Hedge fund managers have a state tax gating issue when it comes to adding crypto to their assets under management. Generally, states such as New York, Connecticut and California encourage asset managers to locate in their respective states by, among other things, granting their out-of-state investors an exemption from in-state income taxes. These exemptions from local taxes are extremely important to investors because of the complexity and cost of dealing with out-of-state taxes, including filing an out-of-state tax return, paying that tax and claiming a credit against home state tax.
For example, in California, a nonresident investor who invests in a California-run hedge fund is generally exempt from filing a California income tax return and paying California state tax if that investor’s sole activity in California is its investment in the hedge fund. For California, the out-of-state investor must invest in a hedge fund that is an “investment partnership” that invests in “qualifying investment securities.” In California, the term “qualifying investment securities” includes, among other things, stock, bonds, foreign and domestic currency deposits, mortgage and asset backed securities, repurchase agreements and loan participations, foreign currency exchange contracts, stock and bond index securities and futures contracts, options for the purchase or sale of certain securities, currencies, contracts or financial instruments and regulated futures contracts. Where do crypto currencies like Bitcoin and Ethereum—for which there are CFTC-approved futures traded—fit into this laundry list of “qualifying investment securities?”
Hedge fund managers and advisers may be scratching their heads when it comes to whether crypto is a qualifying investment security. Some states such as New York have provided some guidance, treating crypto as property. It may be time for California to provide guidance as well.