Provisions Contained in the Hiring Incentives to Restore Employment Act
The newly enacted Hiring Incentives to Restore Employment Act (the “HIRE Act”) includes as a revenue offset many of the provisions of the Foreign Account Tax Compliance Act (“FATCA”) first proposed in October 2009.
The enacted FATCA provisions impose new withholding taxes on payments to foreign entities and on dividend equivalent payments, eliminate exemp-tions related to foreign bearer bonds, and introduce heightened reporting requirements for individuals with offshore assets. Foreign financial institu-tions, including offshore hedge funds and private equity funds, and their U.S. and (to a lesser extent) non-U.S. investors and account holders are among the persons affected by these wide-reaching provisions.
Withholding Taxes on Payments to Foreign Entities that Fail to Comply with U.S. Account Reporting and Withholding Requirements
The enacted FATCA provisions impose a 30% withholding tax on “withholdable payments” made to foreign entities after 2012,1 if those entities fail to comply with certain reporting and withholding requirements. “Withholdable payments” generally will include (i) interest (including original issue discount), dividends, rents, annuities and other fixed or determinable annual or periodical income derived from U.S. sources (“FDAP”), as well as (ii) gross proceeds from dispositions of securities that could produce U.S. source interest or dividends. Under this definition, even payments that would not otherwise be subject to tax (for example, payments eligible for treaty relief or the “portfolio interest” withholding exemption, and gross proceeds from the sale of securities) are subject to withholding. Income which is considered effectively connected with the conduct of a trade or business in the United States is not, however, included within the definition of “withholdable payments.”
These new FATCA provisions are in addition to existing withholding provisions applicable to FDAP and proceeds from the sale of U.S. real property interests, although they do contem-plate coordination of the various U.S. federal income tax withholding systems. Specifically, the new provisions direct the U.S. Department of the Treasury (the “Treasury”) to provide for proper crediting of amounts deducted and withheld under the new legislation with amounts required to be deducted and withheld under other provisions of the U.S. Internal Revenue Code of 1986, as amended (the “Code”).
Foreign entities that are “financial institutions” are subject to more extensive reporting requirements than other foreign entities. Importantly, “financial institu-tions” for this purpose include not only foreign banks and foreign custodial accounts, but also foreign entities engaged primarily in investing or trading in securities, commodities, partnership interests, or any interests therein. This definition is sufficiently broad to capture the vast majority of foreign investment vehicles, including offshore hedge funds and private equity funds.
The withholding tax applies unless the foreign financial institution enters into an agreement with the Treasury to identify and disclose extensive information regarding, with limited exceptions, any of its accounts held by (i) a “specified United States person” or (ii) a foreign entity with one or more “substantial United States owners” (any such account, a “U.S. Account”). A “specified United States person” includes any United States person (that is, a U.S. individual citizen or resident, or a domestic partnership, corporation, estate or trust, as defined for U.S. federal tax purposes), with certain exceptions. These exceptions include publicly traded corporations, certain tax-exempt entities, banks, regulated investment companies, real estate investment trusts, common trust funds, and state and federal governmental entities. A “substantial United States owner” includes any specified United States person who owns more than 10% of (i) the stock in a foreign corporation, (ii) the profits or capital interests in a foreign partnership, or (iii) the beneficial interests of certain trusts. In the case of a foreign financial institu-tion that is engaged primarily in investing or trading in securities, commodities, partnership interests, or any interests in such assets (which, as noted above, would include most offshore hedge funds and private equity funds), the 10% ownership threshold is reduced to 0%. The effect of this 0% threshold apparently is to require reporting with respect to any specified United States person holding an indirect interest in a foreign financial institution through an offshore private fund (such as a fund of funds), regardless of the United States person’s ownership interest in the fund.
Notwithstanding the foregoing, a U.S. Account does not include any financial account in a foreign financial institution if (i) the account is held by another financial institution that itself satisfies the requirements for avoiding the 30% withholding tax or (ii) the holder of the account is otherwise subject to information reporting requirements which the Treasury determines would duplicate the reporting requirements of the new FATCA provisions. Additionally, withholding does not apply to the extent that a withholdable payment is beneficially owned by certain classes of persons, including foreign governmental entities, international organizations, foreign banks and any other class of person that the Treasury identifies as posing a low risk of tax evasion.
