March 16, 2012
On February 8, 2012, the IRS and US Treasury released proposed regulations under the Foreign Account Tax Compliance Act (FATCA), which was enacted for the purpose of combating offshore tax evasion. To achieve this goal, beginning January 1, 2014, FATCA imposes a 30% withholding tax (FATCA withholding tax) on certain payments to “foreign financial institutions” (FFIs) and to non-US entities that are not FFIs, but that have substantial US ownership.
The FATCA withholding tax does not apply if an FFI (i) is a “deemed-compliant FFI” (a limited category of FFIs that are determined, through a separate registration or certification process, not to pose a significant risk of tax avoidance and, consequently, have been exempted from FATCA); or (ii) qualifies as a “participating FFI” (PFFI). An FFI that is not a deemed-compliant FFI and that wants to avoid the FATCA withholding tax as of January 1, 2014 by qualifying as a PFFI must enter into an “FFI agreement” (discussed below) with the IRS by June 30, 2013.
Non-US hedge funds and other non-US investment vehicles generally will be treated as FFIs and, therefore, will be subject to the FATCA withholding tax on payments made to them, unless they satisfy the requirements for PFFI status. In addition, both US and foreign funds will need to understand their obligations as “withholding agents” under the FATCA rules with respect to payments made by them to their investors.
This alert provides an overview of both the PFFI and withholding agent rules under the proposed regulations and related implementation issues, as specifically relevant to private investment funds, including certain key deadlines and the general impact of non-compliance.
Download a PDF of important deadlines and effective dates under proposed FATCA regulations.
Complying with FATCA – Fund Entities as FFIs
For fund managers, a first step toward FATCA compliance will include a review of their fund entities in order to identify FFIs. Most non-US fund entities that make investments will be FFIs, since the proposed regulations define “FFI” broadly to include non-US entities that are engaged primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities or derivatives.
Consequences of FFI Status - FATCA Withholding Tax on “Withholdable Payments”
If a non-US fund entity is an FFI and does not enter into an FFI agreement with the IRS qualifying it as a PFFI, it will be classified as a “non-participating FFI” (NPFFI) and will be subject to the FATCA withholding tax on “withholdable payments” that it receives.
As of the January 1, 2014 FATCA effective date, withholdable payments include US-source interest, dividends, rents, royalties, insurance premiums, and other fixed or determinable annual or periodical gains, profits and income (generally referred to as FDAP income). As of January 1, 2015, withholdable payments also will include gross proceeds from the sale or other disposition of US debt or equity securities (or other property of a type that produces US-source interest or dividend income). In addition, the proposed regulations contemplate that “foreign passthru payments” will be subject to the FATCA withholding tax, but not before January 1, 2017. Although not yet defined, “foreign passthru payments” likely will include foreign-source payments received by an NPFFI (the second FFI) from another FFI (the first FFI) to the extent attributable to withholdable payments received by the first FFI.
Notwithstanding the foregoing, withholdable payments do not include (i) payments made under any legal agreement outstanding on January 1, 2013, that produces or could produce a withholdable payment, other than an agreement or instrument that is treated as equity for US tax purposes or that lacks a stated expiration or term (a grandfathered obligation); or (ii) the gross proceeds from the disposition of such a grandfathered obligation.
A non-US fund entity that is an FFI and that is treated as a partnership for US federal income tax purposes may be entitled to a refund or credit on its FATCA withholding to the extent it properly establishes that such amounts are allocable to investors that are “exempt beneficial owners” under the FATCA rules (e.g., US tax-exempt entities or foreign governments). Refunds and credits also may be allowed to the extent an FFI properly establishes that it is entitled to an exemption or a reduced rate of tax by reason of an applicable US tax treaty.
Qualification as a PFFI - Exemption from FATCA Withholding Tax; FFI Agreements
To avoid the FATCA withholding tax on payments made to it, a non-US fund entity that is an FFI can become a PFFI by entering into an agreement (an FFI agreement) with the IRS to (i) identify the status under FATCA of various types of fund investors; (ii) report certain information to the IRS regarding such investors; (iii) verify its ongoing compliance with its obligations pursuant to the FFI agreement; and (iv) make the appropriate FATCA withholding on withholdable payments made to investors that are NPFFIs or that do not provide the required information to the fund entity (recalcitrant holders).
The IRS will begin accepting applications for PFFI status by January 1, 2013. To qualify for PFFI status effective as of January 1, 2014, a non-US fund entity that is an FFI will be required to execute an FFI agreement with the IRS by June 30, 2013. The IRS intends to release a draft model FFI agreement in early 2012 and a final model FFI agreement in late 2012. Once a fund entity that is an FFI enters into an FFI agreement, it will be required to comply with certain due diligence and reporting requirements with respect to its investors and to withhold the applicable FATCA withholding tax from payments it makes to investors that are determined to be subject to such tax. FFI agreements will require PFFIs to commit to ongoing compliance with FATCA obligations. Fund managers, therefore, must establish compliance procedures that will assist them in ensuring that all fund entities that are FFIs maintain their PFFI status.
In general, to comply with its reporting and withholding obligations, a fund entity that is a PFFI will need to determine its (i) US investors; (ii) foreign investors that are non-FFI entities; and (iii) foreign investors that are FFIs. The fund entity will then need to determine (a) for foreign investors that are non-FFI entities, whether those entities have “substantial US owners” (generally determined by applying a greater-than-10% ownership test); and (b) for foreign investors that are FFIs, whether those FFIs are PFFIs, deemed-compliant FFIs or NPFFIs. Through this process, a PFFI will identify those investors whose information must be provided to the IRS, as well as those investors (i.e., NPFFIs and recalcitrant holders) to which the FATCA withholding tax will apply.
