Background
Briefly, FATCA aims to encourage the disclosure by US persons of their offshore accounts, investments and income, by requiring certain non-US entities to disclose to the IRS information about ‘US account’ holders. FATCA imposes a complex withholding and reporting regime for payments to foreign financial institutions (FFIs), as well as to foreign entities that are not FFIs, subject to limited exceptions. The definition of an FFI is very broad and includes not only foreign banking and broker-dealer institutions, but also foreign entities that are investing or trading in securities, partnership interests, commodities or interests in such assets.
The legislation encourages compliance by imposing a punitive 30 percent withholding tax on certain US-sourced income, as well as on the gross proceeds from the disposal of certain investments, regardless of whether there is any gain. Non-US funds that do not directly or indirectly hold US assets may also be impacted by FATCA owing to their affiliations with other non-US funds with such investments, or where banking or other commercial partners require compliance. FATCA will pose enormous challenges both in relation to systems, processes and operations and, more fundamentally, in relation to business models and strategy. Private equity and real estate are perhaps least prepared for it.
Private equity
The challenges posed by FATCA mean that it should be among the primary concerns of all investors and financial service providers with any exposure tothe US market. The key areas of risk that arise for a private fund under FATCA include:
- Commercial risk: Private equity funds may have obligations as withholding agents (for US funds) or under the FFI Agreement (for foreign funds). Failure to meet those obligations may put a fund or its sponsor at risk for unpaid taxes, penalties and interest. Further, termination of an FFI Agreement may put the entire fund at risk of FATCA withholding on investment returns.
- Reputational risk: Sponsors of private equity funds rely on a continuous flow of capital based on their value proposition within the market. Direct and indirect investors may be required to make disclosures to a fund or its distributors to avoid FATCA withholding. A mismanaged FATCA transition may result in withholding that diminishes after-tax returns to investors, thereby creating a negative perception for fund sponsors in the market that may detrimentally impact future capital raising efforts.
Private equity funds need as a matter of priority to perform an impact analysis to determine how their business structure and investors will potentially be impacted by FATCA and to determine the systems and organizational changes that may need to be introduced. Most private equity funds need to review their operating models, including the identification and documentation of customers, the product portfolio, and internal processes and IT systems. They need to examine their ownership structure, distribution model and relationships with fund administrators and other service providers.
Systems changes are likely to require significant time and investment, and need to be identified sooner rather than later to allow sufficient time for implementation. Absorbing the increased compliance costs without adversely affecting investor returns could raise client relationship challenges.
Real estate
At the time of writing, the detailed rules for FATCA are still under development. There are concerns within the US real estate industry that application of FATCA to the sector could have severe impacts on the inflow of foreign capital that is critical to the US real estate market and to the overall economy. In addition, since various special rules for real estate investments already discourage investment by US persons in US real estate through foreign entities, it is not clear that imposing FATCA on US real estate investment is necessary.
However, unless significant exceptions are made, a US real estate fund that is considered to make payments to foreign entities (including foreign entity investors) will have to set up systems for identifying and complying with potential withholding and reporting obligations. A foreign entity that invests in partnerships or corporations holding real estate could be considered an FFI. Further, persons who hold equity or debt interests in such an FFI would be considered to be ‘account holders’ of the FFI.
Furthermore, there are particular difficulties of application and interpretation in the real estate sector which need detailed analysis. The legislation presents additional challenges here because of the wide variety and complexity of investment structures which have been developed in the last 10 years. The impact of FATCA will depend on the specific characteristics of ownership structures and on the treatment of income flows, profits and losses.
In addition, the FATCA withholding regime will apply to ‘pass-through’ payments made to FFIs. Under current guidance, many non-US real estate funds will therefore have to withhold tax on:
- US fixed, determinable, annual or periodic (FDAP) income including dividends, interest and rents;
- gross proceeds from the disposal of property that could produce US-sourced interest or US-sourced dividends, including US debt, certain investments into US real estate investment trusts and investments in US corporations; and
- any other payment made to nonparticipating FFIs or recalcitrant investors at the fund’s pass-through payment percentage.
The guidance suggests that the passthrough payment will be very complex to calculate, and not necessarily directly related to US-sourced income. Unless it is clarified in a helpful manner, the pass-through regime could have the effect of transforming income otherwise treated as non-US sourced into a withholdable payment, effectively re-sourcing income.
As with the private equity sector, the scale of change implied by FATCA and the systems and process implications could be profound. A similar depth of analysis and planning is necessary. The length of time it will take to perform the required review and analysis, ensure it reflects the most up-to-date version of regulation and guidance, develop implementation plans and then put them into effect should not be underestimated.