hedge LAW REPORT fund law and regulation FATCA What Impact Will FATCA Have on Offshore s and How Should Such Funds Prepare for FATCA Compliance? By Michele Gibbs Itri, Tannenbaum Helpern Syracuse & Hirschtritt, LLP The Foreign Account Tax Compliance Act (FATCA) (added as Sections 1471-1474 of the Internal Revenue Code of 1986, as amended (Code), by the Hiring Incentives to Restore Employment Act of 2010) will begin to impact the offshore investment fund industry in 2013, requiring a foreign financial institution (FFI) to enter into an agreement with the Internal Revenue Service (IRS) and disclose certain information regarding its U.S. account holders on an annual basis. FFIs are broadly defined to include offshore hedge funds or other offshore private investment funds, and compliance with FATCA may be difficult for many of these funds. The principal goal of FATCA is to prevent U.S. taxpayers from using foreign accounts and investments to hide income from the IRS and evade payment of U.S. tax. As the penalties for failure to comply with FATCA are harsh including the imposition of a 30 percent withholding tax on certain U.S. source payments managers of offshore hedge funds should begin to prepare for FATCA and its due diligence reporting requirements. On January 17, 2013, the IRS issued long-awaited final regulations under FATCA (Final Regulations), clarifying many of the items left open by the proposed regulations released in February of 2012 and previously issued IRS guidance. This article discusses the impact that current FATCA rules will have on offshore investment funds and describes the steps that fund managers can take now to comply with these rules to avoid any FATCA tax on the funds U.S. investments. FACTA Tax: Participating vs. Nonparticipating FFIs To incentivize FFIs to disclose their underlying investors to the IRS, FATCA imposes a 30 percent U.S. withholding tax on any withholdable payments to an FFI if such institution does not enter into the requisite agreement with the IRS (FFI Agreement) and fulfill certain compliance requirements. Withholdable payments generally include (1) fixed and determinable annual or periodical (FDAP) income which includes U.S. source payments of interest (including portfolio interest which is currently exempt from U.S. withholding tax), dividends, rents and other similar passive income, and (2) any gross proceeds from the sale of any property that can produce U.S. source interest or dividends. While FDAP income, except for portfolio interest, is currently subject to U.S. withholding tax, proceeds from the sale of stocks and securities are currently exempt from U.S. tax by a foreign fund under a safe harbor provided by the Code, and the FATCA tax would apply to the gross rather than the net proceeds from a sale. The withholding tax under FATCA will be phased in and effective on U.S. source FDAP income beginning on January 1, 2014. Withholding on all withholdable payments will be fully phased in on January 1, 2017, under recent IRS guidance. FATCA will require withholding at the full 30 percent rate from nonparticipating FFIs (i.e., FFIs that do not register and sign FFI Agreements with the IRS). Even FFIs that do register 2013 The Law Report. All rights reserved. 1
and enter into FFI Agreements with the IRS (Participating FFIs) will be required to withhold on certain pass-through payments to recalcitrant account owners (described below). FATCA will force account holders to apply for refunds in order to obtain the benefit of any reduced tax treaty withholding rate. However, no refund will be granted unless the account holder first provides all of the information required under FATCA. Also, if a foreign fund is a nonparticipating FFI and is structured as a corporation in a jurisdiction without an income treaty with the U.S., neither the fund nor the fund s investors will be able to claim a refund of the FATCA withholding tax. FFI Agreements: Obligations and Compliance The Final Regulations require an FFI to enter into the FFI Agreement and obtain a Global Intermediary Identification Number (GIIN) by January 1, 2014 to ensure that it is not subject to a 30 percent withholding tax beginning on January 1, 2014. The Preamble to the Final Regulations provides for the FATCA Registration Portal, which will be a secure online web portal where FFIs can register with the IRS, manage their registration information and agree to any applicable terms of or make the representations required for their status. The Final Regulations provide that online registration for Participating FFI status via this portal will open no later than July 15, 2013. Participating FFIs or registered deemed compliant FFIs (as discussed below) that provide a valid withholding certificate that contains a GIIN that is verified