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United States of America: The application of the US FATCA rules to International Investment Funds

In July 2009, the United States Department of Justice announced that it had reached a settlement with Swiss bank UBS under which the bank agreed to disclose the identities of over 50,000 US customers who used UBS accounts to commit US federal tax evasion. While US taxpayers have used offshore accounts to avoid US tax, the US government has focused keenly over the last several years on offshore tax evasion, enacting significant legislation and announcing several amnesty programs designed to deter future evasion through the use of offshore financial accounts. On 18 March  2010, the President signed the Hiring Incentives to Restore Employment Act (Hire Act) into law1, which contains far reaching rules requiring foreign financial institutions to disclose the identities of US account holders and related account information2.

These disclosure rules not only affect banks and traditional financial intermediaries that customarily deal with the public, they also apply to private equity and hedge fund groups with foreign entities. Since these rules could be effective in a few short months,3 foreign investment funds should take steps to become compliant or begin to quantify their potential exposure to withholding tax that will be imposed on funds that choose not to, or cannot, comply with the statute’s disclosure and compliance mandates. This article will analyse the application of the FATCA rules to certain common international investment fund structures.

Basic FATCA Framework

Generally speaking, any payment made to a foreign fund of a US source item of income, or of gross proceeds from the sale of property that produces US source income, is subject to a 30% gross basis withholding tax under FATCA. The FATCA tax applies even where the traditional withholding rules (so-called ‘Chapter 3’ withholding) do not apply. For example, interest is subject to FATCA withholding even though it may otherwise be exempt from Chapter 3 withholding because it is paid on portfolio debt. FATCA withholding also applies to gross proceeds from the sale of property such as stocks, securities or derivatives that produce US source income even though such proceeds are otherwise not subject to Chapter 3 withholding. The FATCA withholding tax even applies to payments made by foreign persons if the payments relate or are determined by reference to US source investment income. Thus, the FATCA rules may require certain non-US persons to act as US withholding agents.4  A foreign investment fund will generally be treated as a foreign financial institution (FFI) subject to FATCA withholding if it holds itself out as being in the business of investing, reinvesting or trading in securities. While there may be an argument as to whether a particular fund qualifies under this definition, we assume for purposes of this article that most foreign investment funds will qualify as an FFI subject to FATCA.5

A foreign investment fund can avoid FATCA withholding by entering into an agreement with the IRS (an FFI Agreement) or if it is otherwise ‘deemed’ to comply with the FATCA reporting rules. Under the FFI Agreement, a fund must agree to review its existing customer base, identify US account holders and report to the IRS certain information relating to such US accounts annually. Further, the fund must agree to terminate the accounts of account holders that refuse to identify themselves and to withhold on payments it makes to other funds or entities that have not entered into agreements with the IRS or who do not supply information relating to their owners. Alternatively, a foreign investment fund that does not enter into an FFI Agreement may avoid FATCA withholding if it is ‘deemed’ to comply with the FATCA rules by either (1) registering with the IRS or (2) certifying to the US withholding agent that it is eligible for relief. A deemed compliant foreign fund will still need to review its accounts for US account holders and to report information relating to such accounts. Not many foreign funds will likely qualify as deemed compliant, so many will need to consider entering into an FFI Agreement.6

1 L. 111-147 (H.R. 2847).

2 The relevant statutory disclosure rules are contained in a subsection of the Hire Act and are entitled the Foreign Account Taxpayer Compliance Act or FATCA.

3 While actual withholding is not scheduled to begin until January 1, 2014, January 1, 2013 is the cut-off date on which existing obligations may be exempt from FATCA under the grandfathering rules. See also Announcement 2012-42 (expanding the class of instruments that may be eligible for grandfathering).  In addition, taxpayers that enter into an agreement with the IRS under FATCA by June 30, 2013 will receive identification numbers before 2014 that may be given to US withholding agents in order to avoid FATCA withholding. Taxpayers who enter into such agreements after that date may not receive identification numbers before withholding begins in 2014 and may be subject to withholding as a result.

