Foreign institutional investors face new extraterritorial oversight

July 1 this year marks the dawn of the FATCA new world order. Giving the U.S. Internal Revenue Service unprecedented extraterritorial powers to gather information on foreign financial institutions and their underlying account holders, the Foreign Account Tax Compliance Act represents the U.S. Treasury Department’s efforts to prevent U.S. citizens and institutions from evading their tax obligations by holding financial assets abroad.

That’s the textbook definition, at least. In practice, what foreign financial institutions, or FFIs, are likely to see is the U.S. — nostalgic for its more hegemonic days — leveraging its still considerable might to impose a new dichotomy on the financial world growing beyond its borders. That errant world will simply be divided into those who comply with FATCA and those who don’t. And FATCA’s scope is enormous and almost all-encompassing.

FATCA is estimated to affect 300,000 FFIs, according to the IRS. This number is in addition to the estimated 10,000 banks, custodians and transfer agents, more than 4,000 hedge funds and a similar number of private equity funds that will be affected by the legislation. The market consensus, however, is that these numbers are vastly underestimated.

Even non-U.S. pension funds have been caught in FATCA’s broad reach and are generally deemed as FFIs because of their investment activities. However, there is a small measure of solace for some categories of FFIs that might be exempt from registering and reporting. These include most governmental entities, most non-profits and certain retirement entities, such as corporate pension funds. Such retirement funds include those established in a country with which the U.S. has an income tax treaty in force and which are generally exempt from income taxation in that country. Pension plans or other retirement arrangements that are established in the U.K., for example, are excluded as FFIs.

U.S. pension funds and individual retirement accounts often have financial accounts with FFIs such as foreign-based investment management firms, banks, hedge funds and private equity funds. FFIs will not be required to report on U.S. pension funds and individual retirement accounts that certify their exemption from FATCA reporting on the new IRS Form W-9. This exclusion would be on the basis that the account holder is exempt from taxation under section 501(a) of the U.S. Internal Revenue Code.

FFIs that are set up to provide retirement or pension benefits under the law of the country in which they are established and whose contributions are from the employer, government or employee, which are limited by reference to earned income, and in which no single beneficiary has a right to more than 5% of the FFIs assets, might also be exempt.

But as is often the case with sweeping regulatory upheaval, FATCA is likely to cause collateral damage. An estimated 6 million American citizens who reside and work outside of the U.S. could be affected by FATCA.

Enforcement actions against those deemed non-compliant with FATCA’s regulations and requirements will be severe, and ignorance of the law will be no excuse.

Hedge funds, private equity funds and other investment fund structures, as well as many investment managers operating in jurisdictions outside the U.S., are given three choices: Comply; don’t comply; and avoid.

The good choice: Comply.

FATCA was enacted into law in March 2010. Since then, international jurisdictions have begun the work of creating their own intergovernmental agreement-enabling legislation, regulations and regulatory framework to facilitate a continuing exchange of information between FFIs and the U.S.

According to the U.S. Treasury, intergovernmental agreements “are a crucial component to FATCA implementation. … Treasury has signed nine IGAs and is engaged in related conversations with more than 80 jurisdictions.”

Each FFI will need to comply independently with FATCA, including securing a unique global intermediary identification number for the entity, appointing a FATCA-responsible officer, establishing a compliance program, monitoring the effectiveness of the compliance program and the service providers involved in FATCA compliance, and reporting to the IRS or local tax authority.

FATCA casts a wide net. All foreign depositories, custodians, investment entities and specified insurance companies fall under its purview. “Investment entities” include organizations participating in investing, or administering financial assets for or on behalf of a customer. Entities that are customers of yet other financial institutions are no exception.

Foreign entities operating as a collective investment vehicle, mutual fund, exchange-traded fund, private equity fund, venture capital fund, leveraged buyout fund or similar vehicle will be deemed an FFI by the IRS and obligated to comply with FATCA. Hedge funds, whether established as corporations or limited partnerships, generally fall into the FATCA regime and will have compliance requirements to meet. Investment management companies, master funds with U.S. feeders, general partners and even trusts also will be affected.

And while it might seem logical to leave funds and holding companies with no U.S. investors and funds sponsored by non-U.S. managers alone, no such luck. These, too, will be bidden into compliance. Under FATCA, long-only funds with non-U.S. investors might be subject to a 30% U.S. withholding tax on U.S.-sourced dividends, unless there is an applicable treaty in place that reduces or eliminates this tax.

FATCA even has the potential to negatively affect non-U.S. pension fund returns, if the fund or, in some cases, its ultimate beneficial owners are non-compliant.

Complying is rewarded with huge benefits. FFIs that demonstrate their commitment to FATCA compliance will be granted uninterrupted access to the world’s leading global financial institutions, major currencies and securities markets as well as over-the-counter trades. Furthermore, they will not suffer the withholding penalties on U.S.-sourced income.

The bad choice: Don’t comply.

FFIs that willfully or even unknowingly break FATCA rules will be subjected to a number of ugly penalties, including a 30% tax withholding on U.S.-sourced income and withholding on gross proceeds FFIs could face regulatory enforcement action and sanctions, which will vary depending on the FATCA regime in which the FFI operates.

Should compliance not be addressed, the FFI could lose institutional credibility and be treated as a non-participating FFI by the IRS and by the rest of the FATCA-compliant world. Suffering this type of reputational damage will almost certainly result in loss of account holders. In fact, organizations and counterparties might restructure to prevent non-participating FFIs from interacting with them.

The ugly choice: Avoid.

Avoiding the FATCA-compliant financial world has ugly consequences. In the short-term, it might be theoretically possible to find a counterparty willing to fly in the face of the IRS and even a few account holders willing to pay the high ticket price to go along for the ride, but we all know how this story ended for certain banks in Switzerland.

Partner jurisdictions can be expected to enact intergovernmental agreement-enabling legislation, which makes it illegal for non-participating FFIs to continue operating from or within the jurisdiction. Non-participating FFIs must prepare for closure of any account they have in their own name or for customers.

Non-participating FFIs will have limited, if any, access to the U.S. dollar and will be shut out of the securities markets of the FATCA-compliant world.

The choice facing FFI’s, therefore, isn’t much of a choice at all. Non-compliance, it seems, is asking for the rope.

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