by the withholding agent against the published IRS FFI list will not be subject to FATCA withholding. In the FFI Agreement, the FFI will agree to: Obtain information from each of its account holders to determine whether an account is a U.S. account; Comply with verification and due diligence procedures with respect to its U.S. accounts; Report, on an annual basis, certain information about its U.S. account holders (including name, address and taxpayer identification number) and account information (including the account number, the account balance or value, annual income paid or credited to the account and withdrawals and other information) to the IRS; Deduct and withhold FATCA tax from withholdable payments and foreign pass-through payments to recalcitrant account holders (who do not provide the requisite information) and nonparticipating FFI account holders; Withhold FATCA tax from the portion of withholdable payments made to certain Participating FFIs that is allocable to such FFIs accounts maintained for its recalcitrant and nonparticipating FFI account holders; Comply with requests by the IRS for additional information with respect to its U.S. account holders; and Obtain a waiver from each U.S. account holder of any foreign law confidentiality provisions with respect to such holder s U.S. account. In general, a U.S. account includes any account (1) held by one or more U.S. persons (Specified U.S. Persons) or (2) held by a foreign entity with one or more substantial United States owners (U.S. Owned Foreign Entity). FATCA provides exceptions from treatment as a Specified U.S. Person for publicly-traded corporations, banks, tax-exempt 2013 The Law Report. All rights reserved. 2
organizations, individual retirement accounts, governments, real estate investment trusts, regulated investment companies and common trust funds. These exceptions also apply in determining whether a foreign entity is a U.S. Owned Foreign Entity. The exclusion of tax-exempt organizations will significantly reduce the number of investors with respect to which specific information will need to be reported by offshore hedge funds that limit participation to U.S. tax-exempt investors and investors that are not U.S. persons. However, because a U.S. Owned Foreign Entity is any foreign entity with one or more substantial United States owners, these offshore hedge funds will face significant reporting obligations in order to avoid becoming subject to 30 percent withholding. A substantial United States owner generally is defined as the holder of more than a ten percent interest, but in the case of investment funds, any U.S. owner will be deemed to be a substantial United States owner and will, therefore, cause the fund to be a U.S. Owned Foreign Entity. Accordingly, for foreign investment funds invested in offshore hedge funds, the existence of even one U.S. owner will render the investment fund a U.S. Owned Foreign Entity and cause such fund s interest in the offshore hedge fund to be a U.S. account. However, in order to avoid duplicate reporting, an account in an offshore hedge fund owned by a Participating FFI will not be counted as a U.S. account by the offshore hedge fund. The Final Regulations do not require an annual audit to verify that the terms of an FFI Agreement have been complied with. However, participating FFIs will need to identify a responsible officer in the FATCA Registration Portal who will sign and verify compliance with the FFI Agreement once every three years commencing with the effective date for the FFI Agreement. It is unclear at this time who will perform this function for an offshore fund that is structured as a corporation with directors and a third-party investment adviser, but no general partner. It is likely that such a fund could grant this authority to an employee of its investment adviser. Registered Deemed Compliant FFIs: Possible Exception for Certain Funds Certain offshore funds may be able to minimize FATCA s impact by obtaining deemed compliant status. A registered deemed compliant FFI may register with the IRS through the FATCA Registration Portal but does not need to enter into an FFI Agreement. A chief compliance officer or similar officer of such an FFI will need to certify that the FFI meets the necessary requirements to be a registered deemed compliant FFI once every three years. Certain offshore hedge funds may qualify as a registered deemed compliant FFI if they meet the requirements for Qualified Collective Investment Vehicles or QCIV status. An entity which is an FFI solely because it invests in stocks, securities, etc., will qualify as a QCIV if: It is regulated as an investment fund in its country of formation or in all countries in which it is registered and operates or it is managed by a manager which is regulated in all countries in which the fund is registered or operates; Each record-holder of its direct debt interests over $50,000 and each equity interest holder and any other holder of a financial account with the FFI is one of the following: (1) a Participating FFI, (2) a registered deemed compliant FFI or a non-reporting FFI from a jurisdiction with an inter-governmental agreement, (3) a U.S. person that is not a Specified U.S. Person (i.e., a U.S. tax-exempt or other entity exempted from Specified U.S. Person treatment, as discussed 2013 The Law Report. All rights reserved. 3