Funds with Direct Investment

Some non-US based investment funds are based on a relatively straightforward structure consisting of an entity that holds assets (the Fund) and that is managed by another separate entity (the Management Co.). A typical fund may be structured as follows:

a diagram of a fund with direct investment

In the example above, Fund is organised in a non-US jurisdiction. Management Co. may be an investor in the Fund and/or be paid an additional return (the carried interest) based on performance of the Fund’s portfolio. The Fund may invest in a variety of foreign and US based securities as part of its overall investment strategy, and it may have US and international investors. The Fund may be structured to take advantage of certain exceptions to the US net basis tax available to entities that trade for their own account. In addition, the Fund may expect that the bulk of its interest income, capital gains and income from derivatives may be paid free of US withholding tax under various statutory exceptions for such income.7 As a result, the Fund may expect to incur little US tax liability. Under pre-FATCA law, the Fund would generally not be required to disclose anything about its shareholders to the US government. Rather, it would be free to make distributions of its earnings without having to report the identities of its investors.8 If the Fund is a corporation for US tax purposes, as is often the case, the US government may receive information from US-based payors regarding amounts paid to the Fund but this information will show the Fund as the recipient of the income and will not disclose the identities of the Fund’s shareholders.9

Under the FATCA rules, the Fund’s US withholding tax exposure and potential reporting obligations could change dramatically. Under FATCA, the Fund’s US source investment income and gross proceeds from the sale of assets that produce such income will generally be subject to the 30% gross basis FATCA tax unless the Fund enters into an FFI agreement with the IRS or is otherwise exempt from doing so. In the absence of such an agreement or exemption, the Fund will not be able to claim a refund of any tax withheld even if the income is otherwise exempt from US tax unless it is able to claim a reduced rate of withholding under a US income tax treaty. If the Fund is unable to claim treaty benefits, its owners (e.g. the investors, above) may file a claim for refund if such investors are treated as the beneficial owners of the income at issue. For example, if the Fund is a flow-through entity for US tax purposes (e.g. a partnership or trust), the investors may be able to claim a refund of FATCA taxes withheld but only if they can claim benefits under a US income tax treaty that reduces the rate of tax on the item of income subject to FATCA withholding.10 However, if the Fund is a corporation that does not enter into an FFI Agreement and is not otherwise exempt from FATCA, no refund of FATCA tax is available if the Fund cannot claim benefits under a treaty. Even if the Fund’s owners are otherwise resident in a treaty jurisdiction, none of the FATCA tax withheld can be refunded because the Fund, not its investors, would be treated as the beneficial owner of the income.

The FFI Agreement

One way the Fund can avoid FATCA withholding is by entering into an FFI agreement with the IRS under which it agrees to perform due diligence to identify existing US account holders and to put in place procedures to identify such account holders in the future. However, implementing these requirements could result in a significant burden for non-US based funds for several reasons. First, identifying the beneficial owners of a fund is not necessarily an easy task. For example, among the owners of a fund may be other funds (a so-called ‘Fund of Funds’) or other entities that are in turn owned by yet another entity. Each of these entities may be located each in a different 

jurisdiction and may be subject to different local disclosure limitations. Thus, one or more of these entities may be prohibited by local law from disclosing the identity of its owners without explicit consent. Thus, it may be legally (and indeed practically) impossible for a fund to identify its ultimate beneficial owners without obtaining consent from the owners at every level of the organizational structure. Second, even if there is no legal proscription against disclosing the owners of a fund, the fund’s organizational documents may limit or prohibit disclosure of owner information. In that event, organizational documents may need to be amended in order to minimize exposure under FATCA.

