Many in the financial services industry breathed a sigh of relief when the government recently removed the opt-in requirement under the Future of Financial Advice (FOFA) bills for financial planners and other industry members with approved codes of conduct.


Yet lurking in the background are some key pieces of U.S. legislation that may significantly increase reporting and compliance costs for certain Australian financial institutions far beyond any costs that any FOFA opt-in would cause. While some in the industry are abreast of the changes and are considering the potential implications for their business with respect to the Foreign Account Tax Compliance Act (FATCA) and the Dodd-Frank amendments to the Investment Advisers Act, many fund managers and service providers remain unaware of the scope and breadth of the legislation and incorrectly assume that they will not be affected.

FATCA was introduced to combat tax evasion by U.S. citizens in respect of offshore assets and accounts. Its staged implementation, set to commence on 1 January 2013, will require foreign financial institutions (FFIs) to report detailed information to the Internal Revenue Service (IRS) about financial accounts held by U.S. persons. To be able to do this, Australian fund managers will need to implement new know-your-client (KYC) procedures so that they can identify and continually monitor investors who are U.S. persons throughout their product’s investment life. Fund managers and service providers will also need to change their administrative and back office systems to comply with the reporting requirements.

Of even more significance, FATCA imposes a 30% withholding obligation on persons making payments of U.S. source income and related gross proceeds to non-FATCA-compliant payees, including fund investors. Fund managers will need to educate themselves about these withholding obligations under U.S. law, secure the necessary resources and establish appropriate systems and procedures to conduct the withholding and remit the tax to the IRS. Compliance costs will undoubtedly increase. Increased costs are better than the alternative, however; funds that choose to ignore FATCA will expose their U.S. source income receipts to a 30% withholding tax, which in turn will decrease fund returns and significantly impact the fund’s market competiveness.

FFIs must generally enter into agreements with the IRS under which FFIs will provide direct reporting and comply with their withholding obligations. However, following a recent intergovernmental joint statement, FFIs established in certain European countries may be able to report the required information to their own regulators, who in turn would pass on the information to the IRS, and who may not be required to satisfy the relevant withholding obligations. This approach is likely to streamline the reporting process for such FFIs, reducing compliance costs, and may reduce the privacy law concerns of these jurisdictions in respect of reporting personal information to the IRS. The U.S. has not yet extended a similar approach to Australian FFIs. Given that FATCA reporting should be possible by Australian FFIs under Australian privacy law (assuming the appropriate waivers are obtained from investors), the U.S. may be more reticent in entering into an intergovernmental agreement with the Australian government as any privacy law concerns shared by these European jurisdictions do not apply locally.

FATCA exempts certain persons from the reporting obligations (and therefore from being withheld upon). Whilst at a broad level there are exemptions for retirement funds and foreign collective investment schemes, the exemptions (details of which are contained in draft regulations issued in February) are narrowly drafted and many Australian funds may either not be able to rely on them at all, or may need to amend their processes, documentation and registration status in order to do so.

The extra-territorial nature of FATCA illustrates an increasingly common strategy of the U.S. government seeking to impose its legislation on the rest of the world. Rather than imposing penalties on foreign entities that fail to comply with U.S. law, the U.S. effectively circumvents its want of jurisdiction over FFIs by imposing the withholding obligations on the US institutions that make payments of US source income and subjecting them to penalties if they fail to do so.

In addition to FATCA, recent changes brought about to the Investment Advisers Act by the Dodd-Frank reforms mean that Australian fund managers with U.S. clients must register with the Securities and Exchange Commission (SEC) as an investment adviser (a compliance and legal headache), or seek to rely on one of three very limited exemptions from registration. The exemption available to venture capital funds is unlikely to be widely used due to its limited scope. To rely on the exemption available to foreign private advisers, the fund manager must not have more than 15 U.S. investors or clients across its entire funds management business. Even Australian funds that are not marketed to U.S. investors may have difficulty meeting this test given the very low threshold and broad categories of who is considered a U.S. person. The private fund adviser exemption, available for private fund advisers with no more than $150m of assets under management in the U.S., should permit each fund sponsored by the fund manager to have up to 100 U.S. investors but requires the fund manager to comply with certain reporting and a number of substantive requirements imposed by the SEC.

One silver lining is that many of the KYC processes required by FATCA will also be appropriate for ensuring compliance with the Investment Advisers Act exemptions, as fund managers will need to identify any U.S. investors in their funds on an ongoing basis. Both Acts will necessitate changes to application forms and fund documentation – including investor representations and warranties as to an investor’s status as U.S. person – and constitutional changes to permit the fund to redeem the interests of investors whose investment could threaten the manager’s or the fund’s reliance on an exemption or compliance with the legislation.

There is no time for complacency in relation to FATCA or the Investment Advisers Act. Australian fund managers need to arm themselves with knowledge of the effect of these laws on their business and implement appropriate procedures to enable compliance with them.