The Foreign Account Tax Compliance Act (“FATCA”) – part of the Hiring Incentives to Restore Employment Act – introduced a number of new withholding and reporting rules to address tax evasion by U.S. citizens and companies. The rules affect foreign financial institutions (“FFIs”), including, but not limited to, brokerage firms, hedge funds, and other pooled investment vehicles.
FATCA compels FFIs to report to the Internal Revenue Service (“IRS”) on an annual basis regarding their “U.S. accounts” (discussed below). Because the IRS cannot directly tax foreign entities, FATCA induces FFIs to comply with these new regulations by imposing a 30% withholding tax on certain categories of U.S. derived payments to FFIs that fail to comply with FATCA’s disclosure and reporting requirements.
FFIs can comply with FATCA in one of two ways: either (1) register with and sign an FFI Agreement with the IRS, or (2) be organized in a country that has signed an Intergovernmental Agreement (an “IGA”) with the U.S. Under an IGA, an FFI must still register with the IRS, but otherwise is simply required to comply with its local jurisdiction’s rules for the implementation of FATCA, rather than the FFI Agreement requirements. (Importantly for investment managers and hedge funds, both the Cayman Islands and the British Virgin Islands have signed IGAs with the U.S.) FFIs that are in compliance with FATCA are termed “Participating FFIs,” while noncompliant FFIs are termed “Nonparticipating FFIs.”
FATCA’s Disclosure and Reporting Obligations
Participating FFIs need to identify a responsible officer in the FATCA registration system that will sign and verify compliance with FATCA’s withholding and reporting rules. This officer is responsible for ensuring that the Participating FFI completes the following tasks:
- Obtain information about each of its account holders from which it can determine if an account is a U.S. account;
- Observe required verification and due diligence procedures for the identification of U.S. accounts;
- File an annual report with the IRS providing information about each of its U.S. accounts;
- Withhold FATCA tax from withholdable payments and “foreign pass-through payments” to Recalcitrant Account Holders (defined below) and Nonparticipating FFIs;
- Comply with any IRS requests for further information with respect to its U.S. accounts; and
- If foreign law would prevent the disclosure of any such information, secure a waiver of the foreign law prohibition from the owner of the U.S. account or, failing receipt of such a waiver, close the U.S. account.
An account holder that fails to provide the required information, documentation, or waivers to a requesting FFI is termed a “Recalcitrant Account Holder.”
The New FATCA Withholding Tax
The U.S. derived payments to FFIs subject to the new 30% withholding tax include (1) interest, dividends and other similar passive income, which are referred to as fixed and determinable annual or periodical income (termed “FDAP income”), and (2) gross proceeds from the sale or other disposition of any property that can produce interest or dividends (i.e., securities). The 30% withholding tax applies to the gross proceeds of each sale (it does not take the disposed of asset’s tax basis into consideration).
FATCA requires U.S. payors and Participating FFIs to withhold the 30% rate from payments due to nonparticipating FFIs—both FFIs that have not registered and/or signed an FFI Agreement with the IRS and FFIs that are not in compliance with their local jurisdiction’s IGA. Moreover, even Participating FFIs are required to withhold the tax on certain pass-through payments to Recalcitrant Account Owners (as described above).
Identifying which accounts are “U.S. accounts” requires an FFI to look-through its accounts to the actual owners of those accounts. A “U.S. account” is defined as any “financial account” held by any one or more “specified U.S. persons” or “U.S. owned foreign entities.” A financial account includes any debt or equity interest in an FFI (other than publicly traded interests).
A “specified U.S. person” generally is any U.S. person other than publicly traded corporations and their affiliates, tax-exempt organizations, governments, banks, regulated investment companies and common trust funds. A “U.S. owned foreign entity,” is any foreign entity with one or more “substantial U.S. owners.”
A “substantial U.S. owner” generally is defined as the holder of more than a 10% interest but there is an exception for investment funds. In the case of investment funds, any U.S. owner will be deemed to be a substantial U.S. owner and as a consequence the fund is considered a U.S. owned foreign entity.
Offshore Fund Application
Subject to an exception, an offshore hedge fund that is comprised of foreign investors and/or tax-exempt U.S. investors is excluded from FATCA disclosure and reporting. The exception occurs if the foreign investor is an investment fund with at least one U.S. owner. The existence of even a single U.S. owner will render the foreign investment fund a “U.S. owned foreign entity” and cause its interest in an offshore hedge fund to be a “U.S. account.” As a consequence of having a U.S. account, the offshore hedge fund becomes subject to FATCA disclosure and reporting.
The deadline for FFIs within countries that have signed an IGA with the U.S. is December 31, 2014, while the deadline for FFIs required to sign FFI Agreements passed on June 30, 2014. However, regardless of the deadline, all FFIs should begin the due diligence procedures and standards contained in the proposed regulations. This includes developing questionnaires for existing investors and revised investor subscription documentation that will solicit the information about those investors and their actual owners as required by FATCA. Additionally, such funds should review and modify, if necessary, their documents to ensure they require investors to cooperate with the funds’ efforts to comply with FATCA.
Fund managers should speak and work with their tax advisers and legal counsel to properly address the changes imposed by FATCA.