President Obama signed into law on March 18, 2010, the Hiring Incentive to Restore Employment Act (the "HIRE Act"), which adds revenue raising provisions in new Sections 1471, et seq, of the Internal Revenue Code of 1986, as amended (the "Code"). This discussion focuses on the new U.S. federal withholding tax and information reporting obligations that will be applicable to foreign investment funds, master-feeder funds, fund-of-funds, and their investment advisors that have, directly or indirectly, certain United States investors. The new provisions will affect both U.S. and foreign investors and how pooled investment vehicles are structured. Unfortunately, the HIRE Act does not simplify existing rules but, rather, adds an additional layer of compliance obligations on the managers of these vehicles. The Treasury Department has already announced that it will issue additional guidance before these provisions go into effect.

HIRE Act Background

The HIRE Act provisions impose new tax compliance obligations on foreign banks, brokers and other entities with accounts or investment capital funded by "U.S. Persons", which term is generally defined in the Code as meaning any U.S. citizen, resident alien or business entity organized in the United States. The HIRE Act modifies this definition with two additional terms, "specified United States person" and "United States owned foreign entity." (In fact, new definitions include "non-financial foreign entity," "substantial United States owner," "recalcitrant account holder," "withholdable payment," and "passthru payment.") These new reporting obligations back-stop the reporting obligations of U.S. Persons themselves who own or have signatory authority over foreign bank accounts (the Reports of Foreign Bank and Financial Accounts Form TD F 90-22.1 or "FBAR"). The Treasury Department recently issued Notice 2010-23, clarifying that U.S. Persons who invest in foreign comingled funds, other than mutual funds, such as hedge funds and private equity funds, do not have to file FBARs for years prior to 2010, but they will have an obligation beginning in 2010 (for FBARs due by June 30, 2011). The HIRE Act provisions go one step further by imposing parallel reporting obligations on the foreign entities receiving investment capital, making them provide information that can be cross-checked against U.S. investors' FBAR filings. The HIRE Act has the potential to change how investment funds are structured and managed.

In addition to information reporting, the HIRE Act imposes a duty to withhold 30% of any "withholdable payment" and in some cases "passthru payments" made by a withholding agent in the absence of compliance with the information reporting rules, as described below. These new 30% withholding tax provisions are highlighted in the third item below.

In general, the HIRE Act provisions fall into three categories:

  1. new information reporting obligations for U.S. Persons holding shares in passive foreign investment companies ("PFICs") and "specified foreign financial assets" which apply in addition to the FBAR (effective for tax years beginning after March 18, 2010);
  2. the extension of the existing 30% withholding tax under Sections 1441 and 1442 of the Code to "foreign targeted bearer obligations" which will no longer be entitled to the "portfolio interest exemption" (effective for obligations issued after March 18, 2012) and "dividend equivalent amounts" (effective for payments made after September 14, 2010); and
  3. the imposition of a new 30% withholding tax on certain payments to "foreign financial institutions" including banks, brokers and investment funds (for payments made after December 31, 2012 – except with respect to obligations outstanding on March 18, 2012) unless they:
    1. enter into an information reporting agreement with the Treasury Department with respect to certain "U.S. accounts" owned by "specified United States persons" or "United States owned foreign entities" ("Treasury Agreement") and comply with information reporting rules and withhold the 30% tax on passthru payments in the absence of the appropriate documentation to identify owners of accounts;
    2. elect to have either a U.S. withholding agent or a foreign financial institution that has entered into a Treasury Agreement itself collect information and withhold on payments made to them; or
    3. refuse to take deposits or investments from "specified United States persons" or "United States owned foreign entities" and satisfy any other requirements that the Treasury Department may prescribe.

The definition of "foreign financial institution" includes banks and brokers and any foreign investment fund that is engaged (or holds itself out as being engaged) primarily in the business of investing, reinvesting or trading securities, partnership interests, commodities or any interest (including a futures or forward contract or option) in such securities, partnership interests or commodities. This definition covers almost any pooled investment vehicle, including hedge funds, private equity funds, venture capital funds, and fund-of-funds. A non-financial foreign entity, i.e. any foreign entity that is not required to enter into a Treasury Agreement, will nevertheless have to certify to any withholding agent that it has no "substantial United States owners." If it does have substantial United States owners, then it must provide tax identification information to the withholding agent, who then reports such information to the Treasury Department, or else the withholding agent must withhold 30% of any withholdable payments paid to the non-financial foreign entity.

The HIRE Act imposes a 30% withholding tax on all "withholdable payments" made to a "foreign financial institution," unless the foreign financial institution satisfies one of the requirements described above. A "withholdable payment" includes dividends, interest, rents, compensation, and the gross proceeds from the sale or other disposition of property of a type that can produce dividends or interest from U.S. sources. In general, the foreign financial institution must provide information about U.S. account holders and their assets, including specified United States persons and United States owned foreign entities, or designate a withholding agent to whom it provides certain information. The category of specified United States persons generally includes taxable U.S. investors and excludes States, their political subdivisions and agencies, and other tax-exempt entities.

