FATCA UPDATE FOR U.S. INVESTMENT FUNDS (AND THEIR ADVISORS) ABA JOINT FALL CLE MEETING SECTION ON TAXATION INVESTMENT MANAGEMENT COMMITTEE

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1 FATCA UPDATE FOR U.S. INVESTMENT FUNDS (AND THEIR ADVISORS) ABA JOINT FALL CLE MEETING SECTION ON TAXATION INVESTMENT MANAGEMENT COMMITTEE Moderator: Martin T. Hamilton, Proskauer Rose LLP Panelists: Michael H. Plowgian, Office of International Tax Counsel Deanna J. Flores, KPMG LLP OCTOBER 21, 2011 Disclosures This presentation does not purport to reflect the positions of the U.S. Department of the Treasury. To ensure compliance with requirements imposed by U.S. Treasury Regulations, readers are informed that this presentation was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. 2 1

2 Presentation Summary Focus of this panel will be issues facing U.S. investment funds. The presentation will focus on: An overview of the statute and guidance issued to date, and the issues facing U.S. investment funds covered in the guidance. A discussion of implementation issues still pending. 3 I.R.C. Sections a.k.a. FATCA Code Sections were enacted as part of the Hiring Incentives to Restore Employment Act of 2010, and became law on March 18, These provisions are often referred to as FATCA, based on the acronym from the original bill proposing this regime (Foreign Account Tax Compliance Act), and this presentation follows this shorthand. The core target of FATCA is tax evasion by U.S. persons through offshore investment. For FATCA purposes, any financial account that is maintained directly or indirectly by a U.S. persons is a U.S. Account, and it is offshore U.S. Accounts that are the key subject matter of the information reporting and disclosure requirements of FATCA. 4 2

3 FATCA Guidance So Far Implementation of FATCA requires substantial Treasury and IRS guidance, which to date has taken the form of three I.R.S./Treasury Department Notices. Notice (August 27, 2010) provided preliminary guidance on priority issues and requested comments Notice (April 8, 2011) provided further preliminary guidance in response to priority concerns identified by commentators, modifies Notice and requests further comments. Notice (July 14, 2011) provides a timeline for implementing several important FATCA provisions, including extending that implementation past the statutory effective dates for certain matters. The statutory effective date applies prospectively to payments made on or after January 1, 2013, but Notice extends the implementation date for several important FATCA provisions. 5 Notice : FATCA Phase-In Notice phases in the implementation of FATCA in the following manner: Withholding on U.S. source fixed or determinable, annual or periodical (FDAP) income will generally begin on January 1, BUT withholding on passthru payments and gross proceeds from the disposition of securities that can produce U.S. source interest and dividends will be effective on January 1, FFIs must enter into agreements with the IRS ( FFI Agreement ) by June 30, 2013, to ensure identification as a participating FFI to allow withholding agents to refrain from withholding beginning on January 1, This delays the deadline for entering into FFI Agreements to avoid FATCA withholding by six months. For participating FFIs, due diligence for identifying new and pre-existing U.S. accounts must begin in Reporting requirements will begin in 2014 These will be significantly simplified for the first year. Reporting will be based on 2013 account balances. Notice also states that the Treasury Department and the IRS anticipate issuing proposed regulations this year, and final regulations in the summer of

4 What FATCA Targets FATCA target evasion by U.S. persons who maintain non-u.s. intermediary accounts with foreign financial institutions and investments in non-u.s. funds, which are called for this purpose foreign financial institutions ( FFI ). FATCA uses a withholding regime as a tool to expand information reporting by financial institutions ( FI ) to the IRS in respect of U.S.- owned offshore financial accounts. But, the impact of this regime will reach to both U.S. financial institutions ( USFI ) as well as FFIs. 7 Basic Reporting & Disclosure Under FATCA FATCA places the basic reporting burden on the FFI that maintains the U.S. account. At this time, Reporting cannot be passed up the chain to an upper-tier FI (as is possible under the non-resident withholding regulations). Notice : Contemplates that under certain circumstances, agents can perform reporting obligations. Withholding responsibility can be passed to an upper-tier FI. FATCA requires the disclosure of the identity of U.S. owners of privately held foreign entities. This disclosure requires looking through certain foreign corporations and foreign complex trusts, as well as foreign partnerships and simple and grantor trusts, to identify their owners. This means that FATCA reporting and disclosure requires looking through entities that are generally fiscally opaque. 8 4