If the Fund (described in Diagram A above) enters into an FFI Agreement, it will be required to apply due diligence standards specified in the FFI Agreement to identify US account holders among its existing investors. The Fund must also apply complex rules to categorize its account holders under the due diligence standards set forth in the Proposed Regulations. There are separate rules for entity and individual accounts. For accounts exceeding a minimum threshold value, a foreign fund will need to review all information contained in its electronic or physical files and if indicia of US status is found, the fund must obtain documentation and a waiver of local non disclosure law (if applicable) from the US account holders. Alternatively, the Fund may obtain documentation to show that the account holders are in fact non-US persons. While the Fund may have personal knowledge of the status of its investors, it will have to review documentation for each account (or find an exemption) to ensure that it has appropriate documentation to support a conclusion as to US or non-US status under the FATCA rules. Investors in the Fund that are also funds must disclose whether they too have entered into an FFI Agreement or be subject to withholding by the Fund. In addition, the Fund must establish procedures designed to identify all US shareholders that invest in the future. Moreover, the Fund will need to appoint an officer to be responsible for certifying compliance with the due diligence standards in the FFI Agreement.11 In any event, entering into an FFI agreement may require the Fund to expend significant resources reviewing its existing investor base and developing procedures to identify and categorize new investors.

If the Fund enters into an FFI Agreement, it will be required to report information on its US accounts to the IRS. While much of the information the Fund must provide with respect to US accounts is relatively straightforward,12 identifying the accounts that are, in fact, subject to reporting may prove challenging. For example, the FFI Agreement requires reporting on all accounts held by all US persons13 but it also requires reporting on accounts held by foreign entities that are not financial institutions but that are US owned (so-called ‘US owned NFFEs’). A US owned NFFE is a foreign entity that is not an FFI but that is owned by substantial US owners (those who own at least 10% of the equity or profits interest of the entity. Many foreign funds have investors that are themselves foreign entities with no apparent US connection. However, a foreign fund that enters into an FFI agreement will be required to determine whether such investors have substantial US owners and, if so, the fund will be required to provide information regarding the account of the foreign entity investor.14 In addition, accounts that are initially treated as exempt from disclosure may become subject to disclosure at any time upon the discovery of new information.15

Intergovernmental Agreements

If available, a foreign investment fund may enter into an Intergovernmental Agreement (IGA) in lieu of entering into an FFI Agreement. Under an IGA, a foreign fund would not report information regarding US accounts to the IRS but rather would report to its home country tax authority which in turn would provide such information to the IRS automatically. To date, only the United Kingdom has entered into an IGA with the United States. However, several other countries have indicated their interest in pursuing an IGA.16 The IRS has released two model IGAs and will be actively negotiating final agreements with tax authorities around the world. The presence of separate and potentially different IGAs for each country could create a complex patchwork of rules that could make complying with the FATCA rules very difficult indeed. For example, a foreign investment fund that operates in several different countries could be required to adhere to the rules contained in multiple IGAs with different provisions, resulting in substantial compliance burdens. Obviously, it would be preferable to have all members of a fund group subject to a uniform set of rules, but only time will tell if it will be more sensible to pursue that result through an FFI Agreement, or through a series of separate IGAs or possibly some other approach.

4 However, withholding on such passthru payments will not be required until January 1, 2017 at the earliest.

5 Certain types of entities are excepted from the definition of an FFI including start-up companies, non-financial holding companies, group treasury centers, entities emerging from bankruptcy and entities exempt from tax. However, these exceptions will not likely apply to foreign investment funds.

6 Certain qualified collective investment vehicles and registered investment funds are eligible to be treated as registered deemed compliant FFIs. Moreover, certain retirement funds may qualify as certified deemed compliant under FATCA. However, most private foreign investment funds will not qualify as deemed compliant under these provisions.

1 Pub. L. 111-147 (H.R. 2847).

2 The relevant statutory disclosure rules are contained in a subsection of the Hire Act and are entitled the Foreign Account Taxpayer Compliance Act or FATCA.

3 While actual withholding is not scheduled to begin until January 1, 2014, January 1, 2013 is the cut-off date on which existing obligations may be exempt from FATCA under the grandfathering rules. See also Announcement 2012-42 (expanding the class of instruments that may be eligible for grandfathering).  In addition, taxpayers that enter into an agreement with the IRS under FATCA by June 30, 2013 will receive identification numbers before 2014 that may be given to US withholding agents in order to avoid FATCA withholding. Taxpayers who enter into such agreements after that date may not receive identification numbers before withholding begins in 2014 and may be subject to withholding as a result.