Under guidance to be provided by the Treasury Department, the foreign financial institution has the choice to implement procedures that will generally ensure that it does not receive deposits or investments from specified United States persons and United States owned foreign entities, either directly or indirectly. As noted above, the term "specified United States person" does not include U.S. pension funds, university endowments and other U.S. tax-exempt investors.

If the foreign financial institution does not enter into a Treasury Agreement, does not designate a withholding agent or does not implement procedures to block U.S. accounts, a withholding agent must withhold the 30% tax on all withholdable payments made to the foreign financial institution, not just on payments attributable to "specified United States persons" or "United States owned foreign entities." The potential cost of non-compliance to foreign banks and brokers is large enough so that failure to comply is not an option. Likewise, the potential cost to foreign investment funds and their investors is significant. Therefore, we will discuss below certain structuring options that could insulate U.S. taxable and tax-exempt investors from potential liability under the HIRE Act for inadvertent non-compliance.

Pooled Investment Funds and Structures

In a typical master-feeder structure, several domestic and foreign entities are involved. The master fund is typically organized as a Cayman limited partnership with two limited partners, the U.S. feeder fund, typically a Delaware limited partnership with its own general partner entity, typically a Delaware limited liability company and the offshore feeder fund, typically a Cayman limited company classified as a foreign corporation for U.S. federal income tax purposes. In addition, the general partner of the master limited partnership may be either a Cayman limited partnership or a limited company. The master fund and the feeder funds typically have an investment advisor agreement with a Delaware limited liability company that will either make investment decisions for, or present investment opportunities to, the general partner. U.S. tax-exempt investors and non-U.S. investors will buy shares in the offshore feeder fund, and U.S. taxpaying investors will buy partnership interests in the U.S. feeder fund. Most decisions will be made by the financial professionals who own interests in both the general partner entities and the investment advisor. In addition, the investment advisor may perform services for other investment funds, which may be organized in Delaware, the Cayman Islands, or another foreign jurisdiction.

There may be parallel funds which follow the same investment strategy, which for certain regulatory purposes, only allow certain investors to participate. Likewise, certain investment managers may advise clients who place their capital in "managed accounts" which are separate accounts or limited liability companies established for one particular investor.

In a typical master-feeder structure, the Cayman master fund relies on the exemption contained in Section 864(b) of the Code to avoid U.S. net income taxation. Rather, the gross amount of its U.S. source "fixed or determinable annual or periodical" income ("FDAP") will be subject to withholding tax. To the extent that the fund invests in U.S. real property interests, the Cayman master fund will be subject to the 10% withholding tax on the realized proceeds arising from dispositions of the U.S. real property interests under the Foreign Investment in Real Property Tax Act ("FIRPTA").

The Code Section 864(b) securities and commodities trading exemption applies to any foreign corporation or partnership. Thus, the master fund is usually organized outside of the United States. However, the master-feeder group for one fund can often contain five or six different entities. If the advisor has a fund for each of his or her investment strategies, then one advisor could be affiliated with thirty or forty entities, many of them organized outside of the United States.

Structuring and the "Affiliated Group"

The HIRE Act provides that a Treasury Agreement will apply to all of a fund's affiliates, where affiliation is largely determined based on common ownership thresholds. Affiliation can be among corporations, partnerships or a combination of both. Therefore, a fund manager or advisor must first navigate the "affiliation" rules to determine how many affiliated groups for which he or she has potential withholding or compliance responsibility. Each group of foreign entities will require its own Treasury Agreement. Executing one or more Treasury Agreements will be the first step in the process for most foreign fund managers, even though those managers may be U.S. Persons.

The "expanded affiliated group" of any foreign financial institution means an affiliated group as defined in Section 1504(a) of the Code, without regard to Section 1504(b)(2) and (3), applying a 50% common ownership threshold instead of an 80% common ownership threshold. This generally defines an expanded affiliated group as a group of corporations under the common ownership of a parent. More importantly, the HIRE Act provides: "A partnership or any other entity (other than a corporation) shall be treated as a member of an expanded affiliated group if such entity is controlled (within the meaning of section 954(d)(3)) by members of such group (including any entity treated as a member of such group by reason of this sentence)." Section 954(d)(3) provides: "In the case of a partnership, trust or estate, control means the ownership, directly or indirectly, more than 50 percent (by value) of the beneficial interests in such partnership, trust or estate." The ownership attribution rules of Section 958 of the Code apply for this purpose.