To avoid the withholding tax, a foreign financial institu-tion2 must agree:
- to obtain necessary information to determine which of its financial accounts, including any debt or equity interests in the institution that are not regularly traded on an established market, are U.S. Accounts;
- to comply with verification and due diligence procedures with respect to these accounts as re-quired by the Treasury;
- to report to the Treasury, on an annual basis, required information with respect to such U.S. Accounts, including account holder identity (i.e., name, address, and taxpayer identification num-ber (“TIN”), account number, account balance or value, and the gross receipts and gross withdraw-als or payments from the account;
- to deduct and withhold a tax equal to 30% of (i) any “passthru payment” (i.e., a withholdable payment or a payment attributable to a withhold-able payment) made by the institution to a “recal-citrant account holder” (i.e., an account holder who does not comply with reasonable requests for information by the institution and (if applicable) provide a valid waiver of any foreign law that oth-erwise would prevent the reporting of such infor-mation) or to another foreign financial institution which does not itself comply with the require-ments for avoiding the 30% withholding tax and (ii) in the case of any passthru payment made by the institution to another foreign financial institu-tion that itself complies with the requirements to avoid the 30% withholding tax and so elects, that portion of the passthru payment that is allocable to recalcitrant account holders or foreign financial institutions that do not comply with the require-ments to avoid the 30% withholding tax (thus re-lieving such other, electing institution of the obli-gation to withhold with respect to such accounts);
- to comply with requests by the Treasury for additional information on the U.S. Accounts; and
- where a foreign law would prevent the reporting of any required information, to close the account if a valid waiver of the law cannot be obtained from the account holder.
A foreign financial institution will be deemed to meet the above requirements if the institution complies with procedures prescribed by the Treasury to ensure that the institution does not maintain U.S. Accounts and meets such other requirements prescribed by the Treasury with respect to accounts of other foreign financial institutions maintained by the institution.
Additionally, a foreign financial institution will be deemed to meet the above requirements if it falls within a class of institutions with respect to which the Treasury determines that the application of the new FATCA law is not necessary to carry out its purposes. Thus, the Treasury has broad authority to issue guidance defining the scope of the new FATCA withholding and reporting regime, as well as the mechanics of compliance. Until such guidance is issued, much of the impact of the new provisions will remain unclear. For example, the mechanism for establishing that a foreign financial institution has no U.S. Accounts will be of great impor-tance to offshore funds. Unless the account identifica-tion and verification process can be applied in practice, offshore funds may risk withholding tax even in cases where they have no U.S. Accounts, but cannot produce evidence of that fact in a manner that is satisfactory to the Treasury.
As an alternative to complying with the requirements listed above, a foreign financial institution may elect to provide full U.S. Internal Revenue Service (“IRS”) Form 1099 reporting with respect to each U.S. Account as if the holder of the account were a natural person and citizen of the United States. In the case of a foreign account holder with one or more substantial United States owners, the institution would report with respect to each substantial United States owner. Under this election, the foreign financial institution would also be required to report the account number and the name, address and TIN of each specified United States person or substantial United States owner.
The enacted FATCA provisions also impose the 30% withholding tax on withholdable payments made to a foreign entity other than a financial institution (a “non-financial foreign entity”) if that entity or another non-financial foreign entity is the beneficial owner of the payment and certain reporting requirements are not satisfied. Although the majority of offshore private funds will be subject to the more stringent requirements imposed on foreign financial institutions as outlined above, the requirements for non-financial foreign entities may be relevant for certain specialized funds investing in assets that technically may not fall within the definition of a “security” or “commodity” (or related interest) within the meaning of the new FATCA provi-sions.
