational costs, and enhances the efficiency of portfolio
management.

Example:
An Asian-based hedge fund manager creates a U.S. Feeder Fund for U.S. taxable investors
and an offshore feeder for European investors. Both feeders channel capital into a
Cayman-based Master Fund that invests in global equities. The investors in each feeder fund
benefit from the tax and regulatory rules relevant to their respective jurisdictions.

2. Tax Efficiency and Legal Considerations

The Master-Feeder structure is highly valued for its tax efficiency and flexibility in
accommodating investors with different tax obligations.

● U.S. taxable investors avoid heavy tax penalties by investing through the domestic
feeder fund, while non-U.S. and tax-exempt U.S. investors benefit from offshore
structures that help avoid unnecessary U.S. tax exposure.
● Offshore feeders are usually established in tax-neutral jurisdictions like the Cayman
Islands, ensuring that non-U.S. investors don’t face U.S. taxation on their profits.
Tax-exempt U.S. entities, like pension funds, use this structure to avoid UBTI taxation.

Example:
A U.S. pension fund might invest through an offshore feeder to avoid taxes related to leveraged
investments under UBTI, while individual U.S. investors use a domestic feeder to comply with
U.S. federal tax laws.

3. Advantages of the Structure

Economies of Scale

Pooling capital from multiple feeders into one Master Fund allows the hedge fund manager to
reduce trading costs and management fees. The Master Fund trades on behalf of all the
feeders, minimizing transaction costs.

Diversified Investor Base

The structure’s flexibility means that hedge funds can cater to taxable, tax-exempt, and
foreign investors simultaneously. Each group can invest in the same strategy without
negatively impacting the tax status of the others.

Example:
If Feeder A contributes $100 million and Feeder B contributes $200 million, Feeder A would
receive one-third of the Master Fund's profits, while Feeder B would receive two-thirds, based
on their investment sizes.

4. Disadvantages and Challenges

Complex Tax Accounting

Each feeder fund is a separate legal entity, which complicates accounting and reporting. The
profits and losses from the Master Fund must be proportionately distributed to each feeder
fund, which then allocates these gains and losses to individual investors. This can result in
complex tax filings for investors, especially those subject to U.S. tax regulations.
Conflicts in Investment Strategy

Since feeder funds cater to diverse investors, conflicts in investment preferences or risk
tolerances can arise. A strategy beneficial to one type of investor may not suit another group
(e.g., U.S. taxable investors versus non-U.S. investors).

5. Regulatory and Licensing Requirements

Generally, you do not need separate licenses for each feeder and the master fund in many
offshore jurisdictions. The Master Fund typically requires registration or licensing in the
Cayman Islands, where the feeder funds are treated as pass-through vehicles.

However, feeder funds must comply with tax and regulatory requirements based on their
respective jurisdictions. For instance:

● U.S. Feeder Funds may need to comply with the Securities and Exchange
Commission (SEC) regulations.
● Offshore feeders must align with local rules in the Cayman Islands, but they usually
avoid U.S. regulatory burdens.

Conclusion: Blueprint for Vested Finance’s Master-Feeder Structure

For Vested Finance, the Master-Feeder structure allows for attracting a global investor base
with streamlined management and tax efficiency:

1. Set up a Cayman-based Master Fund to pool investments.

2. Create Feeder Fund A for U.S. investors and Feeder Fund B for non-U.S. investors.
3. Manage all investments through the Master Fund, optimizing for operational efficiency
and minimizing trading costs.
4. Ensure compliance with U.S. tax laws for Feeder Fund A and offshore regulations for
Feeder Fund B.

This structure not only provides tax benefits but also scales efficiently, allowing Vested Finance
to accommodate future growth while ensuring regulatory compliance.

For further in-depth reading, visit sources like Eurekahedge​

Eurekahedge
​
Investopedia
and Corporate Finance Institute​
Corporate Finance Institute
.
Overview: How to Mitigate PFIC with a Third-Party Fund in GIFT City

In this scenario, you’re setting up a U.S. hedge fund and partnering with a third-party fund (e.g.,
Mirae Assets) in GIFT City, rather than directly managing the investments yourself. This partnership
creates passive income (from Mirae Assets’ management of the investments), which will trigger
PFIC classification for your U.S. investors. However, you can mitigate PFIC issues using the
Master-Feeder structure.

Step-by-Step Plan to Mitigate PFIC Impact in a Third-Party Fund Setup

Step 1: Set Up U.S. Hedge Fund (Feeder Fund A)

Your hedge fund in the U.S. will serve as Feeder Fund A, where U.S. investors pool their capital.
This fund will directly invest into the Master Fund or tie up with the third-party fund in GIFT City.
Since the income flowing back to U.S. investors is considered passive (as they are not directly
managing it), PFIC rules apply.

