HIRE ACT S EFFECTS ON INVESTMENT FUNDS

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1 CLIENT MEMORANDUM HIRE ACT S EFFECTS ON INVESTMENT FUNDS On March 18, 2010, the President signed the Hiring Incentives to Restore Employment Act ( HIRE Act or the Act ). The Act includes provisions that impose new rules on withholding, reporting of interests in foreign financial accounts, withholding on dividend equivalent payments, and reporting of passive foreign investment companies. The provisions relating to foreign accounts and dividend equivalents are substantially similar to those introduced by the House Ways and Means Committee on December 7, 2009 in a separate bill. 1 Withholding on Payments to Foreign Financial Institutions The Act imposes a 30 percent withholding tax on any withholdable payment made to an offshore fund, a non-u.s. bank, or a non-u.s. broker, each considered a foreign financial institution, unless the institution has entered into a disclosure agreement with the U.S. Department of Treasury regarding its United States account holders. For the purposes of the Act, a financial institution is any entity engaged (or holding itself out as being engaged) primarily in the business of investing or trading in securities, partnership interests or commodities, or any interests therein; any entity that accepts deposits in the ordinary course of business; or any entity that, as a substantial portion of its business, holds financial assets for the account of others. Under the Act, withholding is imposed on withholdable payments, defined as U.S. source interest and dividends, plus gross proceeds from the sale or disposition of any property which could produce U.S. source interest or dividends. No withholding would be required for income already recognized as taxable income effectively connected with the recipient s U.S. trade or business. The 30 percent withholding tax can be avoided if the offshore fund, bank or broker has entered into an agreement with the U.S. Treasury. The agreement must require the disclosure, with respect to each United States account maintained by the institution, of (1) the identifying information of each specified United States person with an aggregate account value exceeding $50,000 (if the United States person is a natural person; otherwise, there is no threshold amount) and, if the account holder is a foreign entity, of each substantial United States owner of the entity; (2) the account number; (3) the account balance or value; and (4) the gross receipts and gross withdrawals or payments from the account. A United States account is any financial account held by a specified U.S. person or a U.S.-owned foreign entity. Financial account is defined to include depository accounts, custodial accounts, and non-publicly traded equity or debt interests in the financial institution. Regulations may be written to provide that, for purposes of determining the aggregate value of various accounts held by an individual, multiple financial institutions may be treated as a single financial institution if they are members of the same expanded affiliated group. 1 See Willkie Farr & Gallagher LLP Client Memorandum of December 30, NEW YORK WASHINGTON PARIS LONDON MILAN ROME FRANKFURT BRUSSELS in alliance with Dickson Minto W.S., London and Edinburgh

2 A specified United States person is defined as any United States person that is not a taxexempt organization; publicly traded corporation; U.S. federal, state or local agency; bank; real estate investment trust; regulated investment company; common trust fund or tax-exempt trust. A substantial United States owner is a specified United States person owning at least 10 percent of the stock of a foreign corporation, 10 percent of the interests of a foreign partnership or 10 percent of the beneficial interests of a foreign trust. A special look-through rule applies to upper-tier foreign entities that are themselves investment vehicles, such as funds of funds, such that the definition of substantial United States owner includes any specified United States person that holds an interest in the entity, even if the interest is less than 10 percent. For this purpose, investment vehicles are financial institutions engaged (or holding themselves out as engaged) primarily in the business of investing, reinvesting, or trading in securities, partnership interests or commodities, or interests therein. Despite generally exempting entities that have in place disclosure agreements with the U.S. Treasury from the withholding tax, the Act still requires that these offshore funds, banks and brokers withhold and pay over a 30 percent tax on any passthru payments made either to a recalcitrant account holder or to another foreign financial institution that has not entered into an agreement with the Treasury. Passthru payments are defined as payments that are attributable to other withholdable payments. A recalcitrant account holder is defined as an account holder who either (1) fails to comply with reasonable requests for either the information that would enable the financial institution to identify the account as a United States account or the information that the institution is required to disclose to the U.S. Treasury under the Act (i.e., the identity of the account holder, the account number, the account balance, and the account transaction activity) or (2) does not provide to the financial institution a waiver from any foreign law that would otherwise prevent the reporting of this information. In addition, if such foreign law applies to an account and the financial institution cannot obtain such a waiver from the account holder within a reasonable period of time, the Act requires that the account be closed. Under certain circumstances, a foreign financial institution may be eligible to elect to be withheld upon rather than to withhold itself with respect to passthru payments allocable to a recalcitrant account holder or a financial institution that has not entered into a disclosure agreement with the U.S. Treasury. This election is available only if the electing financial institution notifies the withholding agent of the election and waives any rights under a tax treaty to the amount deducted and withheld. Further, the U.S. Treasury may promulgate regulations limiting the right to make this election to certain classes of institutions or types of accounts of a foreign financial institution. Payments to foreign financial institutions are not subject to the withholding tax, even if the institution does not have in place a disclosure agreement with the U.S. Treasury, if the institution either complies with certain procedures (to be prescribed by the U.S. Treasury) to ensure that the institution does not maintain U.S. accounts or is classified by the U.S. Treasury as an institution not needing to enter into an agreement. The Act does not require disclosure if either an account is simultaneously held by another financial institution that has in place a disclosure agreement - 2 -

