On February 8, 2012, the IRS released proposed regulations[1] on the Foreign Account Tax Compliance Act ("FATCA") rules that were enacted in 2010.[2] Under the proposed regulations, the FATCA regime remains applicable to non-U.S. investment vehicles, including hedge funds, private equity funds, CDOs, CLOs, venture capital funds, and (in some cases) real estate funds[3] ("Non-U.S. Funds"). Although the new regulations provide some relief on deadlines and other details, the main aspects of the rules remain applicable. Thus, most Non-U.S. Funds must enter into an agreement with the IRS prior to 2014 in order to avoid withholding on U.S.-source payments made to them in 2014 and thereafter, and must report information with respect to U.S. holders of their interests beginning in 2014.

As described in previous Jones Day Tax Alerts, the FATCA rules require a U.S. withholding agent[4] to withhold 30 percent of any U.S.-source payment made to a "foreign financial institution" unless the institution enters into an agreement with the IRS and satisfies significant reporting and disclosure requirements. It is likely that most Non-U.S. Funds will meet the definition of a "foreign financial institution," despite some exceptions provided by the new proposed regulations (discussed below). As a result, beginning in 2014, any U.S.-source payment made to a Non-U.S. Fund on its assets—such as a payment of interest or original issue discount ("OID") on a U.S. debt obligation—will be subject to this 30-percent U.S. withholding tax unless the fund enters into an agreement with the IRS (described below). Withholding on gross proceeds of a sale or other disposition of these assets by a Non-U.S. Fund is required starting in 2015.

No withholding is required on payments on obligations entered into before the FATCA regime's effectiveness. Perhaps the best news in the proposed regulations is the extension of such "grandfather" treatment to U.S. obligations entered into prior to January 1, 2013. (The previous grandfather date was March 18, 2012.) This means that no payment made to a Non-U.S. Fund on an instrument entered into in 2012 will ever be subject to withholding under the above rules. The only qualification is that if the instrument is subsequently modified in a manner that causes it to be treated as a new instrument for tax purposes, the grandfather treatment is lost.[5] The proposed regulations also provide a helpful clarification that payments on a derivative transaction entered into under an ISDA Master Agreement in 2012 or earlier are similarly grandfathered.

The required IRS agreement will obligate the Non-U.S. Fund, among other things, to (1) obtain information necessary to determine which of the holders of its securities (including equity and debt) are U.S. persons, (2) report annually to the IRS the name, Social Security, or taxpayer identification number ("TIN"), and investment amount of each of these U.S. investors, and (3) deduct and withhold 30 percent from any payment it makes either to U.S. investors or foreign financial institutions that do not themselves comply with these provisions. The IRS expects to publish a model agreement shortly. The IRS has announced that agreements should be entered into on or before June 30, 2013; for agreements entered into after that date, the IRS cannot guarantee that sufficient information can be given to withholding agents in order to avoid withholding under the above rules (i.e., withholding on U.S.-source interest and other payments beginning January 1, 2014).

The proposed regulations reduce somewhat the amount of information that must be reported with respect to U.S. investors under the IRS agreement. For 2014 and 2015 (i.e., reporting with respect to the 2013 and 2014 years), what needs to be reported is the U.S. investor's name, address, TIN, account number, and account balance. Starting in 2016 (with respect to the 2015 year), all of the statutory reporting requirements, including the income allocable to the U.S. investor from the Non-U.S. Fund, become applicable. For determining who are the U.S. investors, the proposed regulations contain favorable rules as to the "due diligence" required by the Non-U.S. Fund. For example, for existing accounts of individuals with a balance of $1 million or less, the Non-U.S. Fund needs to review only electronically searchable data in order to find evidence of U.S. status. Existing accounts of entities with a balance of $250,000 or less are entirely exempt from review until the account balance exceeds $1 million, and above that, the Non-U.S. Fund can generally rely on anti-money-laundering/know-your-customer ("AML/KYC") records and other existing account information for U.S. status. Although the rules for new accounts are more complex, the ability generally to rely on data already obtained by the Non-U.S. Fund, including AML/KYC data, was a pleasant surprise to many tax practitioners.

Some relief is provided with respect to other deadlines as well. A Non-U.S. Fund is required to withhold 30 percent on U.S.-source payments made to investors in two situations: (1) when an investor is determined to be a U.S. investor but refuses to give the Non-U.S. Fund the required information, and (2) when the investor is another foreign financial institution or Non-U.S. Fund that has not entered into the required agreement with the IRS. With respect to U.S.-source amounts that the Non-U.S. Fund pays to such investors, such as interest and OID on U.S. obligations, the withholding obligation starts on January 1, 2014 (and January 1, 2015 with respect to payments of gross proceeds). With respect to other "passthrough" payments—indirect U.S.-source payments to the investor resulting from the Non-U.S. Fund's investment in other entities—the proposed regulations defer the withholding obligation until January 1, 2017. (This deferral comes as a relief to many Non-U.S. Funds because earlier IRS announcements had indicated that the withholding amount would be determined on a straight percentage basis according to the Fund's U.S. assets, direct and indirect.) The Non-U.S. Fund must make an annual report to the IRS of the payments withheld.

It was hoped by many in the investment community that the proposed regulations might exclude certain types of Non-U.S. Funds entirely from the FATCA rules. Unfortunately, this turned out not to be the case. There are two exceptions that relate to Non-U.S. Funds. These exceptions have different requirements, but for each of them, the Fund must be regulated as an investment fund in its country of organization. Thus, for many, if not most, Non-U.S. Funds, the FATCA rules above will be fully applicable, with the proposed regulations providing help only on the deadlines and other matters above.

Although currently in proposed form, the IRS has now had the opportunity to refine its thinking with respect to the FATCA rules. Thus, it seems unlikely that there will be major changes when the regulations are issued in final form. Public comments on the proposed regulations may be submitted until April 30, 2012, and a hearing is scheduled for May 15, 2012.