5 Withholding under FATCA The crux of FATCA is a 30% US withholding tax on withholdable payments from US payors to FFIs and non-financial foreign entities (NFFEs), unless an exception applies. The withholding tax is the tool for enforcing the reporting and disclosure requirements, and as such it functions as a penalty for noncompliance. FATCA is an overlay, which trumps general U.S. non-resident withholding and backup withholding where it applies. But, if FATCA doesn t apply, the existing regimes remain relevant. 9 Two Key Definitional Areas Withholdable Payments what they are, and how their amounts are determined. Financial Institutions what they are (and are not) and how they are classified. 10 5

6 Withholdable Payments Section 1473(1) defines a withholdable payment U.S. source payments of interest (including any original issue discount), including interest on bank deposit accounts maintained in the United States or in a foreign branch of a U.S. bank. Dividends Rents, salaries and wages, premiums, annuities compensations, remunerations and emoluments, and other fixed or determinable annual or periodical gains ( FDAP ), profits, and income, if such payments are from sources within the United States. any gross proceeds from the sale or other disposition of any property of a type which can produce interest or dividends from sources within the United States. Exceptions: Income effectively connected with a U.S. trade or business ( ECI ) but the presumption that payments to U.S. branches of foreign banks or insurance companies are ECI does not apply. Payments on obligations outstanding on March 18, 2012 ( Grandfathered obligations ) 11 Withholdable Payments: Gross Proceeds FATCA withholding applies to the gross proceeds from the disposition of any property of a type which can produce interest or dividends from sources within the United States. This is similar to the FIRPTA withholding provision there is no requirement that there be income or gain on the disposition. BUT unlike FIRPTA, the rate of withholding on gross proceeds is not reduced the same 30% rate of withholding is applied. Therefore, where FATCA withholding is required on gross proceeds, it is very likely that an overpayment will result, and therefore a refund or credit will have to be sought. AND such a refund or credit is conditioned on the beneficial owner of the payment identifying and disclosing its U.S. owners. FATCA puts the liability for withholding FATCA-related amounts on every person who is required to deduct and withhold. This means that anyone who is required to deduct and withhold under FATCA is potentially exposed to liability for 30% of gross proceeds paid! 12 6

7 Withholdable Payments: Grandfathered Obligations FATCA withholding does not apply to obligations outstanding on March 18, The recent guidance extending the implementation of FATCA does not extend the grandfathering date. This means that, regardless of the timeline for implementing other processes, FATCA withholding agents will have to start tracking whether grandfathered obligations cease to qualify as such on March 18, Notice : Provides guidance on the term obligation for this purpose. any legal agreement that produces or could produce withholdable payments but does not include: An instrument treated as an equity for US tax purposes. An agreement that lacks a definitive expiration or term. A brokerage, custodial or similar agreement to hold financial assets for others and collect income. Any obligation that is materially modified. Such obligations will be treated as new instruments at the time of modification, and no longer as grandfathered. Note that substantial legal conclusions apply to the determination of whether something is an obligation, Nothing in Notice requires an FI to apply the grandfather rule. If withholding did occur, the withholding agent would appear to lose its indemnification protection under 1474(a), on the theory that the withholding was not required under FATCA. 13 Financial Institution A Financial Institution ( FI ) is an entity which: accepts deposits in the ordinary course of a banking or similar business; as a substantial portion of its business, holds financial assets for the account of others; or Is primarily engaged in the business of investing or trading in securities, partnership interests and commodities/derivatives. This category appears to include investment vehicles. There is a broad grant of regulatory authority to interpret this basic definition. 14 7

8 Financial Institutions: A Broad, Broad Term Custodians Broker-dealers, clearing organizations, trust companies, custodial banks. Employee benefit plan custodians. Investment Vehicles Mutual funds Funds of funds Exchange Traded Funds (ETFs) Hedge Funds Private Equity Funds Venture Capital Funds Depositary Banks Commercial banks Savings and loan associations Credit unions Building societies Cooperative Banking institutions Other Managed Funds Commodity Pools Financial holding corporations 15 Financial Institutions: FI Taxonomy FFIs, NFFEs and USFIs Foreign Financial Institution ( FFI ): Generally defined in Section 1471(d)(4) as a financial institution that is a foreign entity. If an FFI is an investment vehicle, it is sometimes referred to as a Foreign Investment Vehicle. The definition of FFI Includes most (if not all) offshore private investment funds Exceptions: Foreign governments, foreign central banks, international organizations, and entities that regulations determine pose a low risk of tax evasion are not FFIs even if they are FIs. Notice : Certain foreign retirement plans pose a low risk of tax evasion, and so will be exempt from withholding. Non-Foreign Financial Entity ( NFFE ): Any foreign entity that is not an FFI is a NFFE. United States Financial Institution ( USFI ): USFI is effectively defined by exclusion any FI that is not an FFI (or would be an FFI but for an exception) is a USFI The remainder of this presentation focuses on the implementation issues facing USFIs. BUT the distinction between an FFI and an NFFE is important to the entire FATCA framework. 16 8

