The US Department of Treasury (Treasury) and the Internal Revenue Service (IRS) recently released the long-awaited FATCA proposed regulations (Proposed Regulations), providing detailed and significant guidance for impacted entities. These details now provide sponsors and managers of private equity (PE) and real estate (RE) funds sufficient information to more completely assess the potential impacts of FATCA’s requirements and to take steps to address them.
FATCA will apply to any fund that trades or invests (directly, indirectly or through certain derivatives) in US assets, any entity in the same “expanded affiliated group” with such a fund, plus many types of non-US investors, service providers and counterparties of such funds. FATCA has specific implications for those parties in the PE and RE sectors, some of which are considered here.
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 primarily engaged in investing or trading in securities, partnership interests, commodities, notional principal contracts, insurance or annuity contracts, or interests in such assets. For non-US RE funds that invest directly in real property, they may be considered non-financial foreign entities (NFFEs). For NFFEs, there is a certification or reporting requirement depending on whether they are active or passive. Note that while service providers, such as fund administrators and transfer agents, may be able to provide FATCA services, the legal obligation remains with the PE and RE funds.
The legislation encourages compliance by imposing a punitive 30 percent withholding tax on most US-sourced investment income, on gross proceeds from the disposal of instruments that can pay US-sourced interest or dividends, and, eventually, on any payments attributable to US-sourced payments (the so-called “passthru” payments) paid by a FFI. 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 counterparties 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. PE and RE funds are perhaps least prepared for it.
Whether the non-US funds are treated as FFIs or NFFEs, the challenges posed by FATCA mean that it should be among the primary concerns of all fund managers, investors and financial service providers associated with funds that have any exposure to the US market. The key areas of risk that arise for non-US
PE and RE funds under FATCA include:
- Commercial risk: PE and RE funds may have US tax withholding and reporting obligations either as US withholding agents (for US funds) or under their FFI agreements (for non-US funds). Failure to meet those obligations in a complete and timely manner may put a fund or its sponsor at risk for unpaid taxes, penalties and interest. Failure to properly assess the risks associated with FATCA when evaluating and managing fund investments could negatively impact a fund’s investment returns. Further, failure to properly manage the FATCA-relevant obligations and activities of service providers and distribution intermediaries could negatively impact the cash flows of the fund and/or its ultimate investors.
- Reputational risk: Sponsors of PE and RE 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 transition to a FATCA-compliant co-operating model may result in withholding against the fund, certain fund investors and/or certain intermediaries between the fund and its ultimate investors (e.g. feeder funds, fund-of-funds, distributors). In any such case, the withholding would diminish after-tax returns to the ultimate investors, thereby creating a negative perception for fund sponsors in the market that may detrimentally impact future capital raising efforts.
For non-US funds that are FFIs, participating in the FATCA regime will require entering into an FFI agreement with the IRS under which the fund agrees to, among other things:
- document new accounts and other FFI payees
- perform due diligence procedures with respect to existing equity and debt interest holders
- report on US accounts, recalcitrant accounts and payments to non-participating FFIs
- withhold on US source or passthru payments to recalcitrant or non-participating FFIs
- certify compliance with the FFI agreement.
This FFI agreement needs to be executed by 30 June 2012 in order to ensure the fund will not be withheld upon from 1 January 2014 (the first withholding effective date) for US source dividends, interest and rents paid (directly or indirectly) to non-US PE and RE funds. There is a limited exception from withholding for certain debt instruments issued on or before 31 December 2012, but account identification and reporting still apply to those obligations.
The biggest challenge for PE and RE funds at the moment is determining whether its entities are in one or more expanded affiliated groups – which would mean that all entities in that group would need to be FATCA compliant or any entity in the group investing in the US would be considered a non-participating FFI. Expanded affiliated group members include corporations with common ownership of more than 50 percent of vote and value, as well as more than 50 percent of the beneficial ownership of a partnership or other transparent entity. The rules for determining partnership ownership include complex attribution rules that should be worked through to determine which fund entities are in or out of the expanded affiliated group.
For non-US RE funds that are NFFEs, they too will need to document their investors to determine if there are any substantial (10 percent) US owners of the fund. If so, such owners and information about their ownership would need to be disclosed to all FFIs making payments to the fund. Those FFIs, in turn, would provide that information to the IRS.
FATCA poses particular difficulties of application and interpretation in the RE sector. Income and gains that are (or are deemed to be) effectively connected to the conduct of a US trade or business (ECI) are not subject to withholding under FATCA. Under existing law, some US source rents are treated as ECI while other types of US source rents that would otherwise not be treated as ECI are, by the taxpayer’s election, deemed to be ECI. Furthermore, under current law (specifically the provisions of the Foreign Investment in Real Property Tax Act (FIRPTA)), gains from the disposition of US real property interests (including equity interests in US real property holding corporations) are deemed to be ECI. Other than a reporting coordination rule, the Proposed Regulations do not squarely address the interplay between FIRPTA and these current ECI rules.
FATCA will also impact how funds and fund investors evaluate the risks of their investments. Among other things, funds and fund investors should evaluate the FATCA-related risks of investing in particular entities or through various types of structures. FATCA will change the compliance obligations and on-boarding experience of many types of fund investors.
The regulatory environment remains fluid and unsettled, notwithstanding the tight window of time remaining to assess impacts and implement changes and the magnitude of unresolved business and technical issues. Treasury and IRS are not expected to issue final regulations under FATCA before late summer of 2012, and they have not yet issued draft FFI agreements, reporting forms or instructions. Moreover, on the same date that it released the Proposed Regulations, the US government and those of five other countries (France, Germany, Italy, Spain and the UK) announced an intergovernmental approach to FATCA. These countries have agreed to work towards a common approach to FATCA implementation through domestic reporting and reciprocal automatic information exchange based on existing bilateral treaties1. This framework, if adopted, may significantly increase the data collection and reporting obligations of US and foreign funds and withholding agents due to differing requirements for each jurisdiction where a fund operates.
FATCA presents particular challenges to PE and RE funds. This is due, in large part, to the wide variety and complexity of investment structures which have been developed in recent years and the volume of capital committed to these sectors, the implications to the business operating models of PE funds and RE funds and scale of change implied by FATCA could be profound. FATCA’s potential impacts to any fund, non-US members of its expanded affiliated group and investors will depend on the specific ownership structure and US tax characteristics of payments and deemed payments (including gross proceeds, principal repayments, partnership distributions, returns of capital and other redemption payments) that flow into and out of the various entities. The amount of time and effort required to perform an appropriate assessment and then develop and implement changes to properly address FATCA will likely be significant and should not be underestimated. Most PE and RE funds will need to review and analyze (among other things) their capital and ownership structures, capital inflows and outflows, account identification and documentation procedures, internal and external processes and systems, governance policies and procedures, investment due diligence criteria, distribution arrangements, and relationships with fund administrators and other service providers.
In view of the new obligations which generally begin during 2013 and wideranging impacts to operating models and investors, PE and RE funds should, as a matter of priority, assess FATCA’s potential impacts and determine what changes should be introduced within the relevant timeframes.
1 US Treasury department, www.treasury.gov, February 2012
Seconded Partner, KPMG in the UK
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Partner, KPMG in Australia
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