In the example above, if the foreign feeder fund owns more than 50% of the master fund's partnership interests, the two entities are members of an "expanded affiliated group." Any Treasury Agreement that binds one would apply to the other under the affiliation rules.

One would hope that future Treasury guidance would clarify some of the following issues: (a) will there be one form of Treasury Agreement that would apply to all pooled investment vehicles managed or advised by the same investment manager, so the manager can enter into one Treasury Agreement for all of the funds under its management, (b) can a manager of a foreign investment fund designate a related party or related fund to serve as a U.S. withholding agent, and (c) can a manager selectively choose, entering into a Treasury Agreement with respect to some investment vehicles but refusing to accept investments from specified United States persons and United States owned foreign entities for others?

A specified United States person or United States owned foreign entity could include an individual fund manager or his or her partially or wholly-owned foreign entity. A "United States owned foreign entity" is any entity in which a specified United States person owns greater than 10% of the stock, profits interests or capital interests. The 10% threshold does not apply to a "foreign investment entity" so that a foreign investment fund has a "substantial United States owner" if it has any specified United States persons as direct or indirect owners. Thus, if a fund manager or his or her foreign entity is entitled to a "carried interest" from a foreign investment vehicle, then he or she may be viewed as owning an "United States account" with such vehicle because the definition of United States account includes "financial accounts" that are equity interests in a foreign financial institution (other than interests traded on an established securities market). The foreign investment vehicle would be precluded from electing to block United States accounts under Section 1471(b)(2) unless the "carried interest" is eliminated. Otherwise, the sole compliance option for the foreign investment vehicle would be a Treasury Agreement.

Segregating New Investors

Although segregating investors will add layers of reporting, it may reduce the risk of a tax loss to certain investors if they currently have an investment in a foreign investment fund and the fund fails to enter into a Treasury Agreement or eventually has its Treasury Agreement revoked.

Setting up two parallel funds, one domestic fund for U.S. taxable investors and another fund offshore for non-U.S. investors and tax-exempt entities (the "unrelated business taxable income" (UBTI) rules remain the same) will not relieve the foreign pooled investment vehicle of its due diligence obligations, but it may insulate U.S. taxable investors from incurring a 30% withholding tax should something go wrong. If a parallel fund structure is undesirable, the master fund could be organized in Delaware, but going forward, it would not have the protection of the securities trading exemption in Section 864(b) of the Code, exposing the Cayman feeder to liability for U.S. corporate income tax and the branch profits tax.

Foreign investment funds, once they enter into a Treasury Agreement, are excused from reporting information pertaining to U.S. pension plans, other organizations exempt from tax under Section 501(a) of the Code, as well as State governments, their political subdivisions, and State agencies and instrumentalities. Nevertheless, foreign funds that are withholding agents will need to satisfy themselves that such investors are really entitled to their claimed exemption and will have to perform a certain amount of due diligence.

Due Diligence

Currently, tax commentators have speculated whether a foreign financial institution can satisfy its due diligence requirements under the HIRE Act by observing the existing "know-your-customer" and "anti-money laundering" rules. There will almost certainly be Treasury guidance on the level of diligence, because in the absence of appropriate documentation, foreign financial institutions with Treasury Agreements in effect must withhold the 30% tax on passthru payments of withholdable payments to "recalcitrant account holders." A recalcitrant account holder is any account holder who fails to comply with requests for tax information or who fails to waive foreign bank secrecy/confidentiality protections if requested.

Future Treasury guidance should address (a) what documentation will confirm an organization's tax-exempt status, and (ii) what documentation is sufficient to conclude that a non-financial foreign entity does not have a "substantial United States owner." Hopefully, future guidance will allow potential withholding agents to protect themselves from liability.

New Code Section 1473(c)(2) provides that the Treasury Department is permitted to disclose the list of participating foreign financial institutions that have satisfied the requirements by (i) entering into a Treasury Agreement, (ii) electing to appoint a U.S. or foreign withholding agent, or (iii) refusing to accept investments from specified United States persons or from United States owned foreign entities and satisfying any other requirements the Treasury Department may prescribe. Based on this provision, one can assume that the Treasury Department will publish a list on its website of foreign financial institutions that are in compliance. This should make the due diligence process easier for funds and their managers who place investments with foreign banks and brokers, and who also accept investments from other foreign financial institutions. In the absence of clearance through the official list, the 30% withholding could apply.

Compliance Responsibility/Liability

New Section 1474(a) of the Code states: "Every person required to deduct and withhold any tax under this chapter is hereby made liable for such tax and is hereby indemnified against the claims and demands of any person for the amount of any payments made in accordance with the provisions of this chapter." New Section 1473(4) provides: "The term 'withholding agent' means all persons, in whatever capacity acting, having the control, receipt, custody, disposal, or payment of any withholdable payment."