9 Financial Institutions: Foreign Insurers (NFFE or FFI?) Notice : An insurance company is not an FFI if its business consists solely of issuing insurance or reinsurance contracts that have no cash value. Excluded insurance companies become NFFEs required to disclose specified US owners BUT if the insurance company s business includes issuing life insurance or annuity contracts that typically combine insurance protection with an investment component, then the insurance company may be an FFI. 17 When is Withholding Required? What payments are subject to withholding under FATCA? How is the amount of a payment subject to withholding determined? 18 9

10 What payments are subject to withholding under FATCA? Payments by a U.S. Payor to an FFI are subject to 30% withholding: If the payment is a withholdable payment paid to an FFI, unless the FFI is: a Participating FFI ( PFFI ) that has entered into an FFI Agreement, that is, an agreement with the IRS to perform due diligence to identify U.S. Accounts, to disclose and to report information about those U.S. Accounts to the IRS, and to withhold and remit 30% tax on passthru payments made either to account owners who do not comply ( recalcitrant accounts ) or non-participating FFIs; a deemed-compliant FFI; or the FFI is in an excluded category of FFI OR If the payment is a withholdable payment AND a participating FFI elects to have its withholdable payments withheld upon. 19 What payments are subject to withholding under FATCA? A withholdable payment paid by a withholding agent to an NFFE is subject to 30% withholding, unless the NFFE: discloses the identity of its U.S. owners to the withholding agent; certifies to non-us ownership; or is in an excluded category of NFFE. Participating FFIs (but not USFIs) must withhold on passthru payments made to recalcitrant accountholders and nonparticipating FFIs 20 10

11 How is the amount of a payment subject to withholding determined? A withholdable payment is subject to withholding on its gross amount. A passthru payment by a PFFI is defined as a withholdable payment or other payment to the extent attributable to a withholdable payment If a PFFI makes a withholdable payment (e.g., U.S. source FDAP) that payment is a passthru payment. Notice discusses when a passthru payment will be attributable to a withholdable payment. A passthru payment will be determined based on the ratio of U.S. assets to total assets (the passthru payment percentage or PPP) rather than direct tracing of a payment. A U.S. mutual fund will be treated as entirely a U.S. asset thus, its effective PPP is 100% Participating FFIs and deemed-compliant FFIs will be required to calculate and publish PPP s each quarter. The accuracy of the PPPs must be certified to the IRS every 3 years. If a participating FFI or deemed-compliant FFI does not publish its PPP, the PPP is deemed to be 100% (i.e., the entire withholdable payment will be subject to withholding). The deemed PPP of a nonparticipating FFI is 0%. 21 How is the amount of a payment subject to withholding determined? Custodial versus non-custodial payments: Where the PFFI holds as a custodian, the PPP for the custodial payment will be the PPP of the entity that issued the instrument. Where the PFFI makes non-custodial payments (e.g., payments on interests held by an investor in a non-u.s. fund), the payor s PPP will be used

12 Summary of the FATCA Obligations of a USFI USFIs are withholding agents under FATCA if they have control, receipt, custody, or disposal of any withholdable payment. Withholding Tax Obligations USFIs must withhold 30% from withholdable payments made to FFIs that are not participating FFIs or deemed-compliant FFIs, as well as PFFIs that elect to be withheld upon. USFIs must also withhold 30% on withholdable payments made to noncompliant NFFEs USFIs are not required to withhold on recalcitrant individual accounts or on passthru payments attributable to withholdable payments (PFFIs are responsible for passthru payments). Identification and Reporting Obligations USFIs must identify and report to the IRS information on U.S. owners of an NFFE by looking through foreign entities and documenting their ultimate owners unless the foreign entity is an FFI or an excepted NFFE. 23 Result: USFIs Must Classify All Of Their Accounts for FATCA A USFI will need to determine whether to treat an individual account holder as a U.S. person or a foreign person, and then as a foreign individual owner; an FFI; an FI that is excluded from the definition of FFI; or an NFFE If an accountholder is an FFI, then is it: A participating FFI (i.e., does it have a FFI Agreement with the IRS); A deemed-compliant FFI (which does not need an FFI Agreement); or A non-participating FFI (in which case FATCA withholding applies to withholdable payments. If an accountholder is an NFFE, then is it a: a U.S. owned NFFE (having a substantial US owner ) A non-u.s. owned NFFE (no substantial US owners) An excluded NFFE 24 12