A non-financial foreign entity may avoid the withholding tax if:
- the beneficial owner or the payee provides the withholding agent with either the name, address, and TIN of each substantial United States owner of such beneficial owner; or a certification that the beneficial owner has no substantial United States owners;
- the withholding agent does not know, or have reason to know, that any information so provided is incorrect; and
- the withholding agent reports the provided infor-mation to the Treasury in such manner as the Treasury may require.
Payments made to certain limited classes of beneficial owners (including publicly traded corporations and certain affiliates, certain entities formed in U.S. posses-sions, foreign governmental entities, international organizations and foreign banks) are exempted from the withholding tax imposed on non-financial foreign entities. The enacted FATCA provisions also vest the Treasury with broad authority to exempt other classes of payments (including payments made to other classes of persons) that the Treasury identifies as posing a low risk of tax evasion.
As noted above, in the case of both foreign financial institutions and non-financial foreign entities, the new FATCA provisions generally apply to withholdable payments made after December 31, 2012. A grand-fathering provision, however, exempts from this application any payment made under, or gross proceeds from the disposition of, any obligation outstanding on March 18, 2012.3
Withholding Taxes on Dividend Equivalent Payments
The enacted FATCA provisions subject certain “dividend equivalent” payments to U.S. withholding tax by treating such payments as dividends from sources within the United States. A “dividend equivalent” is (i) any substi-tute dividend made pursuant to a securities lending or a sale-repurchase transaction that is determined by reference to a dividend from sources within the United States, (ii) any payment made pursuant to a “specified notional principal contract” that is determined by reference to a dividend from sources within the United States, or (iii) any other substantially similar payment as determined by the Treasury.
A “specified notional principal contract” means any notional principal contract if:
- in connection with entering into the contract, any long party to the contract (i.e., the party entitled to receive any payment pursuant to the contract that is determined by reference to a dividend from sources within the United States) transfers the underlying security (with an index or fixed basket of securities being treated as a single se-curity) to any short party to the contract (i.e., any party that is not a long party to the contract);
- in connection with the termination of such con-tract, any short party to the contract transfers the underlying security to any long party to the con-tract;
- the underlying security is not readily tradable on an established securities market;
- in connection with entering into such contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract; or
- such contract is identified by the Treasury as a specified notional principal contract.
In addition, in the case of payments made after March 18, 2012, a “specified notional principal contract” includes any notional principal contract unless the Treasury determines that the contract is of a type which does not have the potential for tax avoidance.
In the case of a chain of dividend and dividend equiva-lent payments that is subject under these provisions to multiple levels of tax, the Treasury may reduce the tax to the extent that the taxpayer can establish that the tax has been paid with respect to another dividend or dividend equivalent in the chain or is otherwise not due.
Generally speaking, the new rules will impact offshore funds that currently seek to gain exposure to U.S. equities through derivative positions such as U.S. equity-based securities loans, repurchase agreements and swaps.
The new rules are effective for affected dividend equivalent payments made on or after September 14, 2010.
Repeal of Foreign Targeted Obligation Exception to Registered Bond Requirements
The enacted FATCA provisions prospectively repeal certain exemptions related to bearer bonds sold to foreign persons, effectively requiring such bonds to be in registered form. The issuance of such foreign-targeted bonds in bearer form, rather than registered form, would thus result in a number of catastrophic tax penalties, including:
- no deduction for interest paid on such bonds;
- ordinary income treatment for gains on the sale of such bonds; and
- no portfolio interest exemption for interest re-ceived on such bonds by foreign holders, thereby subjecting the interest to U.S. withholding tax.
The impact of this legislation on offshore private funds generally will be to cause such funds to confirm, prior to investing, that U.S. source interest-bearing obligations are issued in registered form.
These provisions apply to debt obligations issued after March 18, 2012.
Individual Disclosure of Foreign Financial Assets
The enacted FATCA provisions mandate that any individual holding an interest in “specified foreign financial assets” report additional information with respect to those assets, subject to severe penalties for nondisclosure, if the aggregate value of all such assets exceeds $50,000. “Specified foreign financial assets” include:
- depository accounts and custodial accounts maintained by a foreign financial institution;
- any debt or equity interest in a foreign financial institution that is not regularly traded on an es-tablished market; and
- certain foreign assets which are not held in an account maintained by a foreign financial institu-tion, including stocks or securities issued by a foreign person, financial instruments or contracts held for investment that have a foreign issuer or a foreign counterparty, and any interests in a for-eign entity.