The proposed regulations provide detailed guidance on the due diligence procedures and presumption rules that a fund entity that is a PFFI will need to follow in order to make these determinations regarding the status of its investors for FATCA purposes, including certain de minimis thresholds. With respect to its pre-existing investors (i.e., individuals or entities that are investors in the fund entity prior to the effective date of the FFI agreement), the fund entity generally will have one or two years (depending on the type of investor and size of the investment) from the effective date of the FFI agreement to obtain the required investor information.
Because of the administrative burden of maintaining PFFI status, fund managers also may want to consider establishing certain non-US fund entities that do not accept US investors. In such cases, the diligence and reporting obligations would be significantly reduced, but such fund entities still would need to establish and disclose the fact that they have no US investors (and comply with other requirements relating to non-US investors) in order to maintain PFFI status. Simply closing the door to US investors would not, on its own, shield a PFFI from its obligations under FATCA.
Qualification as a PFFI - Expanded Affiliated Groups
For an FFI that is a member of an “expanded affiliated group” to qualify has a PFFI, each other member of the group also must be either a PFFI or a deemed-compliant FFI that satisfies certain registration requirements (registered deemed-compliant FFI). Two or more FFIs generally will be part of the same expanded affiliated group if they are linked to a common parent entity (which may or may not be a financial institution) through a chain of greater-than-50% equity ownership (measured by vote and value in the case of corporate entities, but only by value in the case of non-corporate entities). FFIs linked through common management, but not through common equity ownership, would not be members of the same expanded affiliated group. The proposed regulations have provided a transition period, ending December 31, 2015, for the full implementation of this requirement on expanded affiliated groups. During the transition period, an NPFFI will not prevent other FFIs within the same expanded affiliated group from qualifying as PFFIs, provided that the NPFFI agrees to comply with certain more limited due diligence, reporting and other requirements. Full compliance, however, will be required on and after January 1, 2016.
Complying with FATCA – Fund Entities as Withholding Agents
Withholding Agent Obligations
A withholding agent must withhold the FATCA withholding tax on withholdable payments made on or after January 1, 2014 (and on any foreign passthru payments, but not before January 1, 2017) (i) to an FFI or (ii) to a non-US non-FFI entity with one or more substantial US owners, unless such FFI or non-FFI entity provides the necessary documentation to establish that no FATCA withholding is required. The proposed regulations have broadly defined the term “withholding agent” to include any person, US or foreign, in whatever capacity acting, that has the control, receipt, custody, disposal or payment of a withholdable payment. Therefore, both US and foreign fund entities may be obligated to act as FATCA withholding agents.
In addition, starting in 2015 with respect to withholdable payments made by it in 2014, a withholding agent will be required to report such payments on modified IRS Forms 1042 (Annual Withholding Tax Return for US Source Income of Foreign Persons) and 1042-S (Foreign Person’s US Source Income Subject to Withholding), even if (in some circumstances) no FATCA withholding was required.
A withholding agent making withholdable payments generally has the same initial payee identification obligations as a PFFI. In particular, a withholding agent will need to determine its (i) US investors; (ii) foreign investors that are non-FFI entities; and (iii) foreign investors that are FFIs. The withholding agent will then need to determine (a) for foreign investors that are non-FFI entities, whether those entities have substantial US owners; and (b) for foreign investors that are FFIs, whether those FFIs are PFFIs, deemed-compliant FFIs or NPFFIs. The proposed regulations provide detailed guidance on the due diligence procedures and presumption rules that withholding agents will need to follow in order to determine their FATCA withholding and reporting obligations. Notwithstanding the similarities between the PFFI and non-PFFI withholding agent due diligence and reporting requirements (including the obligation to file IRS Forms 1042 and 1042-S, as described above), a withholding agent that is not a PFFI will not be subject to the additional annual reporting obligations that would arise under an FFI agreement.
Consequences of Failure to Withhold the FATCA Withholding Tax
Any person (including a US fund entity and a PFFI) that is a withholding agent is required to withhold the FATCA withholding tax on withholdable payments that it makes to NPFFIs and/or recalcitrant holders, as applicable. A withholding agent will be subject to certain presumptions and standards of knowledge when determining the status of a payee. Any withholding agent that fails to withhold and deposit the appropriate FATCA withholding amounts will be liable for such taxes and applicable penalties and additions to such taxes. In addition, a withholding agent that cannot reliably associate a withholdable payment with the proper FATCA exemption documentation also will be liable for any uncollected FATCA withholding tax.
Fund-of-Funds Investment Considerations
A fund-of-funds, whether US or non-US, should also determine whether unrelated portfolio funds and other entities in which it may have invested are FFIs. If such non-US entities are not PFFIs, payments made to such entities may be subject to the FATCA withholding tax, thereby reducing the amounts available for distribution to investors.
Currently, the IRS and US Treasury are accepting comments and recommendations on the proposed regulations and a public hearing has been scheduled for May 12, 2012, at which time the IRS and US Treasury will entertain oral comments on the proposed regulations. In addition, the IRS plans to issue written guidance relating to (and, in some cases, modifying) the proposed regulations, and has stated that the final regulations will provide guidance on substantive and procedural issues not addressed in the proposed regulations.