On January 17, 2013, the Internal Revenue Service (“IRS”) issued the long awaited final regulations under the Foreign Account Tax Compliance Act contained in Sections 1471-1474 of the Internal Revenue Code of 1986, as amended (“FATCA”). The U.S. has also entered into several intergovernmental agreements governing FATCA (“IGAs”) with foreign sovereigns to provide U.S. tax authorities the tools to identify U.S. persons who fail to report their non-U.S. assets and income.
FATCA generally provides that foreign financial institutions (called “FFIs”) (which generally include non- U.S. private equity funds) need to become participating FFIs (“PFFIs”) in order to avoid U.S. withholding tax of 30% on certain income. A FFI becomes a PFFI by entering into an agreement with the Treasury.
Core Elements of FATCA Final Regulations
The final U.S. Treasury regulations under FATCA are over five hundred pages and include extremely detailed rules to implement the FATCA statute. Given the breadth of the regulations, a detailed analysis is beyond the scope of this article. However, these regulations include several highlights for private equity funds.
- Any foreign entity that primarily engages in trading, portfolio management, investing, administering, or managing financial assets or money on behalf of other persons, regardless of whether the entity has custody over financial assets, can be classified as a FFI. As a result, a non-U.S. fund manager is considered a FFI. In contrast, certain family offices and personal investment corporations would not be expected to constitute a FFI.
- Funds that target primarily non-U.S. investors and comply with certain other requirements (i.e., “restricted funds”) will generally not be required to enter into FFI agreements.
- Certain fund managers may enter into agreements with, and report to, the IRS for their FFIs and comply on an aggregate basis for the entities they control or “sponsor.”
- Non-U.S. holding companies or alternative investment vehicles may be FFIs, even where they only hold shares in operating portfolio companies.
- The final Regulations suggest (although it is not entirely clear) that foreign investment advisors who lack the discretion to invest funds and merely provide investment advice may still be considered a FFI. However, further guidance is needed on this point.
- Foreign governments, pension plans established by foreign governments, and international organizations are generally exempt from FATCA withholding, so long as they are not engaged in commercial activity that relates to the payments or accounts in question.
- Non-U.S. fund investors and non-U.S. portfolio companies may be subject to withholding even though they are exempt from entering into FFI agreements.
- Certain securities that a fund has invested in may be exempt from FATCA under the grandfather rule. For example, revolvers with fixed terms (e.g., a maturity date) and swaps subject to a binding legal agreement (and any collateral posted to secure those swaps) issued prior to January 1, 2014 are considered grandfathered obligations (so long as they are not significantly modified after 2013).
“Funds should keep abreast of the availability of IGAs in [their] jurisdictions”
The U.S. government has signed several IGAs with other governmental entities regarding the disclosure of FATCA information. The U.S. government expects to enter into several more of these agreements imminently, including an IGA with the Cayman Islands.
The IGAs follow two models (“Model 1” and “Model 2”). Countries with IGAs that have followed the Model 1 form include the United Kingdom and Mexico. The Cayman Islands has announced that it will follow a Model 1 form. Switzerland has executed a Model 2 IGA, and Japan has announced its intent to adopt a similar approach.
Basics of a Model 1 IGA
The basics of a Model 1 IGA are as follows:
- FFIs within these jurisdictions report FATCA information to their home country revenue authority, which will then forward the information to the IRS. Local registration requirements may apply.
- Consent of account holders is not required because information is automatically reported to the IRS by the home country.
- FFIs within these jurisdictions do not need to enter into a FFI Agreement, but would still need to perform certain diligence procedures to identify U.S. accounts and report information regarding such accounts to their government.
- The non-U.S. jurisdiction will apply its domestic law (including applicable penalties) to address non-compliance with the IGA. If the U.S. identifies significant non-compliance by a FFI under the IGA and such non-compliance is not resolved within 18 months, the FFI will be identified by the IRS as a non-PFFI and U.S. FATCA withholding will apply.
Basics of a Model 2 IGA
The basics of a Model 2 IGA are as follows:
- FFIs within these jurisdictions will need to register with the IRS, enter into and comply with the requirements of a FFI agreement, and report FATCA information directly to the IRS.
- There will be supplemental reporting under an applicable tax treaty or tax information exchange agreement between the U.S. and the foreign sovereign with respect to persons who fail to report, so-called “recalcitrant” account holders and non-PFFIs.
- FFIs within a Model 2 jurisdiction will need to request certain information regarding the non- PFFIs and the recalcitrant U.S. account holders (such as U.S. taxpayer identification numbers) and obtain consent from the account holders in order to report the information to the IRS.
- FFIs within these jurisdictions must inform U.S. account holders (and FFIs that are not PFFIs) that, if consent is not obtained, aggregate information with respect to such accounts will be reported to the IRS and the IRS may subsequently request specific information about the accounts; in such cases, the FFI will be required to forward specific information to its country of residence for the exchange of such information with the IRS.
- If the U.S. identifies significant non-compliance by a FFI under its FFI Agreement or the IGA and such non-compliance is not resolved within 12 months, the FFI will be identified by the IRS as a non-PFFI and U.S. FATCA withholding will apply.
Some Remaining Questions/Issues
Many questions regarding the FATCA regime remain. A few of the FATCA related issues that could relate to private equity funds include:
- Additional clarity is needed regarding whether a purchaser of a fund interest from a non-FATCA compliant fund owner is required to withhold on the gross proceeds of such a sale.
- The IRS has not formulated certain definitions regarding “passthru payments” that will affect how payments to, or for the benefit of, blockers will be treated under FATCA.
- Further guidance is required to determine how information is shared when a fund and its fund manager are organized in different jurisdictions. An IRS representative has stated publicly that, where a fund and its fund manager are organized in different jurisdictions, information would not need to be disclosed twice and the fund manager/ sponsor would likely control the disclosure of FATCA information. However, further guidance is required on this point.
FATCA can have broad implications for all private equity funds and not only at the fund level, but rather throughout the investment structure of a fund, from fund investment vehicles to portfolio companies. Funds should keep abreast of the availability of IGAs in the jurisdictions in which they are organized, invest, or do business. Private equity funds (both U.S. and non-U.S.) may obtain some relief from the FATCA compliance burden where the relevant fund vehicle is located in a Model 1 country, as the expense of complying with information requests and due diligence procedures will likely fall more heavily on the Model 1 non- U.S. government, as opposed to the FFI. The prompt attention of both U.S. and non-U.S. funds is prudent in order to promptly formulate a comprehensive approach to FATCA compliance.
IRS Circular 230 Disclosure
To ensure compliance with the requirements imposed by the IRS in Circular 230, we note that any tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, of 1986, as amended, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.