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FATCA Update for Funds

Posted on 22 Aug 2013

August 22nd 2013

Delay in Implementation

As expected, many foreign financial institutions have objected to the broad reach of the Foreign Account Tax Compliance Act (FATCA), citing burdensome compliance costs and conflicts with domestic laws that protect account holder privacy.

FATCA mandates that a) foreign financial institutions (FFIs) provide information on U.S. account holders with foreign accounts and b) non-financial foreign institutions (NFFEs) disclose information on substantial U.S. owners to the IRS. FFIs include investment entities such as hedge funds and private equity funds. Such FFIs must “register with the IRS, obtain a Global Intermediary Identification Number (GIIN), and report certain information on U.S. accounts to the IRS.”

In relation to the issue of conflicts with domestic laws, the U.S. Treasury has been negotiating intergovernmental agreements (IGAs) to navigate legal obstacles and allow FFIs to disclose previously confidential data to the IRS.  So far, the Treasury has completed agreements with a number of European countries including the UK, Germany, and Switzerland.

However, as numerous IGAs remained in process throughout the first half of 2013 — and some countries such as China seemed reluctant if not intractable to the idea of compliance — there had been widespread uncertainty for FFIs as to whether they would be held liable for FATCA penalties given the 31 December 2013 deadline. These uncertainties prompted the U.S. to announce a 6-month delay in the enforcement of FATCA penalties in July and the deadline was postponed to 1 July  2014.

Overall, FATCA will undoubtedly increase costs for funds globally. At the very least, they have an extra 6 months to draw up an actionable game plan, and the most proactive may consider registering with the IRS at the new FATCA website, which opened on 19 August. In the meantime, FFIs can get an overview of requirements through a draft of the FATCA registration form here.

Quick Introduction to FATCA

Registration and compliance require that the FFI in question withhold 30% on certain payments to payees if the latter refuse to comply with FATCA. Moreover, U.S. financial institutions must withhold 30% on certain U.S. source payments (salaries, interest, capital gains, dividends, rents, royalties) made to foreign entities if they cannot verify FATCA compliance.

Take the instance of a fund wishing to register with the IRS in order to be deemed a “participating foreign financial institution” (PFFI).  The fund must verify each investor’s U.S. or non-U.S. status by procuring Form W-8 (for non-U.S. residents) or Form W-9 (for U.S. residents) and then report relevant U.S. account data to the IRS annually. In the event of an investor’s non-compliance, the fund itself must act as a withholding agent and deny 30% on certain payments to such investors. Failure of the PFFI to follow these rules will result in a 30% withholding on U.S. source income by the US financial institution. For example, proceeds from the sales of U.S. securities by the fund would be remitted less the 30% withholding.

Institutional investors including foreign banks invested in the fund must also be FATCA-compliant.  Moreover, NFFEs such as foreign corporations that hold accounts in the fund will also need to register with the IRS and disclose any substantial U.S. owners. In both cases, the fund would need to enforce withholding on any non-compliant FFI or NFFE.

Another key issue for the fund in question is the issue of “passthru payments,” defined under FATCA as “any withholdable payment or other payment to the extent attributable to a withholdable payment.” The definition — convoluted if not wholly tautological — can be best expressed through another extended example.

Imagine the fund in our example above has $100 million of assets, all of which are invested in U.S. securities. Further, assume that 50% of investors are non-participating FFIs — that is, for whatever reason, these FFIs have not complied with IRS regulations under FATCA. Non-compliance might involve so-called “recalcitrant” FFIs that have U.S. dealings but refuse to comply with FATCA, or it might involve FFIs such as foreign regional banks that simply do not have offices or investments in the U.S. If the fund realizes 10%, or $10 million, in income over the year, then the non-participating FFIs would be eligible to receive half of the distributions. However, because of the 30% withholding, they would receive only 70% of the $5 million owed to them, or $3.5 million.

Now, consider a situation in which half of the $100 million of assets in the fund is invested in U.S. securities and half is invested in non-U.S. securities. According to FATCA, the fund would have a 50% “passthru payment percentage”..

The current IRS thinking regarding passthru payments implies that a fund with no distributable income from U.S. investments must still withhold a certain percentage of payments to non-participating FFIs if the fund makes any distributable income from non-U.S. investments, so long as the fund maintains some percentage of investments in U.S. securities. In other words, in the example above, if the fund made $0 from its U.S. investments but $5 million from its non-U.S.-based investments, it would still be required to withhold income distribution to non-participating FFIs.

As it stands, the U.S. Treasury is currently “considering ways to ease the compliance burdens associated with passthru payment withholding,” which may be the reason that enforcement of the regulation has been delayed from 2015 to 2017.