above) or (4) an exempt beneficial owner (i.e., foreign governments, international organizations, foreign central banks, governments of U.S. possessions, certain foreign retirement funds and foreign investment entities that are owned by one or more of such exempt beneficial owners), and All other FFIs in its affiliated group are either Participating FFIs or registered deemed-compliant FFIs. The deemed compliant status of a QCIV may be a significant exception for offshore hedge funds that limit their investors to U.S. tax-exempts, Participating FFIs and certain foreign governments and organizations. The determining factor for these types of funds will be whether the jurisdiction in which the fund is organized is deemed to regulate the fund. Luxembourg, Ireland and the Cayman Islands all provide a degree of regulation over the investment funds organized in their respective jurisdictions, but at this point, it is not clear whether such regulation will be sufficient to allow a fund organized in such jurisdictions to claim QCIV status. Readiness: Due Diligence Procedures The Final Regulations require Participating FFIs to follow certain due diligence procedures and standards to identify U.S. accounts, and accounts held by recalcitrant account holders and by nonparticipating FFIs. If a Participating FFI does not obtain the required evidence to identify such accounts within the specified timeframe, it must treat the account holder as a recalcitrant account holder in the case of an individual or a nonparticipating FFI in the case of an entity. These rules set forth separate due diligence procedures with respect to individual accounts and entity accounts and for preexisting accounts and new accounts. All accounts maintained by an FFI prior to January 1, 2014 are treated as preexisting accounts. Enhanced diligence standards are required with respect to pre-existing accounts in excess of $1,000,000 (i.e., so-called high-value accounts ). For new individual accounts, the FFI must collect a Form W-9 or W-8 from each individual account holder and may initially rely upon anti-money laundering and know your client information provided upon opening the account, but additional documentation will be required if U.S. indicia is presented in the initial documentation. For new entity accounts, the FFI will be required to determine whether the entity has any substantial U.S. owners upon opening the account. The Final Regulations confirm the time frame for compliance with the due diligence procedures set forth earlier in IRS released Announcement 2012-42. Under this time frame, withholding agents, including Participating FFIs and registered-deemed compliant FFIs, generally will be required to implement new account opening procedures by January 1, 2014. The Final Regulations allow Participating FFIs and withholding agents until December 31, 2015, to document account holders and payees that are not prima facie FFIs. Readiness: Reporting Requirements Under its FFI Agreement, a Participating FFI will be required to report information about its U.S. accounts and recalcitrant account holders to the IRS. The Final Regulations outline a schedule of dates phasing in when Participating FFIs must begin their reporting. Beginning in 2013, Participating FFIs will be required to report, with respect to each U.S. account, (1) the account number, (2) identifying information (i.e., the name, address, and taxpayer identification number) about the account owner (and its U.S. owners in the case of account owners that are entities) and (3) the value of each U.S. 2013 The Law Report. All rights reserved. 4