Individuals are required to report the maximum value of such assets during the taxable year and such informa-tion (such as the name and address of the financial institutions or issuers that maintain or issue the assets) necessary to locate and identify the assets. While the nature of this information is similar to disclosures already required by Treasury Department Form TD F 90-22.1 (the “FBAR”), the proposed disclosures are broader in some respects, potentially impact a wider range of foreign assets (including interests in offshore hedge funds, private equity funds, and other investment funds), and are required in addition to any FBAR disclosures. Failure to disclose the required information with respect to specified foreign financial assets would result in severe nondisclosure and underpayment penalties.
The practical implication to offshore funds is that U.S. individual investors will be required to disclose the required information relating to their fund investment. To the extent not readily available to such investors through regular account statements or otherwise, offshore funds should be prepared to furnish the necessary information to such investors.
The individual disclosure requirements apply to taxable years beginning after March 18, 2010.
Annual Reporting by U.S. Shareholders of Passive Foreign Investment Companies (“PFICs”)
The enacted FATCA provisions expand the reporting requirements for U.S. shareholders of PFICs by requir-ing each person who is a shareholder of a PFIC to file an annual information return containing such information as the Treasury may require.
This provision became effective on March 18, 2010.
Provisions Contained in the Patient Protection and Affordable Care Act, as Amended by the Health Care and Education Affordability Reconciliation Act
New Medicare taxes and procedural requirements will be introduced by the newly enacted Patient Protection and Affordable Care Act (the “Patient Protection Act”), as amended by the Health Care and Education Afforda-bility Reconciliation Act of 2010 (the “Reconciliation Act” and, together with the Patient Protection Act, the “Health Care Reform Legislation”).
Despite its focus on health care reform, the new legislation contains a number of tax provisions that may be of interest to offshore private funds that offer their shares or other interests to U.S. investors or are advised or managed by U.S. persons. For example, the Health Care Reform Legislation increases the Medicare payroll tax rate for employees, imposes a new Medicare tax on the investment income of certain individuals, trusts and estates, codifies the economic substance doctrine (which previously was only a case law doctrine), and expands the Form 1099 reporting requirements.
Hospital Insurance Tax
The Health Care Reform Legislation increases the rate of the existing Medicare tax.
Currently, the Federal Insurance Contributions Act (“FICA”) imposes a tax on U.S. employers based on the amount of wages paid to an employee (the employee half of the total FICA tax). The tax is a two part tax consisting of (i) a 6.2% tax on covered wages up to the taxable wage base ($106,800 for 2010) for old age, survivor and disability insurance (“OASDI”) and (ii) a 1.45% tax on covered wages for hospital insurance. Similar taxes are imposed on employees. The Self-Employment Contributions Act (“SECA”) imposes parallel taxes on self employed individuals, who must pay both the employer and employee components of the tax and may claim an income tax deduction for half of the tax so paid.
The Health Care Reform Legislation increases the employee half of the hospital insurance tax under both FICA and SECA by 0.9%. The tax will be imposed on individuals earning more than $200,000 and joint filers or surviving spouses earning more than $250,000 ($125,000 in the case of a married individual filing a separate return).
Currently, the employer is required to withhold the entire amount of the employee’s portion of the FICA tax and remit the tax to the IRS. With respect to the additional 0.9% tax, however, the withholding require-ment will apply only with respect to employee wages in excess of $200,000. Furthermore, the employees will be directly liable for any portion of the additional 0.9% tax that is not withheld by the employer.
The increased rate will apply for remuneration received and taxable years beginning after December 31, 2012.
Tax on Net Investment Income
The Health Care Reform Legislation imposes an additional 3.8% Medicare contribution tax on certain net investment income (generally including interest, dividends, annuities, royalties, rents and net capital gains)4 of U.S. individuals, estates and trusts.
