FATCA and Hedge Funds: The Taxman Cometh, This Time with a Passport

Mar 19 2012 | 11:42am ET

KPMG Hedge Fund Tax Expert David Richardson Looks at FATCA Through the Lens of Hedge Fund Managers and Their Investors

On February 8, the U.S. Treasury and the Internal Revenue Service released the much-anticipated proposed regulations for implementing the Foreign Account Tax Compliance Act, or FATCA. The legislation is a new cornerstone in the U.S. government’s long-running campaign aimed at Americans who evade taxes by keeping clandestine accounts offshore. Under FATCA, foreign financial institutions will be required to disclose details about their U.S. and certain foreign clients to the IRS every year.  Any foreign financial institution or U.S. account holder that does not comply will face stiff financial penalties.

FINalternatives recently spoke with David Richardson, KPMG’s managing director of international tax, about the implications of FATCA for hedge funds and hedge fund investors.

Now that you have had time to digest the proposed regulations, what’s your assessment of FATCA?

In some ways, the regulations are not as tough as some feared. That said, implementing FATCA is going to require foreign financial institutions and many U.S. withholding agents to spend significant resources to adopt or adapt new technology to track their U.S. account holders.

What qualifies as a “foreign financial institution”?

Basically, foreign banks, brokers, custodians and funds, including foreign mutual funds, funds of funds, exchange-traded funds, private equity and venture capital funds, other managed funds, commodity pools and hedge funds, and certain insurance companies.

How does FATCA affect hedge funds specifically?

Offshore hedge funds will bear the most direct business and operational impacts.  For example, many of their investors, both U.S. and foreign, will have to give additional documentation as part of the on-boarding process.  Operationally, offshore funds will have to implement new document collection and due diligence processes plus adopt U.S. tax withholding and reporting capabilities.  Beginning in 2014, they will have to report information regarding their so-called U.S. accounts.  These are equity and debt interests in the fund that are determined to be owned by certain types of U.S. investors or be U.S. owned foreign corporations.  As U.S. withholding agents, U.S. funds will have additional duties under the new rules as well.

Why would they go along with a U.S. regulation?

Practically speaking, funds with meaningful direct or indirect exposure to the U.S. capital markets have no option. If the offshore hedge fund doesn’t cooperate, it will incur a 30% withholding tax on all income and eventually, all proceeds from its direct or indirect investment in U.S. assets.  The tax on gross proceeds will apply even if there is no gain on the sale.

What happens if an American investor refuses to disclose information to the offshore hedge fund?

Eventually, any U.S. individual or entity unwilling to provide the required information will also face a 30% tax on amounts that are deemed attributable to its share of the underlying income and gross proceeds from the fund’s direct and indirect U.S. assets.  This rule is written quite broadly and,  presumably, may apply to fund distributions, such as dividends and redemption payments.  However, for equity investors in offshore funds, this rule will kick-in no sooner than 2017.

Will FATCA prompt foreign financial institutions to prohibit Americans from investing to avoid the hassle of this regulation?

A fund cannot avoid the new rules simply by prohibiting American investors.  In most cases, if the fund has underlying U.S. assets, the 30% tax will apply unless the fund is compliant.  To be compliant, the fund would be required to perform due diligence on its investors that represent themselves to be non-U.S.

Don’t a lot of institutional investors in the U.S. have assets in offshore hedge funds?

Yes, many U.S. hedge funds have created offshore feeder funds or side-by-side funds for the benefit of U.S. tax-exempt investors, such as tax-exempt foundations, endowments and retirement funds. These institutions use offshore funds to mitigate the risk of tax on “unrelated business taxable income”, or UBTI, which is perfectly legal to do.  FATCA is not aimed at this group. Instead, FATCA’s aim is to identify American investors (mostly individuals, trusts and private companies) who may be trying to hide income by investing in or through a foreign “financial institution”, such as an offshore fund, foreign trust or foreign bank, brokerage or custody account. 

Aren’t U.S. lawmakers asking a lot of these offshore hedge funds—making them spend their own money to identify U.S. account holders for the benefit of the U.S. government?

That was and continues to be a wide-spread concern.  A good number of affected institutions now view the need to implement changes and comply with FATCA beginning next year as inevitable and have begun in-depth planning to ensure a smooth and timely transition. The proposed regulations have addressed these concerns to some degree in a couple of ways. For instance, the deadlines for implementing the reporting and withholding responsibilities under FATCA have been staggered and extended to give foreign institutions more time to gear up. 

But won’t it be expensive to collect and report this data? 

For many offshore funds, the initial implementation may be costly and complicated. For offshore funds, collecting, verifying, and managing the data, and performing U.S. tax reporting and withholding will require upfront expenditures for new systems and processes. On the other hand, FATCA might offer new service opportunities for some hedge fund service providers.

Privacy laws in some foreign countries prohibit financial institutions from releasing private information about individuals. How does FATCA deal with that?

Congress and the rule-makers were aware of this.  Generally, under the law, if a foreign law would prohibit reporting that FATCA requires, the foreign financial institution is required to request the investor to give a waiver of that prohibition.  If the investor that is subject to reporting does not give a timely waiver, then eventually the fund will have to withhold 30% against amounts that are deemed attributable to that investor’s share of the underlying income and gross proceeds from the fund’s U.S. assets.  On the same day that the government  released  the  proposed regulations, it announced that it intends to enter into an intergovernmental approach with five countries--France, Germany, Italy, Spain and the United Kingdom—to deal with the legal issues of this nature that arise in those countries. In addition, these governments have agreed to help the U.S. by collecting the information that FATCA requires from financial institutions in those countries.  The foreign governments will share that information with the IRS. Therefore, the IRS will get the information indirectly through the foreign governments rather than directly from the foreign financial institutions.  Interestingly, the U.S. will grant reciprocal rights to those countries. 

Why are these five countries cooperating?

In exchange for their cooperation, the U.S. is willing to reciprocate and send similar data to these five countries. In other words, U.S. financial institutions might be required to collect information on their investors and customers that foreign governments request, give that information to the IRS which, in turn, will share that information with the foreign taxing authorities. U.S. authorities hope and expect that other countries will enter into similar intergovernmental arrangements. 

So it sounds as if the Taxman Cometh, this time with a passport.

Yes, as the U.S. Treasury pointed out in its announcement, when American taxpayers avoid paying what they owe by hiding unreported assets offshore, it puts an unfair burden on other Americans. That’s why the IRS and Treasury Department have added more legal tools to their arsenal to identify these assets.

When does FATCA take effect?

Technically, the new law takes effect on January 1, 2013.If the proposed rules are finalized as currently written, hedge funds and other foreign financial institutions will have to begin applying the new document collection and due diligence procedures by the middle of 2013, report to the IRS on their U.S. accounts beginning in 2014 (for the 2013 calendar year), and be prepared to withhold on certain types of payments beginning January 1, 2014.

We’ll plan to check in with you again to get your update on FATCA. Thanks so much, David.

David Richardson is a managing director in the KPMG’s International Corporate Services practice. David has extensive experience advising private equity funds, hedge funds, real estate funds and other investment management clients on mitigating tax risks and ensuring proper compliance. He has also assisted numerous hedge fund, private equity and mutual fund clients with FIN 48/IFRS reviews and sign-off on international tax positions. David joined KPMG from another international accounting firm, where he spent nearly 15 years, most recently serving as a managing director in its International Tax Services – Financial Services practice.

 


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