4 However, withholding on such passthru payments will not be required until January 1, 2017 at the earliest.

5 Certain types of entities are excepted from the definition of an FFI including start-up companies, non-financial holding companies, group treasury centers, entities emerging from bankruptcy and entities exempt from tax. However, these exceptions will not likely apply to foreign investment funds.

6 Certain qualified collective investment vehicles and registered investment funds are eligible to be treated as registered deemed compliant FFIs. Moreover, certain retirement funds may qualify as certified deemed compliant under FATCA. However, most private foreign investment funds will not qualify as deemed compliant under these provisions.

7 Typically, the tax disclosure in the Prospectus or Offering Memorandum of a non-US fund will assert that the fund is not subject to US net basis tax, and will be subject to little, if any, gross basis withholding tax on payments that it receives from US persons. Except for recently formed funds, organizational documents will contain no analysis of the application of FATCA to the funds’ investments, leaving open the issue of how FATCA will apply to existing investors.

8 Of course, US shareholders in the Fund would be required to report income from the Fund on their US income tax returns and to possibly disclose information regarding the Funds overall earnings and certain other information about the Fund.

9 Funds organized as pass-through entities will in most cases be required to submit owner information to their US payors unless the Funds take on direct responsibility for withholding and reporting to the US tax authorities.

10 Any investor claiming a refund must disclose his or her identity to the IRS and must certify beneficial ownership and non-US residence.

11 In addition, this compliance officer must also certify that no fund personnel encouraged or otherwise advised US investors on how to avoid being identified as such to the IRS.

12 Proposed US Treasury Regulation Section 1.1471-4(d)(3) requires disclosure of a US account holder’s Name, Address and Taxpayer Identification Number. In addition, year-end account balances and payments made with respect to the account must also be reported. Transactional reporting may be done using principles already used by the Fund to report such information in the ordinary course. However, if the Fund does not report such information it must do so applying US Federal income tax principles, which may require it to incur additional expense to conform to its existing data to US tax principles.

13 Several exceptions are provided for US persons that are US registered securities brokers, banks, real estate investment trusts, US regulated investment companies, publicly traded corporations and others. See Proposed US Treasury Regulation Section 1.1473-1(c).

14 See Proposed US Treasury Regulation Section 1.1471-4(d)(3)(iii).

15 For example, if an investor in a fund makes a subsequent investment and presents indicia of US status with respect to the second investment or account, the investor’s initial account must then be treated as a US account subject to reporting under the FFI Agreement.

16 Japan, Switzerland, Germany, France, Italy and Spain have all expressed interest in negotiating separate IGAs. The Isle of Man, Guernsey and Jersey are also seeking to negotiate an IGA.

17 Withholding on interest is scheduled to begin on January 1, 2014 and withholding on gross proceeds must begin on January 1, 2017 under current rules.  See Announcement 2012-42 (extending the deadline for withholding for certain payments) Passthru payment withholding will begin on January 1, 2017 at the earliest.

18 Even if the Master Fund otherwise may claim a reduced treaty rate it must file a US tax return to claim a refund and must certify that it has no substantial US owners before a refund will be issued. See Section 1472(b)(2) of the Code. Under the FATCA rules, no interest may be paid on a refund of tax paid to the Master Fund.

19 Of course, a Master Fund must be equipped to report the amount of FATCA tax properly allocable to its investors in order for such investors to claim a refund. This may require modification of the Master Fund’s existing reporting procedures.

