New Tax Reporting Rules Will Significantly Impact Offshore Funds

Jun 28 2010 | 12:26pm ET

Edward H. Dougherty, Deloitte Tax LLP  -- On March 18, 2010, new information reporting rules were adopted which will significantly increase the compliance burden for managers of non-U.S. hedge and private equity funds.  Indeed, in many cases these funds have not been subject to U.S. tax reporting by virtue of their offshore domicile.  While the new rules were adopted as part of the Hiring Incentives to Restore Employment [“HIRE”] Act, the specific provisions have come to be known as the foreign account tax compliance or “FATCA” rules.  

The FATCA reporting requirements will apply to virtually all non-U.S. hedge or private equity funds holding U.S. securities and will generally require reporting to the IRS of any direct or indirect investor who is a taxable, privately-held U.S. entity or individual subject to U.S. income tax. These FATCA provisions are in addition to anti-money laundering and know-your-customer rules [“AML” and “KYC”] which may already impact some offshore funds, and proposed legislation which would require fund managers to register with the SEC.  The FATCA provisions specifically are scheduled to take effect on January 1, 2013, and while the purpose in some measure is consistent with the existing AML and KYC rules, implementation will be under an entirely new set of rules that may not be consistent with those rules.

The main purpose behind the FATCA rules is to increase reporting of offshore accounts held by U.S. persons.  In the wake of recent tax evasion cases involving foreign financial institutions, and with offshore tax havens viewed as contributing to the erosion of the U.S. tax base, offshore hedge and private equity funds are particularly impacted by the new rules.  In essence, the new rules will require offshore funds investing in the U.S. to obtain certification of U.S. or non-U.S. status from every investor.  While not specified at this time, the likely manner of certification could be some “Super W8-BEN“ for non-U.S. investors and a “Super W9” for U.S. investors.  The offshore fund will be required to enter into a binding agreement with the U.S. Treasury to provide an annual report containing information regarding the U.S. accounts, including value, and account deposits and withdrawals.  The information gathering and reporting will be subject to annual verification and due diligence, the rules of which have not yet been defined but likely will be required  to be done by a third party specialist.  Finally, the fund will be required to agree to provide the IRS with additional information about the accounts upon request, obtain waivers of any local country secrecy laws or agree to close or withhold on the account, and deduct and withhold a 30% tax on investors who do not provide requested information or, if necessary, proof the investor has itself entered into their own agreement with the IRS.  As an alternative to this reporting, the fund manager will be able to elect to do “Form 1099” reporting for all income earned by the U.S. investors; however, this will also require the fund to provide cost basis information to the investor.

There will be a significant downside for funds that fail to comply with the reporting requirements, and for investors in those funds who fail to provide the requested information or privacy waivers, the latter deemed in the new rules to be “recalcitrant account holders.”  To ensure compliance, the penalty for not entering into an agreement with the U.S. Treasury to report the required information is a 30% withholding tax on all U.S.-source dividends, interest, and other similar income items earned, and, most significantly, gross proceeds from the sale of securities by the fund.  All persons in a chain of payments will be required to withhold the tax unless they are provided documentation of compliance with the new rules by the recipient.  In applying these rules, no relief will be granted for residents of a treaty country or for income which is not normally subject to withholding, such as interest which qualifies for the portfolio interest exception.  Refunds or credits will be available, however, for taxpayers that choose to file a U.S. income tax return.   The FATCA rules exclude a very limited class of investors from withholding, specifically foreign governments and central banks, international organizations, and to the extent indentified by the IRS, any other class of persons posing a low risk of U.S. tax evasion.

Because this withholding regime is so strict and onerous, we expect that all offshore funds will endeavor to comply with the FATCA rules.  The U.S. Treasury has been given broad authority to implement many aspects of these rules which we expect to see issued over the next 18 months.  Fund managers can take some action now, however, and classify their investors based upon the FATCA rules. Once guidance is issued, fund managers may have a short period of time during which they will need to begin gathering the required documentation in order to be in a position to comply by the effective date.  As noted earlier, for most offshore funds, this will be the first time they have to execute any filings with the IRS.

