FATCA will impact any fund or investment manager who invests in US assets on behalf of their clients, regardless of their domicile.
It appears that much of the financial services sector continues to misunderstand the implications of the US Foreign Account Tax Compliance Act (FATCA)1. Specifically, we continue to hear potentially impacted entities claim that FATCA isn’t relevant to them because they don’t have any US investors. While a common myth, FATCA will impact any fund or investment manager who invests in US assets on behalf of their clients, regardless of their domicile.
The specific requirements for FATCA compliance remain largely unknown. In a recent KPMG study called FATCA and the funds Industry: Defining the Path, 58 percent of the global fund promoters interviewed stated that their level of analysis and research of FATCA for their group is limited to general awareness, while only 10 percent state that they have conducted an impact analysis on their business. In April of this year, the US Internal Revenue Service (IRS) issued a second set of preliminary guidance, further outlining how it believes the new FATCA regime might operate2. While the Notice does address some industry concerns, certain unexpected provisions (e.g. the new documentation rules for pre-existing private banking customers and the expansive application of the pass thru payment concept) have been the most recent topic of debate. This is especially true given the legislation’s looming effective date. Consequently, it is imperative that affected entities fully understand the implications FATCA will have on their business and operating models. Those who wait for definitive guidance are likely to find they will have inadequate time to react, even with the recently issued transition guidance3. In addition, and equally significant, there are still opportunities for the industry, working together, to seek clarification and perhaps influence the new regime’s final requirements.
FATCA is US legislation designed to curtail certain offshore tax abuse by US taxpayers that currently are able to avoid disclosure to the IRS by investing through offshore accounts and/or entities. The core principle of this new regime is the requirement that a ‘foreign financial institution’ (FFI) will need to enter into a disclosure agreement with the IRS, agreeing to identify the direct and indirect owners of its accounts to determine whether they are ‘US accounts.’ To the extent they are, the FFI must disclose them to the IRS.
FFIs that refuse to enter into these disclosure agreements will suffer a 30 percent withholding tax on all US withholdable payments. The effective date for the new regime is 1 January 2013, with phased implementation over the initial years. While the US government has repeatedly stated that FATCA is not primarily intended as a revenue-raising measure, it is estimated that FATCA will generate USD800 million annually over the next 10 years4.
As mentioned, the latest guidance (Notice 2011-53) contains much needed transition rules. The April guidance (Notice 2011-34), however contains numerous detailed definitions and clarifications, of which three themes are particularly significant:
- procedures that participating foreign financial institutions (PFFIs) are to follow in identifying US accounts among their pre-existing individual accounts;
- guidance on the definition of ‘passthru payment’ and the obligation of PFFIs to withhold on passthru payments; and
- guidance on certain categories of FFIs that may be deemed compliant.
Preexisting individual accounts
With respect to the documentation requirements for preexisting individual accounts, Notice 2011-34 introduces new rules that include a welcomed risk based approach. Specifically, instead of a need to document all pre-existing individual accounts at the end of a stated period as set forth in the first Notice, the new Notice introduces the concept of increased documentation scrutiny only where the IRS has identified a heightened risk of abuse (e.g. private banking accounts and accounts with balances exceeding US$500,000). For this new “high risk” class of accounts the PFFI is required to search all files, paper and electronic records, for indications of US status. Significantly, these expansive searches are required even where the account is documented as non-US. While we have heard the expansive due diligence requirements for these accounts explained as the toll that the PFFI must pay for the relaxed rules associated with the preexisting accounts that do not fall within these parameters, these requirements are a substantial departure from the originally stated documentation rules and will create significant administrative concerns for those PFFIs that maintain such accounts.
A PFFI must impose FATCA’s penal withholding on any passthru payment that it makes to a recalcitrant account holder (one that refuses to sign a waiver permitting an FFI to disclose account information, as well as one that does not comply with certain documentation requests in a timely manner) or a nonparticipating FFI. For this purpose, a passthru payment is a withholdable payment as well as any amount attributable to a withholdable payment. While numerous commentators asserted the need for a narrow construction of ‘an amount attributable to a withholdable payment’ on the grounds of both administration and notions of the proper territorial reach of a sovereign nation, Treasury and the IRS seemingly rejected those assertions and, instead, crafted an extremely expansive definition and complex methodology with respect to passthru payments. In fact, as currently drafted, the definition of passthru payment is so broad that it could pull in payments on interest rate swaps, derivative structured products (notwithstanding the fact that the underlying asset may not be related to a US security), and any other payment the PFFI is contractually obligated to make.
Pursuant to the Notice, the new regime would require every participating and deemed compliant FFI around the world to calculate and publicly post its passthru payment percentage (which is its ratio of US assets to all assets), on a quarterly basis. It has been observed that, given the complex ratios and requirements set forth in the guidance, the likelihood of a PFFI imposing withholding on the correct amount of the payment seems remote.
Deemed compliant FFIs
The Notice outlines a number of ‘deemed compliant’ FFI models, such as those for banks that limit service offerings and marketing to their local market, certain local subsidiaries of otherwise global FFI affiliated groups, and financial product distributors that do not market to US citizens. While, as above, it appears that the IRS is on the right track in adopting a risk based approach, the stated requirements that these entities must satisfy are such that few, if any, may actually benefit without significant modifications to their current business operations.
The Notice also provides that certain investment vehicles may be deemed compliant when all direct investors are either participating FFIs, deemed compliant FFIs, or exempted entities (e.g. foreign governments, central banks of issue, and those classified as such by the IRS and Treasury due to a low risk of tax evasion). To obtain this status, the fund must prohibit anyone other than those listed from acquiring an interest as well as certify that it will satisfy its requirements to calculate and publicly post its passthru payment percentage.
Finally, the Notice acknowledges that many funds utilize transfer and paying agents when making distributions. It makes clear that a fund may use these agents to carry out compliance with its FFI Agreement – although the fund will remain liable to the IRS for any compliance shortfalls.
The impact of FATCA will be wide-ranging. Compliance will undoubtedly be challenging for certain impacted entities and likely to force changes to these entities’ core strategy and business models. It is essential that all financial services companies thoroughly review and understand the potential implications, as well as create a strategic plan in response.
At this same time, it is imperative that these entities also understand that the guidance, to date, remains fluid. Specifically, the IRS has repeated stated that it remains open to further representations by the industry, especially where current proposals may cause practical difficulties in implementation. Reasoned arguments, substantiated by specific illustrations of adverse consequences, can still lead to the IRS adopting operationally workable rules without undermining its core purpose – yet another reason why each member of industry needs to engage in a detailed analysis and assessment of FATCA’s impact on its business as a matter of urgency.
1 Passed as part of The Hiring Incentives to Restore Employment (HIRE) Act, March 18, 2010
2 IRS Notice 2011-34, April 8, 2011
3 IRS Notice 2011-53, July 14, 2011
4 Joint Committee Report, JCX-5-10, March 4, 2010