13 Classifying FFIs If a USFI determines that an FFI is a nonparticipating FFI, is the matter settled? A USFI will have to make the determination of whether a nonparticipating FFI is covered by one of the exceptions: foreign governments, foreign central banks, international organizations, and entities that regulations will determine pose a low risk of tax evasion Notice : Foreign Retirement Plans which qualify as a retirement plan under the law of the country where established, are sponsored by a foreign employer, and do not allow US participants or beneficiaries other than those who worked in the foreign country where the benefits are accrued. A USFI will also have to determine whether a nonparticipating FFI is deemedcompliant: if the FFI complies with IRS procedures to insure it maintains no U.S. accounts and meets such other Treasury requirements with respect to accounts of other FFIs maintained by the FFI; or alternatively, the IRS determines the FFI is in a class of entities for which FATCA compliance is not needed. 25 Deemed-Compliant FFIs Notice : To obtain deemed-compliant status, an FFI must: Apply for deemed-compliant status with the IRS. Obtain an FFI identification number from the IRS identifying it as a deemed-compliant FFI. Certify every three years to the IRS that it meets the requirements for deemed-compliant status

14 Deemed Compliant FFIs: Local Banks Notice : a local bank may be treated as a deemed-compliance FFI if each FFI in the FFI s expanded affiliated group that includes the bank is a bank and not engaged primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, or any interest in such securities, partnership interests, or commodities, and: All of the FFI s group members are organized in the same country. No FFI in the FFI s group maintains operations outside the country of organization. No FFI in the FFI s group solicits account holders outside its country of organization. Each FFI in the FFI s group implements policies and procedures to ensure that it does not open or maintain accounts for nonresidents, nonparticipating FFIs, or NFFEs Although helpful to regional banks overseas, it is not clear how this would be documented. 27 Deemed Compliant FFIs: Local Members of PFFI Groups Notice : A local member of a PFFI group may be treated as deemed-compliant if maintains no operations outside its country of organization. does not solicit account holders outside its country of organization, implements the identification procedures required to identify (a) U.S. accounts, (b) nonparticipating FFI accounts, and (c) accounts of NFFEs (other than certain excepted NFFEs); and agrees that if any of the types of accounts described in (3) above are found, it will enter into an FFI agreement, transfer the accounts to a PFFI affiliate, or close the accounts

15 Deemed Compliant FFIs: Collective Investment Vehicles Notice : In order for a collective investment vehicle ( CIV ) to be a deemed compliant FFI: All holders of record of direct interests in the CIV are PFFIs or deemedcompliant FFIs holding on behalf of other investors, or that are FFIs eligible for an exception; The CIV prohibits the subscription for or acquisition of any interests in the fund by any person that is not a PFFI, a deemed-compliant FFI, or an FFI eligible for an exception; and The CIV certifies that any PPPs will be calculated and published in accordance with Notice Also under consideration is whethe entities that are regularly traded on established securities markets, such as exchange-traded funds, could be deemed-compliant FFIs. 29 Classifying NFFEs In order to avoid FATCA withholding, a USFI will have to receive certification from an NFFE of its non-u.s. ownership unless it is an excepted NFFE. An excepted NFFE includes: any corporation whose stock is regularly traded on an established securities exchange (or which is a member of an affiliated group in which there is a member whose stock is regularly traded); a possessions entity; a foreign government, political subdivision, agency, or instrumentality international organization, a foreign central bank of issue; or any other class of persons identified by the IRS