Master-Feeder Structures

In many Master-Feeder Structures, the Master Fund is an entity organized in a non-US jurisdiction, and is owned by other entities (Feeders) organized to facilitate ownership by different groups of investors. For example, a Master Fund may be owned in part by a US based Feeder that facilitates investment by US based persons. Similarly, a non-US entity may facilitate investment by non-US investors, and other entities may facilitate investment by tax exempt entities. The Master Fund may be owned in part by its Managers (frequently a management company) who may also be entitled to performance based fees (i.e. the carried interest) and who may be resident in the US or elsewhere. Let us consider a Master-Feeder Fund that is organized as follows:

diagram demonstrating a master-feeder fund

Assume that the Master Fund is a bond trading fund that trades US debt securities on the US exchanges through a US broker.

Under the FATCA rules, the US broker is a withholding agent and will be required to withhold 30% of the gross amount of any interest or gross sales proceeds from assets belonging to the Master Fund unless the Master Fund enters into an FFI Agreement or is otherwise exempt from doing so.17 Thus, if the Master Fund receives interest on its bond portfolio such interest will be subject to withholding under FATCA if the Master Fund does not enter into an FFI Agreement or is not otherwise exempt from doing so. As discussed previously, any taxes withheld cannot be refunded to the Master Fund unless it is a qualified resident of a jurisdiction with which the US has an income tax convention that provides a tax exemption for interest.18 If the Master Fund is treated as a flow-through or disregarded entity for US income tax purposes, FATCA taxes withheld on payments of interest to the Master Fund may be refunded to the owner of the Master Fund (e.g. the non-US

Feeder in this case) if the owner is treated as the beneficial owner of the income and can claim a reduced rate of withholding under a relevant US income tax treaty.19 However, in most cases, the Master Fund will be organized as a corporation and, therefore, its owners generally will not be treated as the beneficial owners of interest income received by the Master Fund. Moreover, in most cases the Master Fund will be a resident of a non-treaty jurisdiction, creating another hurdle for investors in the Master Fund who may wish to claim a credit for FATCA taxes withheld at the Master Fund level. As a result, FATCA taxes withheld on payments of interest will likely be a substantial and unexpected new cost borne by investors.

Affiliated Group Rules

Special rules relating to affiliated groups may compound the problem for payee foreign funds that are part of an affiliated group of entities. Under these rules, a Fund may not enter into an FFI Agreement unless all FFI members of its ‘expanded affiliated group’ either (1) agree to provide information under the terms of their own FFI Agreement or (2) are registered with the IRS and agree to provide information to the IRS under special rules applicable to registered FFIs. For this purpose, an expanded affiliated group includes all corporate entities related by 50% ownership but also includes partnerships that are ‘controlled’ by other members of the group.

These rules raise additional challenges for Funds considering an FFI Agreement where, as in the typical Master Feeder structure, several entities related to the Master Fund could qualify as FFIs. The Master Fund’s ability to enter into an FFI will be limited if any related entities cannot comply with the disclosure standards set forth by the FFI Agreement. Thus, a thorough analysis of the group structure should be performed in order to determine whether the Master Fund can successfully obtain an FFI Agreement. The Proposed Regulations provide some relief where related entities are bound by local prohibitions on disclosure of account information, but such relief is temporary and may result in the cancellation of an otherwise beneficial FFI Agreement.

Conclusion

Foreign investment funds face potentially burdensome withholding and reporting requirements under the new US FATCA rules. While the application of these rules may change somewhat depending on the outcome of the US Presidential election, it is very likely that the FATCA rules are here to stay. Foreign investment funds should, therefore, assess their exposure and determine whether pursuing an FFI Agreement is practicable. A complete review will include an analysis of the existing investor base and a full examination of existing reporting systems to determine if they are robust enough to meet the information reporting requirements of the FATCA regime.

For further information please contact

Ramon Camacho
Principal
camacho@mcgladrey.com

Or

Paul Bagratuni
Director
bagratuni@mcgladrey.com
McGladrey LLP
T +1 202 370 8243

1 Pub. L. 111-147 (H.R. 2847).

2 The relevant statutory disclosure rules are contained in a subsection of the Hire Act and are entitled the Foreign Account Taxpayer Compliance Act or FATCA.