Offshore fund managers may also wish to begin to educate their investors on the new rules and set the expectation of requiring additional documentation now in order to avoid having to explain the penalty withholding after it has occurred.  Foreign investors who may be concerned that their privacy has been compromised may be comforted by the fact that the information about the investors and their accounts will not [at least under current rules] be filed with the IRS.  Rather, this documentation will be maintained by the fund or its agent, though this information might be requested by the IRS upon an examination.   

We believe that once foreign investors become familiar with the new FATC A rules and provide the required information to the fund, some may begin to request treaty access to reduce or eliminate regular withholding taxes, whether imposed by the U.S. or other jurisdictions.  With existing structures, most investors in offshore funds are “blocked” from treaty access by investing in a tax-haven organized corporate entity.  If these investors instead invested in an offshore limited partnership, many income tax treaties would provide for a “look-through” to the beneficial owner, reducing or eliminating withholding on interest, dividends, and the capital gains taxes that have become an area of focus with the implementation of ASC 740 [formerly, and colloquially, “FIN 48”]for funds reporting their financial statements under U.S. Generally Accepted Accounting Principles.  

The pressure for treaty access will likely be increased by another provision of the HIRE Act which effectively shuts down the use of total return swaps as a means to avoid withholding tax on U.S. source dividends.  This rule is being phased in over the next two years.  Offshore fund managers may even begin to offer non-U.S. limited partnership structures as an investment vehicle before the FACTA provisions become effective to offer treaty access.  These managers should further educate their foreign investors that, as with the residency certification process discussed above, even if the offshore limited partnership is required to file a U.S. income tax return, there will often be no required filing of Schedules K-1 or any other information about the foreign investors with the IRS. 

In addition to pressure from foreign investors for treaty access, fund managers should be aware of a provision which has been proposed several times over the last few years by Rep. Sander Levin, now the Chairman of the House Ways and Means Committee.  His proposal would eliminate the rule which imposes tax on U.S. tax exempt institutions that earn investment income in a leveraged vehicle.  If and when this rule passes, U.S. tax exempt investors would no longer need to invest in an offshore corporation to block unrelated business taxable income, and then, at that point, may clamor to be invested in a pass through vehicle such as a limited partnership to minimize withholding. While these investors would presumably be indifferent then to a U.S. or a foreign partnership vehicle, fund managers that are prepared to offer both have a better chance of maintaining their investor base. 

Finally, fund managers should also consider the impact of withholding tax rules on their fund’s performance, and the correlative effect on performance fees.  Many fund documents provide that withholding taxes are treated as an expense of the fund, and so reduce performance.   Even in situations where the controlling documents provide that withholding taxes are treated as a distribution, many fund managers calculate the performance fee incorrectly because U.S. GAAP requires the taxes to be treated as an expense.   By better managing their funds’ withholding tax liabilities, fund managers can improve performance. 

As the major offshore fund centers grapple with the various U.S. rules designed to increase transparency and reporting, each has begun to focus on various tax issues as a way to attract and retain capital.  For example, Ireland and Luxembourg offer investors access to their income tax treaty networks and perhaps a more robust regulatory regime than traditional tax havens.  Both Ireland and Luxembourg have recently made it easier for offshore funds to redomicile to their country as a way to rapidly expand their base of funds. Fund managers considering such treaty access and regulatory oversight must balance these benefits with an increased cost of doing business.  More traditional tax havens cannot offer treaty access per se, since they do not impose income taxes themselves, but they have generally entered into tax information exchange agreements which provide, at a minimum, the appearance of transparency. Further, in reaction to the FATCA and ASC 740 [FIN 48] pressures, we understand that several of these tax havens have begun to consider new rules making it easy to convert from corporate to limited partnership form, as a way to grant treaty access to beneficial owners.  These tax havens are also reviewing local regulatory rules in an environment where most investors seem to welcome some sort of oversight.

In summary, offshore fund managers should begin to assess the impact of the new FATCA rules, and once further guidance is issued, begin to educate their foreign investors on the need to comply.  Fund managers launching new products or considering domicile issues should consult their advisors to understand the benefits and drawbacks of the various jurisdictions.  Fund managers and financial institutions should also consider whether and to what extent they can adapt existing technology to gather and maintain information necessary to comply with FATCA, AML and KYC rules at the same time.

Edward H. Dougherty is a Tax Partner in Deloitte’s Financial Services Practice in New York, Director of Hedge Fund Services for the Northeast Region, as well as the National Tax Leader for Hedge Funds.

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