- FATCA Compliance for Offshore Hedge Funds
- September 19, 2012 | Authors: Carol Spawn Desmond; Howard A. Neuman
- Law Firm: Satterlee Stephens Burke & Burke LLP - New York Office
The Foreign Account Tax Compliance Act (“FATCA”), which was a part of the Hiring Incentives to Restore Employment (HIRE) Act, included a number of new withholding and reporting rules that are intended to address tax evasion by U.S. citizens and residents, corporations, partnerships, trusts and estates (“U.S. persons”).  The new rules affect foreign financial institutions (“FFIs”) , including offshore 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.” Because the U.S. cannot simply impose its will on foreign entities, FATCA induces compliance by imposing a thirty percent (30%) withholding tax on certain categories of U.S. source payments to FFIs that elect not to comply with FATCA’s reporting, disclosure and other requirements. Compliance with the new rules may be difficult for many offshore investment vehicles.
The IRS issued proposed regulations earlier this year and has issued a number of Notices that provide guidance on the manner and timing of the implementation of the FATCA rules. Under current guidance, FIIs will be required to enter into agreements with the IRS (discussed below, “FFI Agreements”) by June 30, 2013 to ensure that they will avoid being subjected to withholding beginning January 1, 2014. The IRS has not announced when it will issue final regulations or the form of the FFI Agreements to be utilized.
New Withholding Tax
The U.S. source payments to FFIs that will become subject to the new 30% withholding tax include (i) interest, dividends and other similar passive income, which are referred to as fixed and determinable annual or periodical (“FDAP”) income, and (ii) gross proceeds from the sale or other disposition of any property that can produce interest or dividends (i.e., securities). Unlike the current withholding regime, FDAP income does not exclude portfolio interest. More importantly, the second category is completely new and the 30% withholding tax applies to the gross proceeds of each sale, without regard to any capital gain or loss that may have been realized on the sale. Under the proposed regulations, withholding on FDAP income is scheduled to begin January 1, 2014, while withholding on gross proceeds is scheduled to commence January 1, 2015.
FATCA’s withholding tax provisions are intended to supersede (or at least delay) benefits granted under tax treaties other countries have entered into with the United States. Ordinarily, the filing of a form such as Form W8-BEN insures that an account holder will be subject only to whatever reduced withholding rate is in effect under the tax treaty between the United States and the account holder’s country. FATCA will require withholding at the full 30% rate from nonparticipating FFIs (i.e., FFIs that do not register and sign FFI Agreements). Moreover, even FFIs that do register and enter into FFI Agreements with the IRS in order to avoid the new withholding tax (“Participating FFIs”) will be required to withhold on certain pass-through payments to recalcitrant account owners (described below). FATCA will force account holders to apply for refunds in order to obtain the benefit of any reduced tax treaty withholding rate. Of course, no refund will be granted unless the account holder first provides all of the information FATCA is intended to solicit with respect to itself (the scope of that information is discussed in “Avoiding the Tax,” below). Moreover, if the foreign fund is structured as a corporation, neither the fund nor the fund’s investors will be able to claim a refund of the FATCA withholding tax.
As noted above, information gathering rather than revenue generation is the principal purpose of the new tax withholding requirements. Regardless of their purpose, a potential unintended consequence of the new withholding and reporting rules may be to cause some offshore investment vehicles that trade primarily in the U.S. to shift their trading to other markets simply in order to avoid the new reporting rules.
Avoiding the Tax
Participating FFIs will need to identify a responsible officer in the online FATCA registration system who will sign and verify compliance with the FFI Agreement. In general, a single nonparticipating FFI in an affiliated group will prevent all FFIs in that group from becoming Participating FFIs. However, for FFIs that are located in jurisdictions that have laws prohibiting the tax withholding or reporting required under FATCA the proposed regulations provide a two-year transition rule (until January 1, 2016) for certain members of an expanded affiliated group to become Participating FFIs.
