FATCA as applied to investment funds: suggested fund agreement provisions

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1 JUNE 10, 2011 FATCA as applied to investment funds: suggested fund agreement provisions By Christian M. McBurney This alert provides a brief background of the potential impact of FATCA on investment funds and focuses on what investors and fund managers should do now in terms of inserting FATCA-related provisions in their fund agreements. While some fund managers are now beginning to do this, not all of them do, and few investors currently press for such provisions, despite the importance of the matter to them. These provisions may be important to any fund investor, regardless of whether it is a U.S. or non-u.s. person. Background potential 30% U.S. withholding tax On March 18, 2010, Congress enacted a new law, commonly called the Foreign Account Tax Compliance Act or FATCA, which is now set forth in sections 1471 through 1474 of the Internal Revenue Code. Despite the fact that the law is generally effective for payments made after December 31, 2012, investors and fund managers should take FATCA into account when negotiating fund agreements now. Under the FATCA provisions, a foreign financial entity (an FFI ) generally will suffer a 30% U.S. withholding tax on certain payments to it of U.S. source income (such as dividends, interest, and gross proceeds on the sale of stock) if it does not enter into an agreement with the IRS (an FFI Agreement ). The FFI Agreement is designed primarily to require FFIs to identify, and provide information on, its U.S. account holders. It is also intended to force FFIs to withhold 30% of certain payments they make to their account holders who do not cooperate in identifying whether they are U.S. persons (whether such recalcitrant account holders are U.S. or non-u.s. persons). While the goal of FATCA is to identify U.S. persons who have non-u.s. accounts and make sure they are paying U.S. income tax on their account earnings, the provisions of FATCA are broad and their application is uncertain. The initial inquiry is whether an investment fund could be an FFI and whether it could receive (directly or indirectly) any U.S. withholdable payments that could be subject to the 30% withholding tax. As to the first question, an FFI is broadly defined to include not only banks and stock brokerage houses, but also any entity engaged primarily in the business of investing or trading 1

2 in securities, interests in partnerships, or commodities. According to guidance issued by the IRS, it is expected that most non-u.s. investment funds will be FFIs including private equity, venture capital, hedge, real estate, and similar collective investment vehicles. This would also include U.S. funds that establish offshore parallel entities. Each FFI should determine if it has or could receive any payments that would be treated as withholdable payments, subject to the new 30% U.S. withholding tax. Importantly, a withholdable payment must have a U.S. source. Accordingly, interest paid by a Japanese bank or a dividend paid by a United Kingdom company would not be a withholdable payment. A withholdable payment generally includes U.S.-source (i) dividends; (ii) interest; (iii) royalties; (iv) rents, salaries, wages, premiums, annuities, and other fixed or determinable, annual or periodical income; and (v) the gross proceeds from the sale of U.S. stock or securities (whether or not at a gain). Note that withholdable payments would include certain types of U.S. source income that is not subject to U.S. withholding tax under current general rules, such as portfolio interest and gross proceeds on the sale of stock of a U.S. corporation. 1 Some non-u.s. fund-of-funds may attempt to avoid receiving any U.S. source income in order to avoid the FATCA rules. However, if such a fund invests in another offshore fund, such fund could in turn purchase an interest in a U.S. portfolio company that makes withholdable payments subject to FATCA. A beneficial owner of a withholdable payment on which a tax has been imposed may claim a full or partial refund or credit from such tax by filing a U.S. income tax return. The determination of whether an overpayment has been made is made by applying the regular U.S. tax rules (without regard to FATCA) and U.S. tax treaty provisions. Accordingly, for example, gross proceeds on a stock sale and portfolio interest may be eligible for 100% credit or refund. A harsh refund rule applies to the common case of offshore investment funds that are treated as corporations for U.S. income tax purposes. In such a case, refunds and credits generally will not be allowed. So, for example, if an offshore investment fund that is an FFI suffers 30% withholding with respect to gross proceeds on a stock sale or portfolio interest received, the fund would not be entitled to a refund or credit of the withheld tax. This rule would apply even to the extent its equity holders are U.S. tax-exempt entities or foreign governments. While refunds and credits are allowed to the extent the FFI is entitled to an exemption or a reduced rate of tax by reason of a U.S. tax treaty, offshore investment funds that are treated as corporations for U.S. income tax purposes are typically established in countries that do not have a tax treaty with the U.S. This harsh treatment was apparently intentionally designed to serve as a strong inducement for such funds to avoid the 30% withholding by entering into FFI Agreements. Avoiding the U.S. 30% withholding tax FFI agreements 1 Withholdable payments generally do not include income that is effectively connected with the conduct of a U.S. trade or business; in this case, the ECI is required to be reported on a U.S. income tax return and is subject to regular U.S. income tax. Such ECI could flow through to an investment fund if the fund invests in a U.S. portfolio company that has U.S. operations and is treated as a pass-through for U.S. income tax purposes. 2

