FATCA Another Acronym, Another Headache
By Jean Paul Schwarz, JD, LLM, Principal, Marcum LLP's Alternative Investment Group
What is FATCA?
The Foreign Account Tax Compliance Act or FATCA is designed to prevent tax evasion by U.S. persons through the use of offshore financial accounts and offshore entities. It was enacted in March 2010 as part of the Hiring Incentives to Restore Employment (HIRE) Act. Beginning January 1, 2014, the provisions of FATCA will impose a 30% US withholding tax on any US-sourced interest and dividends paid to non-participating offshore fund and foreign financial institution (FFI) and starting January 1, 2015 the 30% US withholding will be imposed on all withholdable payments including the gross proceeds from the sale of investments that produce US sourced interest or dividends received by any offshore fund or other FFI. This withholding tax is avoided if the FFI enters into an agreement with the US Government and agrees to comply with new documentation requirements, due diligence procedures, and reporting obligations. These new requirements are aimed at detecting US tax residents that may be evading US federal income tax by holding investments directly or indirectly through an FFI.
Should Hedge funds and private equity funds be concerned?
FFI includes a foreign entity engaged primarily in the business of investing, reinvesting or trading securities, partnership interests, commodities or any interest (including a futures or forward contract or option) in such assets. Hedge funds and Private Equity funds formed under the laws of a jurisdiction other than the U.S. clearly constitute FFIs, so do foreign feeder funds of US funds and non U.S. parallel funds.
US funds that have either an FFI or a non-financial foreign entity (“NFFE”) as limited partners will be a withholding agent under FATCA with respect to any U.S. source income it derives that is allocable to such foreign partner.
How does FATCA work?
The new 30% withholding tax will apply to any US sourced interest and dividends received by an FFI after December 31, 2013 and any withholdable payment received by an FFI after December 31, 2014, unless the FFI has entered into an agreement (FFI agreement) with the Internal Revenue Service (IRS). An FFI agreement will obligate the FFI to:
- Obtain information on each investor (account holder), that holds the FFI's equity or debt (accounts) in order to determine which accounts are US accounts (i.e., accounts held, directly orindirectly, by certain US individuals or foreign entities with substantial US owners).Payments under credit agreements involving US borrowers and foreign lenders will require additional certification and information from the lenders in order to avoid the imposition of the new FATCA withholding tax on interest and principal payments.
- Perform required due diligence/verification procedures, including searching its files for indicia of US status of the account holders (e.g., a US address associated with the account holder’s account).
- Seek waivers from its US account holders for any applicable bank secrecy, confidentiality, data privacy, or other information disclosure restrictions that would otherwise limit the FFI’s ability to share information with the IRS regarding its US account holders.
- In some instances, close accounts when it is not able to obtain these waivers.
- Report information on US accounts.
- Deduct and withhold a 30% tax on any pass thru payment to any recalcitrant account holders or noncompliant FFIs.
- Comply with IRS information requests.
What should be done?
As a business matter, FATCA’s tax provisions will compel most offshore funds that have meaningful direct or indirect US investments, including certain synthetic investments (e.g., through equity derivatives), to enter into FFI agreements. Otherwise, the 30% tax on gross proceeds from the disposition of investments, regardless of whether received directly through withholdable payments or deemed to have been received indirectly through pass thru payments, will make most US investments uneconomical. If a fund has any material turnover, the tax could readily exceed the fund’s net asset value (each time the fund trades a US investment 30% of the gross proceeds is paid in taxes).
Did the IRS provided any guidance?
So far the IRS has issued two notices to provide some guidance.
The first notice (notice2010-60) addresses the following topics:
- Definition of an FFI;
- Description of the compliance obligations for FFI, including detailed procedures for gathering information and identifying United states accounts;
- “Grandfather rule” exempting obligations issued prior to March 2012 from potential withholding under FATCA (does not include any instrument treated as equity for federal income tax treatment or any legal agreement that does not have a definitive expiration or term).
The second notice (notice 2011-34) provides that FFI agreements will become effective on the later of the effective date of FATCA, or the date they are executed and provides guidance on the following:
- Procedures to be followed by participating FFIs in identifying United States Accounts among their preexisting clients;
- Certain categories of FFIs that will be deemed to have entered into FFI Agreements;
- Obligation of participating FFIs to report with respect to United States Account
IRS and Treasury will continue to issue additional guidance.
While the provisions of FATCA will not have any effect before January 1st 2014 and significant guidance with respect to the operation of FATCA will be forthcoming, fund managers should immediately begin the process of assessing the impact of FATCA and prepare to implement systems, procedures in response to such guidance.