Each FFI Agreement will require the Participating FFI to:
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 certain information about each of its U.S. accounts;
Withhold FATCA tax from withholdable payments and “foreign pass-thru payments” to recalcitrant account holders (as defined below) and nonparticipating FFI account holders;
Withhold FATCA tax from the portion of withholdable payments made to certain Participating FFIs that is allocable to such FFIs’ accounts maintained for its recalcitrant account holders and nonparticipating FFI account holders;
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.
Account holders that fail to provide the required information, documentation or waivers to a requesting FFE are referred to in this Advisory as “recalcitrant account holders.”
Identifying which accounts are U.S. accounts will require an FFI to look-through its accounts to the ultimate 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). Thus any equity interest in an offshore hedge fund (which, as noted above, will be an FFI), whether in the form of shares, limited partnership interests or other equity interests, will constitute a financial account.
A specified United States 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. The exclusion of tax-exempt organizations will, of course, reduce significantly the number of investors with respect to which specific information will need to be reported by offshore hedge funds that limit participation to U.S. tax-exempt investors and investors that are not U.S. persons. However, because a U.S. owned foreign entity, is any foreign entity with one or more “substantial United States owners,” even those offshore hedge funds will face significant reporting obligations in order to avoid becoming subject to 30% withholding.
A substantial United States 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 United States owner and the fund will be a U.S. owned foreign entity. Accordingly, for foreign investment funds invested in offshore hedge funds, the existence of even one United States owner will render the investment fund a U.S. owned foreign entity and cause such fund’s interest in the offshore hedge fund to be a U.S. account. However, in order to avoid duplicate reporting, an account in an offshore hedge fund that is owned by a Participating FFI will not be counted as a U.S. account by the offshore hedge fund.
The proposed regulations provide certain due diligence procedures and standards with which an FFI must comply to identify U.S. accounts, accounts held by recalcitrant account holders and accounts held by nonparticipating FFIs. These rules distinguish between the diligence expected with respect to individual accounts and entity accounts and between preexisting accounts and new accounts. With respect to preexisting accounts, diligence standards generally are greater with respect to accounts in excess of $1,000,000. With respect to new individual accounts, the FFI may initially rely upon information, including AML/KYC data, provided upon opening the account, but additional documentation will be required if the initial documentation reveals certain U.S. indicia (e.g., U.S. address or other contact information, instructions to transfer funds to a U.S. account, or power of attorney or signature authority granted to a person with a U.S. address). With respect to new entity accounts for passive investment entities, FFIs will be required to determine whether the entity has any substantial U.S. owners upon opening the account.
The proposed regulations also provide time limits for completing the due diligence process. The rules generally set one or two-year periods for completing diligence, depending on the nature of the investor and size of the account. If the Participating FFI does not obtain the required information within the applicable period, it must treat the account holder as a recalcitrant account holder in the case of an individual or a nonparticipating FFI in the case of an entity.
In order to induce account holders to provide the information called for by an FFI Agreement, as noted above the Participating FFI must agree to withhold FATCA tax on certain payments to recalcitrant account holders and to nonparticipating FFIs as well as the portion of payments of U.S. source FDAP income it makes to certain other Participating FFIs that is allocable to accounts that such other FFI maintains for recalcitrant account holders and nonparticipating FFIs. Failure to act as a withholding agent with respect to such payments will cause the Participating FFI to lose its status as a Participating FFI and to become subject to the FATCA withholding requirements with respect to all of its U.S. source FDAP income and gross proceeds. For this reason, it is important that the FFI have the ability to force recalcitrant account holders and nonparticipating FFIs to withdraw from the fund, to permit the fund to avoid its own withholding obligations and to protect itself from becoming subject to FATCA withholding.