Step 2: Offshore Feeder Fund for Non-U.S. Investors (Feeder Fund B)

Set up an offshore feeder fund (likely in the Cayman Islands) for non-U.S. investors and U.S.
tax-exempt entities. The offshore feeder will invest directly into the third-party fund in GIFT City,
ensuring that these investors avoid U.S. tax complications, including PFIC.

• Why This Matters: Non-U.S. investors and U.S. tax-exempt entities will not be subject to
PFIC rules, making it easier for them to invest in GIFT City assets without facing U.S. tax
burdens.

Step 3: Pooling Capital in the Third-Party Fund (e.g., Mirae Assets)

Instead of setting up your own Master Fund in GIFT City, your U.S. feeder fund (and offshore feeder
fund) will invest directly into the third-party fund (like Mirae Assets). This structure means:

• You are passive investors in the third-party fund.

• The third-party fund (e.g., Mirae Assets) manages all the investments in Indian assets.

• Your role is primarily as a feeder fund, pooling U.S. and non-U.S. capital to invest in the
GIFT City fund.

Step 4: PFIC Mitigation for U.S. Investors

To manage PFIC concerns, you can implement one of the following strategies:
A. QEF Election (Qualified Electing Fund)

• How It Works: The third-party fund (e.g., Mirae Assets) must provide annual financial
information to U.S. investors so they can make a QEF election. This allows U.S. investors to
pay tax on the income from the PFIC annually at regular tax rates (long-term capital gains for
investments held over a year).
 • What You Need: You’ll need to ensure that Mirae Assets (or whichever third-party fund) is
willing and able to provide the necessary annual reports for U.S. investors to elect QEF.
Example: The GIFT City fund provides detailed annual financial statements to U.S. investors in
Feeder Fund A. These investors can elect QEF, which reduces their PFIC tax burden.

B. Mark-to-Market Election

• How It Works: U.S. investors can elect to mark their shares to market at the end of each
year. They’ll pay taxes on any unrealized gains, which may still result in a lower tax burden
than the excess distribution rules under PFIC.

• Benefits: This election ensures that U.S. investors are taxed at ordinary income rates but
avoids the harsh penalties associated with the excess distribution regime.

Step 5: Using Active Income from GIFT City

Although you are tying up with another fund like Mirae Assets (which mainly manages passive
investments), you can still reduce the PFIC risk by ensuring that some portion of the GIFT City
fund’s income comes from active investments.

• Example of Active Investments:

• Real estate development or operational businesses.

• Infrastructure projects that generate operating income rather than passive returns
like dividends or interest.

• Why It Helps: If a significant portion of the GIFT City fund’s income comes from active
business activities, it may help reduce the passive income component that triggers PFIC
classification.
Step 6: Profit Repatriation and Taxation
The third-party fund in GIFT City will generate returns, and you’ll need to ensure smooth
repatriation of profits:

• Free Repatriation: GIFT City allows for free repatriation of profits back to the U.S., which
is important for maintaining tax efficiency.

• DTAA (Double Tax Avoidance Agreement): The GIFT City fund can take advantage of
DTAA to ensure U.S. investors aren’t taxed twice (in both India and the U.S.).
Example: The profits earned by your U.S. feeder fund (after being taxed under PFIC rules) can be
repatriated back to the U.S. without additional Indian taxes, thanks to free repatriation and DTAA
agreements.
Step 7: Communication and Reporting
Make sure to maintain clear communication with Mirae Assets or the third-party fund you’re
partnering with. This includes:

• Annual Reports: Request annual reports that provide the necessary information for U.S.
investors to file their QEF or Mark-to-Market elections.
 • Partnership Agreement: Ensure that your agreement with Mirae Assets outlines their
responsibilities in providing information, managing capital, and complying with IFSCA
regulations.
Summary: Key Steps to Mitigate PFIC Using the Master-Feeder Structure

1. Set up a U.S. Feeder Fund (for U.S. investors) and an Offshore Feeder Fund (for
non-U.S. investors and U.S. tax-exempt entities).

2. Invest both feeder funds into the third-party GIFT City fund (e.g., Mirae Assets).

3. Implement QEF or Mark-to-Market elections for U.S. investors to reduce their PFIC
tax burden.

4. Ensure that the third-party fund generates some active income to minimize passive income
exposure.

5. Communicate with the third-party fund to receive annual reports for U.S. tax filings.

6. Benefit from free repatriation of profits and DTAA agreements to avoid double
taxation.