3 As noted above, an FFI will be required to enter into an FFI Agreement or suffer a 30% withholding tax on any withholdable payments that it receives. In general, the FFI must agree to the following six requirements: 1. Obtain information necessary to determine if any of its accounts are held by U.S. persons. 2. Report annually information with respect to any of its U.S. accounts, including account balances and earnings. 3. Comply with verification and due diligence procedures as the IRS may require regarding the identification of U.S. accounts. 4. Comply with requests by the IRS for additional information with respect to any of its U.S. accounts. 5. In any case in which foreign law would (but for a waiver) prevent the reporting of information required to be reported with respect to any U.S. account maintained by it, attempt to obtain a waiver of such law as applied to each account holder, and if a waiver is not obtained for each such account holder within a reasonable amount of time, close the account. 6. Withhold a 30% tax from any passthrough payment that is made, generally to (a) a recalcitrant account holder (i.e., someone who refuses to cooperate in confirming the account holder is not a U.S. person or otherwise fails to provide information reasonably requested by the FFI or who fails to provide the waiver described in paragraph 5 above), or (b) a foreign financial institution that does not enter into its own FFI Agreement with the IRS or that fails to provide the waiver described in paragraph 5 above. A passthrough payment is defined as any withholdable payment or other payment which is attributable to a withholdable payment. A withholdable payment is as defined above; as discussed, a withholdable payment must have a U.S. source. An example of a passthrough payment occurs when a U.S. portfolio company pays a dividend to a non-u.s. investment fund that is an FFI, and such fund pays one of its investors cash that is attributable to such dividend. The Treasury Department has indicated that it will issue rules that do not rely on tracing but instead will treat a certain percentage (related to the fund s percentage of U.S. assets) of a withholdable payment as attributable to the withholdable payment. If an FFI withholds with respect to a recalcitrant account holder, it appears that such holder does not have a mechanism for obtaining a refund of the withheld tax. If an FFI fails to withhold the 30% U.S. tax, the FFI will become responsible for paying such tax. If the U.S. Treasury determines that an FFI is out of compliance with the FFI Agreement, the agreement may be terminated. It is not clear what level of noncompliance would lead the IRS to revoke an FFI Agreement or to penalize the FFI. The FATCA provisions provide that certain categories of account holders are exempt from FATCA, such as, among other categories, foreign governments or any political subdivision of a foreign government (which would include sovereign wealth funds); foreign central banks; corporations the 3