3 with the U.S. Treasury, or the account holder is otherwise subject to information reporting requirements that would in the view of the U.S. Treasury make these reporting requirements duplicative. Withholdable payments to non-financial foreign entities are also affected by the Act. Withholding is required on these payments if either the beneficial owner of the payment is the entity itself or another non-financial foreign entity, or the beneficial owner does not provide the withholding agent with a waiver. The waiver must either certify that the beneficial owner does not have any substantial U.S. owners or disclose the identities of each substantial U.S. owner. The withholding agent is not permitted to rely on such a waiver if it knows or has reason to know that the information in the waiver is incorrect. Upon accepting a valid waiver, the withholding agent must report to the U.S. Treasury the identities of the foreign entity s substantial U.S. owners. The term non-financial foreign entity is defined as any foreign entity that is not a financial institution but does not include publicly traded corporations, entities organized in a U.S. possession and wholly owned by residents of the possession, foreign governments, international organizations, foreign central banks and any other entities identified in U.S. Treasury regulations. The withholding obligations imposed by the Act are effective as to payments made after December 31, The Act also includes a grandfather provision, which states that no withholding is required from any payment under any obligation outstanding on the date which is 2 years after the date of enactment of this Act or from the gross proceeds from any disposition of such an obligation. The Joint Committee on Taxation s Technical Explanation of the Senate bill (the Committee Report ) states that it is anticipated that the Secretary may provide guidance as to the application of the material modification rules under section 1001 in determining whether an obligation is considered to be outstanding on the date that is two years after the date of enactment. Reporting of Foreign Financial Assets The Act imposes a new reporting obligation on U.S. taxpayers with respect to certain non-u.s. investments. This disclosure obligation is in addition to the annual obligation to file a Report of Foreign Bank and Financial Accounts ( FBAR report ) with the Financial Crimes and Enforcement Network, a bureau of the U.S. Treasury that shares jurisdiction over FBAR reporting with the IRS. The Act s new reporting obligation requires that information substantially similar to that shown on the FBAR report be disclosed on a statement attached to a taxpayer s income tax return. The Act requires any individual to provide detailed disclosures of all specified foreign financial assets if the aggregate value exceeds $50,000 (or such higher amount specified by the U.S. Treasury). Specified foreign financial assets includes non-u.s. stocks, non-u.s. bonds, financial instruments and contracts issued by non-u.s. persons, interests in foreign entities, and any financial accounts maintained by foreign financial institutions. As in the Act s withholding provisions, a foreign financial institution is defined as any foreign entity engaged primarily in the business of investing, reinvesting, or trading in securities, partnership interests or - 3 -

