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PwC alternatives alert, March 31, 2010
Foreign Account Tax Compliance Act of 2009: Understanding the impact on the alternative investments industry
On March 18, 2010, the final version of the Foreign Account Tax Compliance Act of 2009 (FATCA) became law as part of the Hiring Incentives to Restore Employment (HIRE) Act. FATCA dramatically changes the current system of withholding on payments made to non-US persons. The final version of FATCA is generally similar to the original Bill introduced by the Chairman of the House Ways and Means Committee and the Senate Finance Committee on October 27, 2009, but has been modified in response to public comments.The attached PwC Global IRW Newsbrief, Understanding FATCA, What you need to know about the sweeping legislation, is a comprehensive review of the recently passed Act. Highlighted below are specific observations on how this wide-reaching legislation will impact the alternative investments industry.
Who in the alternative investments industry will be affected?
FATCA will impose additional information reporting and withholding requirements on alternative investment funds that are foreign entities by treating them as "foreign financial institutions" (FFIs). FATCA requirements could extend to every type of foreign investment entity used in an alternative fund structure, including foreign master trading entities, offshore feeder fund vehicles, foreign private equity investment funds, SPVs and securitization vehicles, if they invest in securities generating U.S. source income. Failure to comply with FATCA's requirements results in the withholding of 30% of the payment to the FFI of U.S. source investment income and the gross proceeds on disposition of a security that generates U.S. source interest or dividends. Prime brokers that service the alternative investments industry will also be subject to additional reporting and withholding requirements. These new reporting and withholding provisions generally are effective for payments made on or after January 1, 2013.Under a separate provision of FATCA, many investors who are U.S. individuals will be required to do increased reporting of their foreign investments or face penalties for failure to disclose this information. The additional reporting obligation will require the attachment of a list of foreign assets to the individual's U.S. tax return if the aggregate value of all the assets exceeds $50,000 (or such higher amount as the Secretary may prescribe). This requirement applies to taxable years beginning after the date of enactment. These added requirements on individual U.S. investors could become an added burden on the funds.
What is the impact?
Over the past several years, press accounts have suggested that the alternative investments industry has facilitated some investors' desire to avoid U.S. taxation. FATCA may be viewed as an overreaching attempt to counter this purported behavior. The industry could be negatively impacted by FATCA's additional compliance burden and the lack of certainty surrounding its technical application even in advance of the January 1, 2013 effective date. The specific application of these rules is highly dependent on future guidance to be issued by Treasury in the form of regulations. The enactment of FATCA could have an adverse effect on investment in U.S. markets, foreign funds otherwise wishing to access U.S. investments or even bank deposits. At minimum, impacts on the alternative investments industry will include the following:- There will be additional compliance burden for funds in gathering information on U.S ownership from investors, drafting withholding agreements with IRS and ongoing maintenance of agreements - including IRS audits of the overall withholding processes. The expansive definition of a FFI will require some organizations to make substantial changes to their processes, technology, and internal governance to handle the expected increase in due diligence procedures and compliance.
- Funds will have the added burden of providing information to their U.S. investors on the fund's foreign investments in order for the investors to be able to meet their reporting requirement for specified foreign assets. Moreover, the $50,000 threshold for reporting information is an aggregate calculation for all specified foreign assets, determined at the individual investor level. The extent and detail of the information that may be required to be provided by each fund to each U.S. investor could be enormous, unless otherwise limited by the Treasury regulations to be provided. Unlike the general FATCA provisions, this requirement is effective for tax years beginning after March 18, 2010 (January 1, 2011 for calendar year funds).
- Many of the provisions of FATCA will require Treasury guidance on how they will be implemented before they become effective in 2013. In the short term, the lack of Treasury guidance could impact the ability of new funds to raise and lock up foreign capital from investors who are concerned about the lack of guidance. In the longer term, funds may be limited in their ability to raise capital from non-U.S. investors who may not want, or may not be able to provide the required disclosures on U.S. ownership.
- Investment structures offered to foreign investors not wanting to be tainted by other investors subject to withholding may be limited. For example, a foreign investor may only want to invest through a wholly owned managed account rather than investing in a foreign structure open to other investors.
