FATCA Impact

DMITRI SEMENOV, MARIA MURPHY and ANN FISHER, ERNST & YOUNG LLP

On 8th April 2011, the US Treasury Department and the Internal Revenue Service (IRS) issued Notice 2011-34, the second in what is expected to be a series of guidance under the Foreign Account Tax Compliance Act (FATCA) which became law as part of the Hiring Incentives to Restore Employment Act. While FATCA applies to certain payments made on or after 1st January 2013, alternative fund managers and their service providers are already planning for its implementation. Timely assessment of the fund entities, investors and processes is necessary to meet the FATCA implementation deadline.

FATCA will have a far-reaching impact on US and foreign alternative investment funds, their managers and service providers. While the implementation rules for FATCA are under development and FATCA is not effective until 1st January 2013, fund managers should begin preparing for FATCA now. This is crucial as the implementation challenges are substantial and touch almost every functional asset management area.

What is FATCA?
FATCA is designed to prevent US taxpayers from avoiding US tax on their income by investing through foreign financial institutions and offshore funds. Both US and foreign managed funds, including mutual funds, funds of funds, hedge funds, venture capital and private equity funds, will be impacted.

Under FATCA, foreign financial institutions (FFIs) (e.g., an offshore investment fund) will need to enter into an agreement with the IRS that requires them to disclose information to the IRS on “specified US persons”. Non-financial foreign entities (NFFEs) need to disclose the information on their substantial US owners. FFIs and NFFEs that refuse to comply with FATCA will suffer a withholding tax of 30% on “withholdable payments” – generally certain US source fixed determinable annual and periodical income, e.g., interest or dividends, and gross proceeds from securities that can generate US source interest or dividends. However, US effectively connected income is not included.

Under FATCA, US-based funds are treated as US financial institutions (USFIs) and are required to withhold on payments to non-US entity investors who refuse to provide the required information and/or documentation under FATCA (recalcitrant account holders). FATCA withholding is a parallel withholding system to Internal Revenue Code section 1441 withholding. Accordingly, any potential treaty and US domestic withholding exemptions are not available under FATCA. They can, however, be claimed by the beneficial owner through the refund process, except that, in the case of an FFI that is the beneficial owner of income subject to FATCA withholding, a refund is not available for US domestic withholding tax exemptions and no interest is paid on a treaty-based refund.

New guidance
Notice 2011-34 focuses on “priority concerns” identified by the numerous comments received on Notice 2010-60 (which provides preliminary guidance on certain implementation aspects of FATCA) and adds the following information:

• Revised guidance was provided on how participating FFIs will identify which pre-existing individual accounts are “US accounts” for purposes of FATCA. The concept of “private banking accounts” is introduced; enhanced due diligence requirements apply to them as well as to high-value accounts ($500,000 or more).

• The chief compliance officer (or an equivalent) of an FFI must certify to the FFI’s policies on not advising investors on how to avoid being documented as US and timely completion of required review processes for pre-existing individual accounts as well as to the institution of written policies and procedures by the effective date of the FFI agreement prohibiting employees from advising US account holders on how to avoid having their US accounts identified.

• Application of the “passthru payment” rules (pending further guidance, applies to all payments) is clarified and participating FFIs are required to determine and publish “passthru payment percentages” corresponding to the US assets computed on a quarterly basis.

• The reporting requirements for US accounts were simplified, and it will not be necessary to report gross contributions to/withdrawals from such accounts. Account balances will be reported on an annual, rather than quarterly basis.

• Funds that are withholding foreign partnerships are required to enter into FFI Agreements, unless they are deemed compliant.

• Certain local (foreign) institutions and fully intermediated funds will be treated as deemed compliant and will not have to enter into FFI Agreements. Currently, no general carve out from FATCA for publicly traded, regulated and other investment funds is provided, although Treasury and the IRS are considering whether funds with a restricted investor base and exchange-traded funds could be deemed compliant or could be considered to present a low risk of use for tax evasion purposes.

• The government is considering whether there should be a centralized application procedure for investment funds under common management.

Responsible party for FATCA compliance
Alternative investment clients typically engage third parties to perform administrative tasks such as collecting subscription documents and other relevant paperwork to comply with the know your customer (KYC) and/or anti-money laundering (AML) requirements, managing the fund’s assets, distributing and marketing the fund, redeeming and/or selling assets, calculating net asset value, as well as other tasks. Clearly, investment funds want to make sure that the FATCA compliance process is properly managed, as failure to do so will have a detrimental impact on their business. Also, the fund advisors and respective service providers involved in executing FATCA compliance-related issues for alternative investment funds will likely also be impacted (even though they do not meet the precise definition of the FFI or USFI).

Centralized compliance approach
Treasury and the IRS are considering whether an administrator of the funds, as agent, could perform the necessary due diligence and take any required action associated with maintaining compliant status for the FFIs. However, each fund participating in an agreement under the centralized compliance approach still remains liable for the performance of its obligations under the FFI agreement.

Passthru payments
Withholding is required on passthru payments by participating FFIs to recalcitrant accountholders and non-compliant FFIs to the extent that the payments are attributable to a withholdable payment. The new passthru payment rules will have a significant impact on the asset management industry since all offshore funds that are considered participating FFIs will need to publish and calculate their passthru payment percentage (PPP), which will require quarterly analysis of the underlying assets.
The PPP corresponds to a percentage of the FFI’s assets that could give rise to a withholdable payment (US assets over total assets). An FFI is required to determine its PPP quarterly (based on FFI’s fiscal year), which must be published on a website or database readily searchable by the public within three months after the quarterly test date. Further, all values must be translated into US dollar.

Fund-raising considerations
Implementationand ongoing compliance regarding FATCA provisions will require cooperation and agreement from existing and prospective investors, including education, legal review, account closure, information rights, etc.

Timing and recommended approaches
Meeting these challenges requires significant planning. We believe the following are critical steps in the initial FATCA assessment process:

1. Legal entity structure assessment and classification of fund entities as FFIs, NFFEs and USFIs
2. Review of investor data to classify investors into the appropriate FATCA categories
3. Review of current on-boarding processes and determination of whether know-your-customer processes are adequate
4. Review of payment systems that will be impacted by FATCA withholding and reporting

Fund managers and their service providers will be significantly impacted by FATCA. It is important to act now since almost every functional area will be affected. The timeframe for implementation is short, especially considering that the government has not yet released all the details.

Dmitri Semenov is a Partner in the Financial Services Office of Ernst & Young LLP in New York. Maria Murphy is a Washington, DC-based Executive Director and Ann Fisher is a Senior Manager in Boston.