16 NFFEs with Substantial U.S. Owners An NFFE that has one or more substantial U.S. owners (other than excluded U.S. owners) is considered a U.S. owned NFFE The following types of U.S. owners are NOT considered substantial U.S. owners of a NFFE A corporation the stock of which is regularly traded on an established securities market and any of its affiliates Any tax-exempt organization under IRC section 501(a) or an individual retirement plan Any bank, any REIT or any RIC The United States government, its agencies, any State (or D.C.), U.S. possession, or its political subdivision or its wholly owned agency. Substantial ownership means more than 10 percent of: Vote or value of a corporation s stock Profit or capital interest in a partnership Any U.S. person that is an owner of a grantor trust and, to the extent provided in regulations, any U.S. person which holds more than a 10% beneficial interest in the trust If a NFFE has substantial U.S. owners, such owners must be disclosed to the IRS. 31 Holding Companies Are holding companies FFIs or NFFEs? A traditional holding company of a group of operating subsidiaries engaged primarily in a non-financial institution business is not an FFI (and thus an NFFE). This does not extend to an investment fund or any investment vehicle whose purpose is to acquire or the fund the start-up of companies and then hold those companies for investment purposes for a limited period of time

17 FATCA Documentation Notice provides basic guidance on how and when both FFIs and USFIs must document account holders step-by-step Distinguishes pre-existing accounts from new accounts Distinguishes individuals from non-individuals If individuals have certain U.S. indicia, requirements are more stringent. Notice modifies procedures for individuals For existing Private Banking accounts, relationship managers must review both paper and electronic records For other pre-existing individual accounts, an electronic search of account data bases for U.S. indicia is sufficient For new accounts, FIs must review all account information (including AML/KYC) even if not electronic. Phases in documentation requirements over 1-2 years 33 FATCA Documentation Notice modifications for pre-existing accounts. An FFI may treat all deposit accounts with a year-end balance of $50,000 or less as non-u.s. accounts (even if documented as a U.S. account) An FFI may treat custodial accounts with a year-end balance of $50K or less as non-u.s. accounts, unless documented as a U.S. account. This exception does not apply to fund investments. For private banking accounts, the relationship manager (RM) must identify accounts for which the RM has actual knowledge that the client is a U.S. person or has certain U.S. indicia Request documentation establishing U.S. or foreign status for these accounts and a waiver of restrictions from U.S. accounts Treat all associated accounts (including joint accounts) as U.S. accounts Create and retain list of existing accounts and their classification Complete the procedure within the first year Repeat the procedure if RM subsequently become aware of U.S. indicia Retain written requests and responses for 10 years 34 17

18 FATCA Documentation Notice modifications for pre-existing accounts. List of U.S. indicia revised to include U.S. place of birth and green cards, and to exclude P.O. box addresses outside the United States. (If an individual is born in the U.S. but is not a U.S. citizen, a written explanation of why not or renunciation is needed) For high value accounts (other than Private Banking accounts) the minimum value was lowered from $1 million to $500K, a diligent search of the entire account file is now required, and if find U.S. indicia, must obtain documentation within 2 years 5-year period for documenting all individual accounts that lack U.S. indicia has been eliminated Means FFIs will not be required to document ALL individuals Chief compliance officer of the FFI must certify to the IRS the completion of the procedures for preexisting accounts Responsible officer will be required to certify that, between the publication date of Notice , (April 8, 2011) and the effective date of the FFI Agreement, FFI management personnel did not engage in any activity or have any policies to direct, encourage or assist account holders in avoiding detection as U.S. account holders 35 FATCA Reporting Notice : New information returns are forthcoming Electronic filing will be required Account balance/value must be reported in dollars Notice : Limits reporting on deposit and custodial accounts to year-end account balance/value (rather than the highest reported balance/value for the year). For interests in an FFI, report in accordance with the most frequent determination of value. FFIs that are not U.S. controlled will not be required to report adjusted tax basis information on covered sales

19 FATCA Reporting Notice requires reporting by FFIs: For deposit and custodial accounts, the gross amount of dividends, interest or other income paid or credited to the account; No reporting of accrued but unpaid income (e.g., OID) Gross proceeds from the sale or redemption of property paid or credited to the account, but only if the FFI acted as a custodian, broker, nominee or other agent for the account holder The FFI must use a consistent method to determine the amount and character of the payment, use U.S. tax principles or the same principles used by the FFI in reporting on residents to the local tax administration. If none, use the same manner as for reporting to the holder. If neither, use generally applied accounting principles 37 FATCA Reporting Notice requires: Reporting for interests in an FFI of: All distributions, interest and similar credits; and Each redemption payment Reporting for closed U.S. accounts of: Income paid or credited up to transfer or closure date; Value or amount withdrawn or transferred; and Account closure (also applies to transfer). FFI must retains account statements for 5 years and provide them to the IRS upon request