Automatic Exchange of Information

FATCA, CDOT & CRS – What should you be doing now?

Originally published in the November 2015 issue

Hedge funds and hedge fund managers, like much of financial services sector, have been firmly swept into the global battle against tax evasion. The introduction of the Foreign Account Tax Compliance Act (“FATCA”) by the US, UK FATCA for the UK’s Crown Dependencies and Overseas Territories (“CDOT”) and the Organization for Economic Cooperation and Development’s (OECD) Common Reporting Standard (“CRS”) are the key driving force behind this.

The regimes require in scope organisations to collect, validate and report the financial account information of their customers to tax authorities as a pre-cursor to automatic information exchange between tax authorities worldwide. In doing so, tax authorities will be better equipped to detect instances of tax evasion as they seek to validate such data against tax filings made by individuals and entities tax resident in their jurisdictions. With over 90 jurisdictions having committed to adoption of the CRS (59 of which have committed to undertake first exchanges by 2017), we will see a vast increase in the volume of reporting required as compared to FATCA.

Although compliance is a legal obligation, given the nature of the data being reported and what tax authorities will be doing with it, the more pressing concern for many organisations is the significant impact burdensome compliance processes or inaccurate reporting could have on customer relationships and customer experience.

Operationalising such Automatic Exchange of Information (“AEOI”) regimes in the hedge funds industry has posed a number of challenges, not least due to the breadth of stakeholders typically involved.
Ultimately it is the fund’s obligation, as the Financial Institution in the context of the AEOI regimes, to ensure compliance with AEOI requirements in respect of its investors. In reality for FATCA, as is expected to be the case for CDOT and CRS, achieving compliance has required funds to determine how best to engage with a range of stakeholders from fund managers, fund boards of directors, fund administrators, advisors, counterparties, distributors and of course investors themselves. The relationship between the fund manager and fund board of directors is of particular interest with the manager often having to determine how best to provide comfort to fund boards that all appropriate processes will be in place.

Whilst FATCA and CDOT compliance procedures, on the whole, are in place across the hedge fund industry, their transition to “business as usual” operations, expanded FATCA and CDOT reporting obligations, as well as CRS readiness, all continue to be key challenges as we approach 2016.

A reminder –what is expected in 2016?
2016 will be the first time we see all three AEOI regimes in operation. Four key sets of compliance processes (on-boarding, due diligence, changes in circumstance monitoring and reporting) will therefore need to be operational to some extent across all three regimes, making the compliance challenge greater than in previous years. This is particularly the case given the need to monitor variations and potential changes in local requirements across jurisdictions as local country guidance continues to evolve.

We are seeing a range of operating models being adopted across the industry; however most hedge funds are seeking to achieve compliance through a mix of the fund manager’s tax and operations functions, fund administrators and support from other third party advisors. In the following sections, we outline the key requirements to be addressed as well as our observations on key challenges funds have faced in addressing these to date.

With FATCA and CDOT both coming into effect in the UK from 1 July 2014, investor on-boarding processes are expected to be operational and compliant with FATCA/CDOT requirements over 2016. With CRS coming into effect on 1 January 2016 (for the 59 early adopting jurisdictions), on-boarding procedures will also need to be CRS compliant for the first time from that date.

In all cases this will require subscription documents to incorporate appropriate self-certification forms (designed to capture tax residency status amongst other information across new investors) as well as processes to assess the reasonableness of the information received through such forms (e.g. through cross reference back to information received during KYC/AML processes). In particular, processes to assess reasonableness should be considered to ensure clarity around how and by whom this is to be completed given the role the fund administrator typically plays across wider investor on-boarding processes.

Our experience with regards to FATCA and CDOT to date has been that fund on-boarding processes were not fully in place as of 1 July 2014 across the board, and subsequently significant remediation efforts were required to identify and classify new investors. Indeed our experience tells us there are still many funds that are not collecting the right information to comply with their obligations under CDOT, despite the fact that reporting will be required in the first half of 2016. Such remediation efforts under CRS will inevitably be much more challenging due to the potential volume of impacted investors. Ensuring CRS on-boarding processes are in place from 1 January 2016 should therefore be a key focus.