4 stock of which is regularly traded on an established securities market; and any entities that are engaged in an active trade or business (other than the business of a financial institution ). In addition, the IRS has announced that it plans to issue regulations that would exempt from FATCA withholding certain foreign pension plans maintained by foreign companies. Informally, a Treasury official recently stated it was seriously considering extending the same treatment to certain foreign charitable organizations. As will be explained below, however, even exempt investors still must be acutely concerned about the FATCA provisions in their fund agreements. IRS Notice states that the Treasury and IRS are considering permitting a fund manager to execute a single FFI Agreement that would cover any investment fund that the fund manager manages. Drafting FATCA-related provisions in fund agreements It is evident that most offshore investment funds that could receive substantial U.S.-source withholdable payments will want to enter into FFI Agreements. As a result of not entering into an FFI Agreement, the offshore fund would be subject to a 30% U.S. withholding tax on withholdable payments it receives. And if the offshore fund is treated as a corporation for U.S. income tax purposes, it would not be entitled to a refund or credit with respect to any of the withheld tax. Such a result would harm all of the offshore fund s investors, even those non-u.s. investors that are otherwise exempt from FATCA (such as foreign governments and foreign pension plans) or that are U.S. investors (such as U.S. tax-exempt organizations, which sometimes invest in offshore blockers). Entering into FFI Agreements would also be in the best interest of fund managers, whose carried interest return could be reduced if the offshore fund were subject to 30% U.S. withholding tax and who want to provide their investors with the highest after-tax return possible. While fund investors and managers generally will be in alignment in the desire to enter into an FFI Agreement and to make sure the agreement is not terminated, few fund agreements contain provisions addressing the matter. Yet if the FFI Agreement is not complied with, the IRS could terminate it, which could then result in the offshore fund being subject to the 30% U.S. withholding tax under FATCA. An FFI Agreement might not be complied with if a number of investors refuse to cooperate in providing information mandated by the FFI Agreement. Investors who expect to cooperate with the fund s FATCA disclosure and reporting requirements therefore have an interest in insuring that all investors cooperate. We note that a number of fund managers have recently inserted in their limited partnership agreements or subscription agreements provisions obligating investors to cooperate in complying with FFI Agreements. A typical provision applicable to an offshore blocker entity or other offshore fund would obligate the fund investor to: Provide information deemed necessary for the fund to enter into and comply with an FFI Agreement. Waive any provision of foreign law that would, absent a waiver, prevent compliance with an FFI Agreement and acknowledge that, if it fails to provide such a waiver, it may be required by the general partner to withdraw from the offshore fund. 4

5 Acknowledge that if the investor fails to provide information on a timely basis, the investor may be subject to a 30% U.S. withholding tax on the investor s share of withholdable payments received by the fund. Acknowledge that if the investor fails to comply with such obligations and such failure could result in the fund being unable to enter into or comply with an FFI Agreement, the fund manager could sell the investor s interest or transfer the interest to another entity. Acknowledge that the investor would indemnify the fund and its other investors for any losses resulting from the investor s failure to meet its obligations under the provision, including any withholding tax imposed by FATCA on the fund. A fund investor who wants to insure that fellow investors cooperate with the fund manager in complying with an FFI Agreement will be pleased with the inclusion of the above provisions in a fund agreement. Yet some fund investors may want further protections. They may seek to require the fund to enter into an FFI Agreement. In addition, an FFI Agreement might not be complied with if a fund manager fails to use due diligence to determine whether its non-u.s. investors, directly or indirectly, have U.S. account holders. Accordingly, they may press to insert a provision in the fund agreement requiring the fund manager (i) to use commercially reasonable efforts (or other applicable standard) to cause the fund to enter into an FFI Agreement; (ii) to comply with the due diligence efforts, reporting, withholding, and other terms of the FFI Agreement; and (iii) to deal with those investors who do not cooperate in providing information needed to comply with such agreement. To date we have not seen such a provision inserted in a fund agreement, but such a provision could some day become an industry standard. We also note that some fund managers of U.S. master funds are now also requiring their investors in offshore feeder funds to provide them with information necessary to determine whether the investors are FFIs subject to 30% withholding. This is because the fund manager in this circumstance is in effect a withholding agent and could be liable for failure to impose a required 30% withholding tax under FATCA. A typical provision applicable to an offshore feeder fund or other offshore entity would obligate the fund investor to: Provide information to the fund manager for it to determine if the investor is an FFI. If the investor is an FFI, to provide information to determine if the investor has entered into its own FFI Agreement (so that it is not subject to 30% withholding under FATCA). If the investor is not an FFI, to provide information to determine if the investor is otherwise subject to FATCA withholding. Acknowledge that if the investor fails to provide information on a timely basis, the investor may be subject to a 30% U.S. withholding tax on the investor s share of withholdable payments received by the fund. The above provisions would not be appropriate for certain funds that determine that the administrative costs and burdens of entering into and maintaining an FFI Agreement outweigh the benefits. This could arise if a non-u.s. fund is expected to generate an immaterial amount of U.S.- 5

6 source income. Treasury might also provide an exemption for foreign funds that take certain precautions to avoid having U.S. investors. For more information on this issue or any private equity matter, please contact your Nixon Peabody attorney or: Christian M. McBurney at or John J. Koeppel, Chair, Private Equity and Investment Funds, at or To ensure compliance with IRS requirements, we inform you that any tax advice contained in this communication is 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. 6