For individuals, the tax is imposed on the lesser of either net investment income or the excess of modified adjusted gross income over a threshold amount. The threshold amount is $200,000 for individual filers and $250,000 for joint filers or surviving spouses ($125,000 in the case of a married individual filing a separate return).
For estates and trusts, the tax is imposed on the lesser of undistributed net investment income or the excess of adjusted gross income over a threshold amount equal to the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.
Effectively, the tax will not apply to a taxpayer who earns less than the threshold amount.
The tax does not apply to non-resident aliens or trusts all the unexpired interests in which are devoted to charitable purposes. The tax also will not apply to a trust exempt from tax under section 501 of the Code or a charitable remainder trust exempt from tax under section 664 of the Code. Finally, the tax is subject to the individual estimated tax provisions and not deductible in computing any tax imposed by subtitle A of the Code (relating to income taxes).
This new tax will apply to taxable years beginning after December 31, 2012.
Information Reporting on Payments to Corporations
The Health Care Reform Legislation imposes new reporting requirements on businesses.
The Code imposes a variety of information reporting requirements on participants in certain transactions. Section 6041 of the Code requires an information return from every person engaged in a trade or business making certain payments aggregating $600 or more in a taxable year to a single payee in the course of that trade or business. Under current law, payments to corpora-tions are exempt from section 6041.
The Health Care Reform Legislation expands the current information reporting requirements under section 6041 of the Code to payments to corporations (excluding corporations treated as tax exempt under section 501(a) of the Code). Therefore, any payments to corporations covered by section 6041 will need to be reported on the appropriate form.
The information required is also expanded and now includes gross proceeds paid in consideration for property or services. Such information will continue to be submitted primarily on an IRS Form 1099 or IRS Form 1096.
The rules of section 6041 of the Code generally do not apply to information reporting with respect to payments of dividends, interest and redemption proceeds; reporting of such payments (generally on IRS Form 1099-DIV, IRS Form 1099-INT, or IRS Form 1099-B, as applicable) is governed by other Code sections. Accord-ingly, the expanded reporting requirements for payments governed by section 6041 of the Code generally should not impact offshore private funds.
The expanded reporting requirements for transactions governed by section 6041 of the Code will apply to payments made after December 31, 2011.
Codification of the Economic Substance Doctrine
The Health Care Reform Legislation codifies the economic substance doctrine.
Previously, the economic substance doctrine was a case law doctrine applied by courts to deny the tax benefits of tax-motivated transactions, even though such transactions may satisfy the literal requirements of the Code.
The codified version of the doctrine is meant to enhance the doctrine’s application and provide a uniform definition. The determination of whether the economic substance doctrine applies to a transaction will require a facts and circumstances analysis made in the same manner as if the provision were never enacted (that is, the common law determination will continue), but using the two-part test described below, rather than the various tests previously applied by some courts.
Under the codified economic substance doctrine, a transaction will be treated as having economic sub-stance only if:
- the transaction changes in a meaningful way (apart from federal income tax effects) the tax-payer’s economic position; and
- the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.
The requirement that a transaction meet both tests is meant to eliminate a disparity in the application of the doctrine currently existing among federal circuit courts.
The Health Care Reform Legislation also modifies the penalties on underpayments and understatements of tax to apply to any such underpayments or understate-ments attributable to transactions lacking economic substance.
A new strict liability penalty will apply to underpayments attributable to any disallowance of claimed taxed benefits as a result of the transaction lacking economic substance. The penalty generally is 20% of the under-payment, but can be increased to 40% if the taxpayer fails to adequately disclose the relevant facts affecting the transaction’s tax treatment either in the return or on a statement attached to the return. The 20% penalty also will apply to certain claims for refund or credit that lack economic substance.
No exceptions to the penalty (for reasonable cause or otherwise) will be available. Therefore, outside legal opinions or analyses by in-house counsel will not protect a taxpayer from this penalty if the transaction is determined to lack economic substance. This penalty will not apply, however, to the extent that a fraud penalty applies to an underpayment.
These provisions will be effective for transactions and understatements and underpayments attributable to transactions entered into after March 30, 2010.