account. In 2016, reporting also will be required with respect to the FDAP income payable to U.S. accounts (with respect to the 2015 calendar year). In 2017, full reporting, including reporting of gross proceeds, will begin (with respect to the 2016 calendar year). For each calendar year, a Participating FFI will be required to report the total number and value of accounts held by recalcitrant account holders and to specify the portion of these accounts attributable to owners with U.S. indicia. Reports generally will be due by March 31 of the year following the relevant year, but the Final Regulations provide that a Participating FFI will be required to file the information reports with respect to the 2013 and 2014 calendar years not later than March 31, 2015. Reports will be made on a soonto-be released IRS Form 8966 (FATCA Report). Intergovernmental Agreements: Impact on Funds Located in Certain Jurisdictions The U.S. Department of the Treasury (Treasury) has announced that it will pursue inter-governmental agreements (IGAs) with certain foreign countries as an alternative to regular FATCA compliance for FFIs in those countries. This past summer, Treasury has published two forms of model IGAs for implementing FATCA to serve as the basis for concluding bilateral agreements with interested nations. Under the Model I IGA, an FFI in a participating country would gather and report U.S. account holder information directly to the government in that country, and FFIs would not be required to enter into an FFI Agreement with the IRS, but rather would be subject to an IRS registration requirement. FFIs in jurisdictions which enter into a Model II IGA will be required to enter into an FFI Agreement and fully comply with the Final Regulations, except as modified by the applicable Model II IGA (which may modify the due diligence procedures and reporting requirements of FFIs in the jurisdiction). To date, the IRS has concluded Model I IGAs with the United Kingdom, Denmark, Mexico, Ireland, Norway and Spain and has entered into a Model II IGA with Switzerland. Treasury recently announced that it is in the process of finalizing Model I or Model II IGAs with France, Germany, Japan, Canada, Guernsey, Jersey and certain other countries. It also indicated that it is actively engaged in concluding an IGA with certain other countries, such as the Cayman Islands, and expects to be able to conclude negotiations with several of these jurisdictions by year end. Further, Treasury is working to explore options for IGAs with countries such as Bermuda, the British Virgin Islands and Luxembourg. While the conclusion of these agreements with jurisdictions such as the Cayman Islands, Bermuda, the British Virgin Islands and Luxembourg may simplify FATCA compliance by investments funds organized in these jurisdictions, the degree of reporting and compliance requirements that will be required under the local country s rules remains unclear. Next Steps for Investment Funds Newly organized offshore hedge funds and other pooled investment vehicles should review and modify their fund documents (e.g., partnership agreement or other organizational document, offering memorandum and subscription documents) to include FATCA related provisions to enable the fund to comply with FATCA s due diligence procedures and standards outlined in the Final Regulations. Such provisions should include (1) representations from investors as to their U.S. and FFI status, (2) covenants to cooperate with the fund s efforts to comply with the FATCA disclosure rules and acknowledgements that failure to comply may result in the fund withholding on payments to such investor and (3) indemnification and compulsory redemption provisions for failure to provide the needed information. Investors should be required to waive any foreign law provision that might otherwise prevent compliance with an FFI Agreement 2013 The Law Report. All rights reserved. 5
and to consent to the fund providing required information to the IRS. Existing funds should also revise their fund documentation to provide similar provisions. While certain provisions may require investor consent, managers of such funds should review their fund documentation to determine which information the fund has the ability to obtain and the remedies for non-compliance (i.e., compulsory redemption) contained under existing documents. Such funds should also develop questionnaires for existing investors to obtain the required information. Michele Gibbs Itri is a partner at Tannenbaum Helpern Syracuse & Hirschtritt, LLP. Her practice focusses on the tax and legal aspects of investment funds, financial instruments, international transactions, corporate and real estate transactions. She works closely with clients to structure transactions to achieve the most favorable tax results. Her practice encompasses all aspects of federal, state, local and international taxation, with an emphasis on onshore and offshore investment funds, venture capital transactions, corporate acquisitions, financial instruments and real estate acquisitions and dispositions. Michele also assists clients in the structuring and organization of private partnerships and limited liability companies (primarily investment management and real estate management firms). She is reachable at 212-508-6732 or at itri@thsh.com. 2013 The Law Report. All rights reserved. 6