- Some funds could decide that complying with FATCA's due diligence and verification provisions may not be cost effective; and, consequently, for business reasons, some may not continue making U.S. investments or seeking U.S. customers. Some investors may react negatively to funds who limit their U.S. investments in order to avoid US withholding and compliance obligations imposed by FATCA.
- FATCA potentially changes the economics of many investments from which income generated qualifies as a withholdable payment under the Act. Withholding on dividend equivalents would be required even when no actual payment is made to the foreign investor (i.e., the foreign investor is on the losing end of the swap) and gross proceeds even in a loss position. Contractual agreements and ISDAs will need to be reviewed and amended to clarify responsibilities and procedures for withholding on dividend equivalent payments. Time will be critical given the September 18, 2010 effective date for withholding on dividend equivalent payments received in connection with repos, securities loans and certain specified swaps.
Obtaining Certification from the IRS & ongoing compliance - challenges affecting alternative investment firms
With the imposition of a new 30% withholding tax on withholdable payments, most foreign financial institutions will attempt to comply with the provision and avoid being withheld upon by entering into an agreement with Treasury to report U.S. persons who are account holders. The certification and withholding requirements under FATCA create a significant burden on a much larger group of effected entities than the current Qualified Intermediary regime, and may not be feasible to abide by. Moreover, the verification procedures, although not yet fully defined, are expected to increase the costs of compliance for every FFI regardless of whether they are done internally (i.e., through internal audit or confirmations) or through an external resource (i.e., using an outside firm to opine).Many of the implementation aspects of the certification process have been reserved for the Secretary to develop via Treasury regulations. However, it is not too early to identify some of the specific challenges to obtaining and complying with the certification process including the following:
- In a typical alternative investments structure with a foreign Master fund, domestic feeder and foreign feeder, two outcomes can result with respect to withholding under the Act. If the Master fund enters into an agreement with Treasury and maintains compliance with the provisions of this agreement, payments made to the Master fund from the U.S. broker-dealer would not be subject to withholding. In order to receive this certification, each entity in the ownership chain would ultimately have to provide to the Master fund owner information (likely to consist of information on U.S. persons or proof of entering into an agreement with the IRS if the account holder is an FFI). The likelihood that all entities in a large structure will be able to provide the complete, required information to obtain certification is slim.
- Obtaining ownership information will be particularly difficult in a fund of funds structure whereby funds with other foreign financial institutions as investors would need to gather information from third party investors. If the Master fund cannot obtain the necessary certifications from all account holders, the proportion of "pass thru payments" made to these recalcitrant account holders or non participating FFIs would be subject to 30% withholding. Recalcitrant account holders are defined as those account holders who fail to provide the required information regarding their U.S. investors.
- In a multi tiered structure, it could be difficult and impractical for these foreign entities to gather information on all U.S. investors or to request confirmation from their direct investors that there are no U.S. account holders within the entire chain of ownership. While a foreign entity might be able to satisfy this requirement by getting confirmation that its direct investors have entered into an agreement with the IRS themselves, as a practical matter, getting confirmation all the way up the chain may be impossible to obtain, thus resulting in additional withholding on the income allocated to those account holders missing information.
- Even if a fund is able to obtain information about its U.S. investors all the way up the chain, it is unclear what requirement it will have to monitor if there has been a change in ownership and an introduction of a U.S. investor or a recalcitrant account holder in the chain. Presumably, the Treasury will address this in order to avoid imposing on multiple tiers of FFIs the requirement to engage in due diligence each time a payment subject to withholding is received.
- There will be potential FIN 48 and FAS 5 implications due to potential exposures for non compliance with FATCA, for example, failure to meet withholding obligations for payments to an investor who refuses to provide the required information to identify U.S. account holders. Alternatively, there could be penalties for providing inaccurate or insufficient information to a withholding agent (e.g., a U.S. bank) to enable them to determine the appropriate amount to withhold with respect to a payment that is allocable to recalcitrant account holder. There could also be exposures for failure to meet additional information reporting obligations that may be imposed on a fund so that U.S. investors can meet their increased reporting obligations of foreign accounts and investments.
Of further interest