Participating FFIs will be required to comply with reporting requirements with respect to their U.S. accounts and recalcitrant account holders. Under the proposed regulations the reporting requirements for U.S. accounts may be phased in. Beginning in 2013, Participating FFIs will be required to report the account number, identifying information about the account owner (and its U.S. owners in the case of account owners that are entities) and the value of each U.S. account. In 2015, reporting also will be required with respect to the income payable to U.S. accounts. Full reporting, including reporting of gross proceeds, will begin in 2016. For accounts held by recalcitrant account holders, the Participating FFI will be required to report the total number and value of accounts held by such owners and to specify the portion of such accounts attributable to owners with U.S. indicia. Reports generally will be due by March 31 of the year following the relevant year, but for 2013, the Participating FFI must report by September 30, 2014 all accounts it has identified as either U.S. accounts or accounts held by recalcitrant account holders as of June 30, 2014.
Intergovernmental FATCA Agreements
The Treasury Department has announced that it will pursue inter-governmental agreements with certain foreign nations as an alternative to regular FATCA compliance for FFIs in those countries. On July 26, 2012, the Treasury Department issued model agreements that were developed with the governments of France, Germany, Italy, Spain and the United Kingdom. The Treasury Department announced that it will move to enter bilateral agreements with these and other countries based on the model agreements. Under these agreements, FFIs located in participating countries would be deemed in compliance with FATCA and would not be subject to FATCA withholding. Rather, the participating countries would gather and share the required information regarding financial accounts in the respective countries. It is not clear whether any such agreements will have been completed before the January 1, 2014 effective date for FATCA withholding.
Other FATCA Effects
FATCA expands reporting requirements with respect to a passive foreign investment company (“PFIC”). U.S. shareholders of PFICs will have to file an annual report with the IRS containing such information as may be required by the IRS. Although previously certain shareholders were required to file Form 8621 to report income or gain with respect to a PFIC, the new requirement would force annual reports to be filed by all PFIC shareholders. An offshore hedge fund that is a corporation will be a PFIC if either seventy five percent (75%) or more of its gross income for a taxable year is passive income such as dividends, interest and gains from investment transactions or the average percentage of its assets held during a taxable year that produce or are held for the production of such types of income is at least fifty percent (50%). The new filing requirement was effective for tax years beginning after March 18, 2010, but the IRS has temporarily suspended the filing requirement until it announces the additional information that will be required and releases a revised version of Form 8621. Every PFIC will have to determine whether or not to provide information about itself or its shareholders that may be needed to complete such a report.
Another FATCA tax law change requires U.S. persons to file Form 8938 with respect to certain foreign financial assets, including an interest in an offshore hedge fund. Such reports are required if the total value of the person’s foreign financial assets exceeds $50,000 at year end or exceeded $75,000 at any time during the year (the thresholds are higher for married taxpayers filing jointly and for taxpayers living outside of the United States). This new reporting obligation became effective for tax years beginning after March 18, 2010.
Based upon the due diligence precedures and standards contained in the proposed regulations offshore hedge funds, funds-of-funds and other pooled investment vehicles should begin developing questionnaires for existing investors and revised investor subscription documentation that will solicit the information about those investors and their ultimate owners required by the new FATCA reporting requirements.
In addition, such funds and other vehicles should review and/or modify their charter documents, partnership or other operating agreements and subscription documentation to ensure that they require investors to cooperate with such funds’ and other vehicles’ efforts to comply with the FATCA disclosure rules. For example, an investor should be required to waive any foreign law provision that might otherwise prevent compliance with an FFI Agreement, and the funds or other vehicle should be permitted to force withdrawal of recalcitrant investors.
Finally, such funds and other vehicles should begin to review their investor accounting systems to determine if they will permit compliance with any withholding requirements that may be imposed upon them because they will be nonparticipating FFIs or because they will have recalcitrant account holders or nonparticipating FFIs as investors.
 The definition of an FFI includes (a) foreign banks and similar businesses, (b) non-U.S. entities that hold financial assets for the accounts of others as a substantial part of their businesses and (c) offshore vehicles that are engaged or hold themselves out as being engaged primarily in the business of investing, reinvesting or trading in securities, partnership interests, commodities, notional principal contracts, insurance or annuity contracts, or any interest in any of such assets, including offshore hedge funds, funds-of-funds and other pooled investment vehicles.