4 commodities, or any interest therein; any entity that accepts deposits in the ordinary course of a banking or similar business; or any entity that, as a substantial portion of its business, holds financial assets for the account of others. The U.S. Treasury has the authority to promulgate regulations exempting certain classes of assets from the category of specified foreign financial assets. If an individual does not provide sufficient information to demonstrate the aggregate value of specified foreign financial assets, the Act presumes that the value is greater than $50,000. As noted, items reportable under the Act include any interest in a foreign entity and any financial account... maintained by a foreign financial institution. This would require reporting of interests in foreign hedge funds, foreign private equity funds and other foreign investment vehicles. The required disclosures include, for a stock or security, the name and address of the issuer and the class or issue of the stock or security; for a financial instrument or contract, sufficient information to identify the instrument or contract, and the name and addresses of all counterparties; and for a foreign financial account, the name and address of the foreign financial institution and the account number. The penalty for failure to disclose is $10,000 per year plus an additional $10,000 per month for up to five months if the taxpayer has been mailed a notice of a failure to disclose, such that the total maximum penalty would be $60,000. The Act contains a reasonable cause exception, but reasonable cause does not include [t]he fact that a foreign jurisdiction would impose a civil or criminal penalty on the taxpayer (or any other person) for disclosing the required information. The U.S. Treasury may provide in regulations exceptions for non-resident aliens and bona fide residents of any U.S. possessions. Regulations may also expand the scope of the Act so that it applies not only to individuals but also to any domestic entity which is formed or availed of for purposes of holding, directly or indirectly, specified foreign financial assets, in the same manner as if such entity were an individual. Understatements of tax related to income from undisclosed foreign financial assets will result in a penalty of 40 percent of the underpayment of tax. The Act also extends the statute of limitations on significant omissions of income from foreign assets. There is a significant omission if either the amount omitted from the tax return is greater than 25 percent of the total gross income on the taxpayer s return, or the omitted amount is $5,000 or greater and is attributable to a specified foreign financial asset (without regard to whether the asset value is greater than $50,000, and without regard to whether the taxpayer would be exempted under regulations from disclosing the asset). All of the above provisions relating to the reporting of foreign financial assets are applicable to taxable years beginning after the date of the enactment of the Act. Dividend Equivalents The Act includes a provision taxing dividend equivalent payments as actual dividends, with the result that such payments will be subject to 30 percent withholding if paid by U.S

5 corporations to foreign persons. Dividend equivalents are defined as (1) any substitute dividend made pursuant to a securities lending or a sale-repurchase transaction that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a dividend from sources within the United States, (2) any payment made pursuant to a specified notional principal contract that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a dividend from sources within the United States, and (3) any other payment determined to be substantially similar to the payments described in (1) and (2). A specified notional principal contract is defined, at least for the first two years after enactment of the Act, as any notional principal contract if either (1) upon entering the contract, any long party to the contract transfers the underlying security to any short party to the contract, (2) upon termination of the contract, the short party transfers the underlying security to the long party, (3) the underlying security is not readily tradable on an established securities market, (4) in connection with entering into such contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract, or (5) the contract is identified by the Secretary of the Treasury as a specified notional principal contract. The term underlying security is defined as the security with respect to which the [dividend equivalent] is paid, and an index or fixed basket of securities is treated as a single security. The foregoing definition of specified notional principal contract is effective for payments made on or after 180 days after enactment of the Act. However, after the date which is two years after the date of enactment, any notional principal contract will be treated as a specified notional principal contract unless the Secretary determines that such contract is of a type which does not have the potential for tax avoidance. Passive Foreign Investment Companies The Act also adds a new reporting requirement for U.S. shareholders in passive foreign investment companies ( PFICs ). Generally, a PFIC is any foreign corporation if either 75 percent or more of its gross income for the taxable year consists of passive income, or 50 percent or more of its assets consist of assets that produce, or are held for the production of, passive income. Under regulations which were previously proposed but not finalized, a U.S. person that is a shareholder of a PFIC must file Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualifying Electing Fund, for taxable years in which any of certain triggering events took place. The Act requires that, unless otherwise provided by the U.S. Treasury, each U.S. person who is a shareholder of a PFIC must file an annual information return containing information as the U.S. Treasury may require, regardless of whether a triggering event has occurred. This requirement is effective as of the date of the Act s enactment. Because a person subject to this new reporting requirement may also have to satisfy the new reporting rule requiring disclosure of information with respect to foreign financial assets (discussed above), the Committee Report states that it is anticipated that the IRS will exercise its regulatory authority to avoid duplicative reporting

6 * * * * * * * * * * * * * * * If you have any questions regarding this memorandum, please contact Joseph A. Riley ( , jriley@willkie.com), or the attorney with whom you regularly work. Willkie Farr & Gallagher LLP is headquartered at 787 Seventh Avenue, New York, NY Our telephone number is (212) and our facsimile number is (212) Our website is located at March 25, 2010 IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any U.S. tax advice contained in this communication (including any attachments) 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. Copyright 2010 by Willkie Farr & Gallagher LLP. All Rights Reserved. This memorandum may not be reproduced or disseminated in any form without the express permission of Willkie Farr & Gallagher LLP. This memorandum is provided for news and information purposes only and does not constitute legal advice or an invitation to an attorney-client relationship. While every effort has been made to ensure the accuracy of the information contained herein, Willkie Farr & Gallagher LLP does not guarantee such accuracy and cannot be held liable for any errors in or any reliance upon this information. Under New York s Code of Professional Responsibility, this material may constitute attorney advertising. Prior results do not guarantee a similar outcome