3 While actual withholding is not scheduled to begin until January 1, 2014, January 1, 2013 is the cut-off date on which existing obligations may be exempt from FATCA under the grandfathering rules. See also Announcement 2012-42 (expanding the class of instruments that may be eligible for grandfathering).  In addition, taxpayers that enter into an agreement with the IRS under FATCA by June 30, 2013 will receive identification numbers before 2014 that may be given to US withholding agents in order to avoid FATCA withholding. Taxpayers who enter into such agreements after that date may not receive identification numbers before withholding begins in 2014 and may be subject to withholding as a result.

4 However, withholding on such passthru payments will not be required until January 1, 2017 at the earliest.

5 Certain types of entities are excepted from the definition of an FFI including start-up companies, non-financial holding companies, group treasury centers, entities emerging from bankruptcy and entities exempt from tax. However, these exceptions will not likely apply to foreign investment funds.

6 Certain qualified collective investment vehicles and registered investment funds are eligible to be treated as registered deemed compliant FFIs. Moreover, certain retirement funds may qualify as certified deemed compliant under FATCA. However, most private foreign investment funds will not qualify as deemed compliant under these provisions.

7 Typically, the tax disclosure in the Prospectus or Offering Memorandum of a non-US fund will assert that the fund is not subject to US net basis tax, and will be subject to little, if any, gross basis withholding tax on payments that it receives from US persons. Except for recently formed funds, organizational documents will contain no analysis of the application of FATCA to the funds’ investments, leaving open the issue of how FATCA will apply to existing investors.

8 Of course, US shareholders in the Fund would be required to report income from the Fund on their US income tax returns and to possibly disclose information regarding the Funds overall earnings and certain other information about the Fund.

9 Funds organized as pass-through entities will in most cases be required to submit owner information to their US payors unless the Funds take on direct responsibility for withholding and reporting to the US tax authorities.

10 Any investor claiming a refund must disclose his or her identity to the IRS and must certify beneficial ownership and non-US residence.

11 In addition, this compliance officer must also certify that no fund personnel encouraged or otherwise advised US investors on how to avoid being identified as such to the IRS.

12 Proposed US Treasury Regulation Section 1.1471-4(d)(3) requires disclosure of a US account holder’s Name, Address and Taxpayer Identification Number. In addition, year-end account balances and payments made with respect to the account must also be reported. Transactional reporting may be done using principles already used by the Fund to report such information in the ordinary course. However, if the Fund does not report such information it must do so applying US Federal income tax principles, which may require it to incur additional expense to conform to its existing data to US tax principles.

13 Several exceptions are provided for US persons that are US registered securities brokers, banks, real estate investment trusts, US regulated investment companies, publicly traded corporations and others. See Proposed US Treasury Regulation Section 1.1473-1(c).

14 See Proposed US Treasury Regulation Section 1.1471-4(d)(3)(iii).

15 For example, if an investor in a fund makes a subsequent investment and presents indicia of US status with respect to the second investment or account, the investor’s initial account must then be treated as a US account subject to reporting under the FFI Agreement.

16 Japan, Switzerland, Germany, France, Italy and Spain have all expressed interest in negotiating separate IGAs. The Isle of Man, Guernsey and Jersey are also seeking to negotiate an IGA.

17 Withholding on interest is scheduled to begin on January 1, 2014 and withholding on gross proceeds must begin on January 1, 2017 under current rules.  See Announcement 2012-42 (extending the deadline for withholding for certain payments) Passthru payment withholding will begin on January 1, 2017 at the earliest.

18 Even if the Master Fund otherwise may claim a reduced treaty rate it must file a US tax return to claim a refund and must certify that it has no substantial US owners before a refund will be issued. See Section 1472(b)(2) of the Code. Under the FATCA rules, no interest may be paid on a refund of tax paid to the Master Fund.

19 Of course, a Master Fund must be equipped to report the amount of FATCA tax properly allocable to its investors in order for such investors to claim a refund. This may require modification of the Master Fund’s existing reporting procedures.

Disclaimer: The information contained herein is general in nature and based on authorities that are subject to change. McGladrey LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. McGladrey LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of McGladrey.

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