Fund managers the world over are facing the reality of the U.S. Foreign Account Tax Compliance Act (“FATCA”), encountering requests from U.S. withholding agents for FATCA documentation from funds and inquiries from potential investors regarding the status of FATCA compliance. A fund manager, tasked with assessing the FATCA status and compliance of numerous funds, frequently must review not just the U.S. FATCA regulations, but also the application of a Model 1 or Model 2 intergovernmental agreement (“IGA”) if funds are resident in countries with an IGA in place. In this Alert, we briefly highlight the key factors fund managers must analyze when determining the FATCA status and compliance obligations of funds resident in a Model 1 IGA country.

Background

As a means of combatting U.S. tax evasion, FATCA generally imposes registration, due diligence, withholding, and reporting obligations on foreign financial institutions (“FFIs” or “FIs”), including banks and all types of funds that are organized outside the United States. Failure by an FFI to comply with FATCA can result in a new 30% penalty tax being withheld from certain U.S. source income.

While FATCA was signed into law in March 2010, it is taking effect in stages with key deadlines staggered over several years. The first major deadline arrived on July 1, 2014, when U.S. withholding agents and FFIs were required to begin withholding the FATCA tax on payments made to non-FATCA compliant parties.

Under FATCA, FFIs generally are required to register their FATCA status on an online portal administered by the U.S. Internal Revenue Service (“IRS”) and enter into an agreement (an “FFI Agreement”) with the IRS to undertake U.S. tax compliance obligations, including reporting certain information to the IRS.

However, in a bid to collaborate with other governments to simplify the burden imposed by FATCA and avoid conflicts with local laws, the United States has entered into “Model 1” IGAs regarding FATCA with over 35 countries, including the U.K., France, Germany, Spain, Sweden, and Italy. In addition, the United States has reached agreement in substance on a Model 1 IGA with more than 50 other countries, including China, which now are treated as having a Model 1 IGA “in effect” for all FATCA purposes.

An FI resident in a Model 1 jurisdiction still must register with the IRS on the online portal (unless exempted), but it need not enter into an FFI Agreement. Instead, it must comply with the IGA and its government’s local implementing rules, including reporting any required information to its home government instead of the IRS. Model 1 FIs are treated as “deemed compliant” under FATCA and generally are not subject to the FATCA tax.

Some countries, including Japan, Switzerland, and Hong Kong have entered into “Model 2” IGAs with the United States. The Model 2 IGA still requires an FFI to both register on the online portal and enter into an FFI Agreement with the IRS, making it generally less attractive than the Model 1 approach.

FATCA Status under the Model 1 IGA

Is the Fund an FI?

Firstly, a fund manager must determine whether the fund in question is an FI under the relevant Model 1 IGA. Generally, the fund will be an FI if it falls within the scope of the “Investment Entity” prong of the FI definition, set out in the Model 1 IGA as:

  • any entity that conducts as a business (or is managed by an entity that conducts as a business) one or more of the following activities or operations for or on behalf of a customer:
    • trading in money market instruments; foreign exchange; exchange, interest rate and index instruments; transferable securities; or commodity futures trading;
    • individual and collective portfolio management; or
    • otherwise investing, administering, or managing funds or money on behalf of other persons.

Most foreign funds will clearly fall within this designation. Foreign collective investment entities, private equity and hedge funds, mutual funds, venture capital and leveraged buyout funds and other similar investment vehicles generally should expect to be an FI within the Investment Entity category under a Model 1 IGA.1

Is the Fund a Reporting FI or Non-Reporting FI?

Once FI status for a fund is established, the second undertaking for the fund manager is to analyze whether the fund is a “Reporting FI” or a “Non-Reporting FI” pursuant to the relevant IGA. A Reporting FI is subject to the FATCA obligations imposed by the IGA, including registration, due diligence, and reporting, while a Non-Reporting FI generally is exempt from all such obligations. An FI generally will be treated by default as a Reporting FI. However, before a fund assumes the Reporting FI obligations, the fund manager should determine whether the fund might qualify as a “Non-Reporting FI” under its IGA.

The Non-Reporting FI categories are set out in the Annex II of each IGA, which is the one section of an IGA that is customized to accommodate the particularities of each country’s financial entities and products. In addition, exempt FFI categories set out under the U.S. Treasury’s FATCA regulations can be applied to Model 1 FIs as an alternate means for an FI to qualify as a Non-Reporting FI. Although guidance for interpreting these exempt categories remains scarce, the analysis should become better defined as Model 1 countries issue implementing regulations, as the U.K. and Germany have done.

Generally, Non-Reporting FI categories include FIs that are perceived to present a low risk of facilitating U.S. tax avoidance, such as government entities, local banks, and certain regulated collective investment vehicles. Funds may be able to avail themselves of certain fund targeted exempt categories including those for regulated collective investment entities, sponsored investment entities, and restricted funds. Fund managers generally should engage a legal adviser to assist in ascertaining the application of such categories to a fund. In particular, fund managers will want to assess the suitability of potentially acting as a sponsor for a fund whereby the fund manager can render the fund a Non-Reporting FI by agreeing to take on the fund’s FATCA obligations directly.

When to register?

Upon registration an FFI is assigned a “Global Intermediary Identification Number” or “GIIN” which will be used by other FFIs and U.S. withholding agents to quickly identify the FATCA compliance of counterparties, investors, and account holders. Reporting FIs in Model 1 IGA countries must register by December 31, 2014 to be compliant with their IGA, while the deadline for most other FFIs to register and enter into an FFI Agreement was June 30, 2014.2

The IRS publishes a monthly list of FATCA compliant entities and their GIINs. The first list was published on June 2, 2014. It is generally advised that Reporting FIs in Model 1 IGA countries register no later than December 22, 2014 in order to ensure processing before year end and inclusion on the first list published in January 2015.

The United States recently confirmed that it would view 2014 and 2015 as a transition period for those attempting in good faith to comply with the new FATCA regime.3 However, this development did not delay the aforementioned registration deadlines.

The FATCA online registration system can be found on the IRS website at: https://sa1.www4.irs.gov/fatca-rup/.

What happens after registration?

While registration of a fund may not be a terribly difficult undertaking once the fund’s FATCA status has been determined, it should be understood that the act of registering certifies a Reporting FI’s commitment to comply with its obligations under its IGA. This commitment in turn requires that such Reporting FI have the knowledge and systems in place to carry out these obligations, such as due diligence reviews of accounts and, if relevant, collection and reporting of certain information. Consequently, the manager of a fund that is a Reporting FI must position itself to understand and act on the fund’s obligations under its IGA.

Conclusion

Fund managers dealing with funds in Model 1 IGA countries must start focusing now on the application of FATCA to these funds. These entities have until the end of 2014 to determine their FATCA status and the obligations that follow. Any Reporting FI should ensure that it registers before year-end in order to comply with its Model 1 IGA. Consequently, time is of the essence.