Due diligence on pre-existing investors
All AEOI regimes include requirements to complete due diligence procedures for pre-existing investors. FATCA and CDOT due diligence must be completed for all pre-existing investors by 30 June 2016 (with the deadline for completion of reviews for “high value” individual accounts having already passed on 30 June 2015). Due to the later implementation of CRS, due diligence reviews for “high value” pre-existing individuals are required to be completed by 31 December 2016 for early adopting countries (with all remaining accounts to be reviewed by 31 December 2017).

On the whole, most funds had completed high value individual account due diligence for FATCA/CDOT purposes by 30 June 2015. But, in some cases timing of commencement and pre-existing investor volumes were such that reviews were not completed within this timeframe. Complexities also arose where fund managers changed fund administration service providers, which caused challenges in terms of access to data as funds transitioned between providers. Given the spike in relevant in-scope investors under CRS, due diligence processes should be mobilised sooner rather than later.

Change in circumstance monitoring
In addition to both on-boarding and due diligence procedures, effective processes are expected to be in place to monitor changes in circumstances and to ensure that the accuracy of data held is maintained on an ongoing basis.
Whilst processes were typically in place to monitor changes in circumstance, lower volumes tended to mean that in some cases these were based around manual tracking through spreadsheets and other basic applications. With the greater volumes of reportable persons anticipated under CRS, and the inherent complexity in tracking tax residency changes (as opposed to just US citizenship/ residency under FATCA), more sophisticated automated solutions will be required to track and flag potential changes in circumstance and have the necessary workflows in place to validate and gather updated documentation where necessary.

Without doubt FATCA reporting has been one of the most complex and challenging issues that has had to be addressed to date. Variations in local country reporting formats or schemas, differences in local country submission mechanisms across Model 1 IGA locations, data privacy and transfer restrictions in some jurisdictions and teething problems in tax authorities’ submission systems/portals all created a perfect storm of reporting challenges for those with reportable accounts or those required to file nil returns.

In 2015, funds completed their first FATCA reporting (principally for “new investors” only, i.e. on-boarded post 1 July 2014). In 2016, we will see the first reporting under CDOT as well as expanded reporting requirements for FATCA and CDOT not only due to the need to report pre-existing customers but also to report additional data around account payments (e.g. for investment entities this will include gross amounts paid or credited to the account holder in the reportable period).

Although reporting under CRS for early adopting jurisdictions is not required until 2017, ongoing activity is anticipated across the industry as funds seek to evaluate outsource provider capabilities to address the significant complexity of high volume, multi-jurisdictional reporting under CRS. All such providers will need to have processes in place to analyse and monitor local tax law across multiple jurisdictions, compile significant volumes of data from a range of sources, produce and validate tax reports in prescribed formats and transmit those reports to the proper tax authorities where permissible. Key decisions will therefore need to be made in the near future about how to access such expanded reporting capabilities.

A further area for consideration is the extent to which potential synergies across data being reported for AEOI purposes and other forms of tax reporting being completed for the fund (e.g. US PFIC or K1 reporting) should be leveraged to drive efficiency in reporting processes and to ensure consistency in data being reported across differing regimes.

What should hedge funds be doing next?
Fund administrators and other third party advisors inevitably play a critical role across the industry in supporting hedge funds achieve and maintain compliance with AEOI requirements. In almost all cases, funds have already aligned the necessary support to enable delivery against FATCA and CDOT requirements. However, there are still a number of considerations funds should assess in terms of their AEOI operating models to gain comfort that obligations are being met fully, efficiently and with minimal adverse impact on investor experience.
Assess the coverage gaps
Although many funds will rely on their fund administrators to meet a number of compliance requirements, there will continue to be requirements and processes that typically cannot be outsourced to an administrator and will need to either be completed internally by fund managers or addressed by other external advisors. Such activities may include legal entity classification (which may differ across FATCA, CDOT and CRS), maintenance of entity registrations with the IRS under FATCA, processes to monitor changes in entity status, investor communications and provision of self-certifications to relevant counterparties. Furthermore, specific considerations are also likely to be needed around how the removal of the sponsored entity concept under CRS (which under FATCA effectively enabled the consolidation of certain compliance requirements in relation to one or more funds into a sponsoring entity) will be addressed where previously adopted for FATCA.

Ensuring a comprehensive understanding of any such potential coverage gaps, particularly in respect of CRS, should therefore be a key focus now to ensure compliance requirements are not overlooked.