Note that the term "withholding agent" is not synonymous with "foreign financial institution", and liability is not limited to the "foreign financial institution"; therefore, the choice of language in these two provisions would lead one to believe that any individuals, including investment fund managers, investment advisors, general partners, administrators, directors, officers, and employees of entities acting in those capacities who have control of cash receipts and disbursements would have personal liability under these new provisions.

Impact on Funds and Investors

Income Taxation

Effective September 14, 2010, the existing FDAP 30% withholding tax will apply to "dividend equivalent amounts." This represents an additional tax on payments that were exempt from U.S. withholding tax in past years (because of the source rules under Treasury Regulation § 1.863-7). Foreign investors and U.S. tax-exempt investors will bear the increased tax cost. U.S. taxable investors that are currently providing their tax identification information to a foreign fund classified as a partnership have been including dividend equivalent amounts in their gross income already.

For years after 2012, when the new regime goes into effect, master-feeder funds can restructure as two parallel funds to protect U.S. investors from an inadvertent tax cost due to compliance failure, one for U.S. investors (most likely a Delaware limited partnership) and one for non-U.S. investors and U.S. tax-exempt investors (most likely a Cayman limited company).

Capital Taxation

The definition of "withholdable payment" includes the gross proceeds from the sale or disposition of securities that produce interest or dividends from U.S. sources. A tax at the rate of 30% of the value of securities which is imposed on a hedge fund that normally turns over its net asset value on a regular basis could substantially reduce or wipe out the value of a hedge fund. U.S. investors would probably prefer to avoid this risk (or seek indemnification from the investment manager) in case the manager fails to enter into a Treasury Agreement (or in the event of some other compliance failure). Thus, U.S. taxable investors will probably seek the safety of investing through a parallel Delaware limited partnership rather than a U.S. feeder partnership.

Non-U.S. investors and tax-exempt investors have different risks. They have the option of investing in an offshore fund that blocks any specified United States person from investing in the fund. As noted above, guidance would be welcome from the Treasury Department on whether a foreign investment fund that accepts investments exclusively from non-U.S. Persons and U.S. tax-exempt investors will comply with Section 1471(b) (2) rules if a "specified United States person" owns a "carried interest," directly or indirectly, in the profits of the fund. The manager could replace the "carried interest" arrangement with a performance fee, which would be taxable as ordinary income without the availability of the long-term capital gains rate. Likewise, tax-exempt investors could avoid an investment in a foreign fund by establishing a "managed account" with a U.S. financial advisor, but the manager would be subject to tax at ordinary income rates with respect to any performance fee.

Buyers and sellers of real estate are familiar with the requirements of FIRPTA withholding equal to 10% of the realized gross proceeds arising on the sale or disposition of U.S. real property interests. At the time of its enactment, the 10% realized gross proceeds withholding tax was meant to equate with a 30% gross income (capital gains) withholding tax. The buying and selling of stocks and bonds occurs more rapidly and at a much higher volume. Assuming rules are promulgated that are similar to the FIRPTA withholding regulations, every buyer of stocks and bonds will be required to ascertain whether the seller is a U.S. person or not, and if not, ascertain whether such foreign seller is a "foreign financial institution" that satisfies new Section 1471(b) of the Code. If the seller is a non-financial foreign entity, the buyer will have to ascertain whether the seller has any "substantial United States owners." Otherwise, the buyer will have to withhold the 30% tax on the purchase price, or place the proceeds with a withholding agent who will ensure compliance or accept withholding liability.

Information Reporting

The information reporting requirements (FBARs, PFIC returns, and returns regarding foreign financial assets under new Section 6038D of the Code) imposed on U.S. investors are substantially reinforced by the new provisions which impose parallel obligations on foreign financial institutions with whom they invest their money. Foreign financial institutions will need to report tax information correctly to their U.S. investors. In many cases, foreign banks and brokers that have a U.S. presence are already equipped for U.S. tax compliance; however, many foreign investment funds are not yet familiar with U.S. information reporting and withholding obligations.

Considerations and Recommendations

Fund managers, even those with no direct United States connection, should review the legal entity structure of their entire fund group with a view to identifying which of the group's funds will become subject to these new information reporting and withholding rules. One would assume that any foreign fund with U.S. securities and commodity investments held directly or indirectly, needs to prepare for compliance. Inadvertent non-compliance with the new rules will lead to a 30% withholding tax on interest otherwise entitled to the "portfolio interest exemption" as well as capital gains (gross proceeds) otherwise sourced outside of the U.S. tax jurisdiction. The magnitude of the potential tax cost on investment vehicles, depending on their legal structure, is sure to influence fund operations. Managers should contact their banking and brokerage relationship professionals to determine what steps those institutions are taking to ensure compliance with the HIRE Act provisions, and a foreign fund's investor relationship officer should become well versed in the new rules to respond to investor inquiries.