Pro-actively challenge readiness of third parties
As well as having a firm grasp on their own obligations, given their ultimate obligation for compliance, funds should pro-actively challenge the readiness of their fund administrators and third party service providers. This is particularly the case when dealing with multiple providers, each having their own systems, processes, procedures and interpretations in place.

Based on our experience, some service providers may still not be fully prepared for the commencement of new CRS requirements from 1 January 2016 and continue to face the challenge of remediating deficiencies in FATCA/CDOT readiness from previous years. Being able to drive consistency in approach and service quality in such cases will largely be dependent on the fund having a comprehensive understanding of all critical requirements across the FATCA, CDOT and CRS regimes, being able to engage in effective dialogue with their service providers around their readiness and ensuring clear demarcation of roles and responsibilities across all stakeholder groups.

Particularly with reporting, ensuring a full understanding not only of local country tax technical reporting requirements, but also practical considerations relating to data validation and transfer protocols, submission mechanisms and sign off procedures should all be considered as part of discussions with service providers to assess reporting capabilities and readiness for expanded reporting needs.

Ensure continuing focus on customer experience
Although day to day operation of many AEOI compliance processes and procedures will be delivered by fund administrators, funds should be conscious of the impact such processes can have on the customer experience of their investors. Inefficient or overly burdensome processes, for example in terms of the approach to collection of self-certification forms, investor due diligence outreach and investor communications around reporting obligations all potentially risk alienating investors from making future investments if not managed well. Funds should therefore focus on ensuring they understand the way in which outsourced processes will impact end investors and gain sufficient comfort that customer experiences are being preserved.

The extent and quality of training provided to client facing and investor relations teams is also a key factor in preserving customer experience. Ensuring client facing staff are aware of AEOI compliance requirements across product ranges and are able to communicate effectively with investors accordingly should form part of “business as usual” operations.
Manage data quality and security risks

Reporting high volumes of complex data from multiple locations will always make it difficult to guarantee data accuracy in all cases, but discussions around data quality with fund administrators can help minimise errors. The data reported will ultimately be used by tax authorities to inform their audit procedures going forward. HMRC have made it clear that they see the data they will receive under CRS as “a game changer” in how they can combat tax evasion. Therefore, ensuring the completeness and accuracy of data reported is fundamental.

It is therefore important to be able to understand potential gaps that exist in customer or product data and initiate remediation efforts to close those gaps as soon as possible. Prioritising remediation efforts to focus on essential data that is of long-term interest, such as the tax residency of the investor, can help reduce compliance effort required to meet the reporting requirements.

Funds must also have comfort that the right safeguards are in place across their various third party providers in terms of cross-border data transmission. Taking steps to understand the unique regional requirements for data security, privacy and encryption that allow for centralisation of data and data processing across third party providers will be critical to defining a cost-effective future state operating model. The recently successful challenges to the Safe Harbour Rules for data transfer between the EU and the US highlight that this is a complicated area of the law which can change rapidly.

Develop assurance frameworks
Given the number of stakeholders potentially involved in supporting a hedge fund’s AEOI compliance program, a final consideration is the need for a robust assurance framework. Such frameworks are expected to be necessary, particularly for larger funds, to allow comfort to be gained that all necessary procedures are being undertaken effectively to meet their compliance requirements on an ongoing basis. Within larger hedge fund organisations, it is not unusual to see operational oversight teams in place to monitor and oversee activities of specific external service providers, with agreed procedures in place to periodically assess performance to ensure continuity and quality of service provision as well as readiness for future compliance requirements.

The months ahead
The coming months are a key period for hedge funds in respect of their AEOI compliance programs. The opportunity should be taken to assess, or reassess, readiness for AEOI compliance and the effectiveness of the operating models in place to do so. Ultimately this will be a balancing act between reliance funds should be able to place on the competence and capability of third party service providers, and reasonable steps that should be taken to ensure all the right pieces of the compliance puzzle are not only in place but will operate accurately, efficiently and cost effectively.

Amit Thaker is a Senior Manager in EY’s Financial Services Operational Tax and Technology group focusing on the Wealth and Asset Management sector in the UK. Stuart Chalcraft is a Tax Partner in EY’s Financial Services business and leads its Wealth and Asset Management AEOI group in the UK.