The U.S. Foreign Account Tax Compliance Act (FATCA): Impact on Foreign Investment Funds

This article analyzes certain key provisions of the U.S. Foreign Account Tax Compliance Act (“FATCA”) that are most relevant to investment funds — for example, hedge funds, private equity funds, and sovereign wealth funds — particularly foreign investment funds.

The information in this article is current as of June 19, 2014.

FATCA’s impact on investment funds may generally be twofold. U.S. investment fund vehicles will typically be considered withholding agents for purposes of FATCA and will be required to withhold on certain payments to non-U.S. recipients that do not establish an exemption from FATCA. Foreign investment fund vehicles that are not able to establish an exemption from FATCA will usually constitute “foreign financial institutions” (“FFIs”) for purposes of FATCA and, as a result, will be subject to a 30 percent withholding tax on certain payments, unless they become “Participating FFIs” by agreeing to undertake due diligence and report information about their “U.S. Account Holders.” U.S. Account Holders will generally include U.S. holders of a fund’s non-publicly traded debt and equity interests as well as substantial U.S. owners of non-U.S. account holders (i.e., most direct and indirect U.S. investors in a fund).

To comply with FATCA requirements, funds will generally need to collect appropriate U.S. Internal Revenue Service (“IRS”) Form W-8 and W-9 forms from investors (as they normally do), which forms have been updated to elicit additional information required by FATCA. Funds may also wish to include provisions in governing documents that require investors to provide information necessary for the fund to comply with FATCA and that authorize the fund to take actions necessary for FATCA compliance.

As discussed further below, it may be possible for a group of funds to engage in collective streamlined FATCA compliance through a sponsoring entity (typically the manager).

In Notice 2014-33, the IRS announced that calendar years 2014 and 2015 will be regarded as a transition period for purposes of IRS enforcement and administration, such that the IRS will take into account the extent to which a good faith effort has been made to comply with FATCA in determining whether to assess penalties and amounts due for underwithholding or take administrative action.

A few key FATCA-related dates are as follows:

• July 1, 2014: Grandfathering period ends and withholding on most “Withholdable Payments” (discussed below) begins

• January 1, 2015: Withholding agents must confirm global intermediary identification numbers (“GIINs”) for FFIs in Model I Intergovernmental Agreement (“IGA”) jurisdictions

• March 31, 2015: Reporting begins for FFIs in non-IGA jurisdictions and Model II IGA jurisdictions

• September 30, 2015: Reporting begins for FFIs in Model I IGA jurisdictions

• January 1, 2016: Registered deemed-compliant FFIs that are sponsored entities must provide their own GIINs

• January 1, 2017: Earliest date withholding on foreign passthru payments may begin

Overview of FATCA

Foreign Financial Institutions

FATCA is intended to reduce the evasion of U.S. tax by U.S. citizens and U.S. residents who hold offshore assets. To this end, FATCA incentivizes FFIs, if not otherwise exempt from FATCA, to enter into an agreement with the IRS (an “FFI Agreement”) pursuant to which the FFI becomes a “Participating FFI,” and thereby agrees to:

• report the names, addresses, and taxpayer identification numbers of U.S. Account Holders (as well as certain information about the accounts); and

• withhold 30 percent on all or a portion of payments that are considered to be attributable to the Participating FFI’s U.S. assets (referred to as “Foreign Passthru Payments”) when made to either FFIs that have not entered into an FFI Agreement (“Non-Participating FFIs”) or to other payees that fail to provide the Participating FFI with certain information.

The final FFI Agreement was published by the IRS in early 2014 in Rev. Proc. 2014-13.

The incentive for becoming a Participating FFI is that Non-Participating FFIs are subject to 30 percent withholding tax on Withholdable Payments, which include:

• U.S. source interest, dividends, rent, salaries and other fixed or determinable annual or periodic payments (paid on or after July 1, 2014);

• gross proceeds from the sale of assets that produce U.S. source interest or dividends (paid on or after January 1, 2017); and

• Foreign Passthru Payments from Participating FFIs (withholding on such payments is delayed until January 1, 2017, at the earliest, and such payments are not yet defined by the Regulations, but are generally expected to include such payments as interest on a bank deposit maintained with an FFI).

Under a grandfathering rule, FATCA withholding generally does not apply to payments in respect of, or gross proceeds from the disposition of, obligations (generally, instruments with a stated maturity date that are not treated as equity for U.S. tax purposes (and associated collateral)) that are outstanding on July 1, 2014, and that are not “materially modified” thereafter. Specifically with respect to Foreign Passthru Payments, the grandfathering rule applies to any obligation that is executed on or before the date that is six months after the date of publication of final regulations defining the term “foreign passthru payment.”

FFIs will become Participating FFIs by registering with the IRS and agreeing to comply with the reporting and withholding provisions of FATCA through the FATCA Registration Portal. The IRS published an initial list of Participating FFIs on June 2, 2014. It is intended that the list of Participating FFIs will be updated on a monthly basis going forward. FFIs in Model I IGA jurisdictions (discussed below) have additional time to register with the IRS because withholding agents are not required to confirm their GIINs before January 1, 2015.

The IRS is issuing GIINs to Participating FFIs as registrations are finalized in 2014. The FFI Agreement of a Participating FFI that receives a GIIN from the IRS on or before June 30, 2014, will have an effective date of June 30, 2014. Withholding agents generally will be required to implement new account opening procedures by July 1, 2014, or, in the case of a Participating FFI, by the later of July 1, 2014, or the effective date of its FFI Agreement.

Non-Financial Foreign Entities

FATCA also imposes a 30 percent withholding tax on Withholdable Payments to certain foreign entities that are not FFIs (non-financial foreign entities, or “NFFEs”) unless the NFFE either provides certain information to a withholding agent regarding the NFFE’s “substantial U.S. owners” (generally, a U.S. 10 percent stockholder) or certifies to not having any such owners (that is, an NFFE is generally not required to enter into an FFI Agreement to avoid FATCA withholding).

An NFFE will generally not be subject to this disclosure or certification requirement regarding its substantial U.S. owners if it is:

• a publicly traded corporation (or part of an expanded affiliated group containing a publicly traded corporation);

• a foreign government; or

• an “Active NFFE” (typically an NFFE with less than 50 percent passive income or assets).

Intergovernmental Agreements

The U.S. has taken an intergovernmental approach to the implementation of FATCA by entering into IGAs with governments in other jurisdictions. The Regulations were drafted to complement and coordinate with IGAs.

The U.S. has two forms of IGAs, referred to as “Model I” and “Model II.”

Model I reflects a government-to-government approach, pursuant to which the partner jurisdiction adopts local laws requiring FFIs in that jurisdiction to report information about U.S. accounts to the local tax authority, which the local tax authority then provides to the IRS. FFIs in Model I partner jurisdictions generally need not enter into FFI Agreements, but merely comply with local law, to be compliant with FATCA. Note that, subject to certain exceptions, a group of funds having some funds in Model I IGA jurisdictions and some funds in non-IGA jurisdictions may not be able to be considered fully compliant with FATCA unless the funds in the non-IGA jurisdictions become Participating FFIs.

Model II is the business to-government approach, pursuant to which the partner jurisdiction agrees to direct and enable FFIs in that jurisdiction to report information about U.S. accounts directly to the IRS (notwithstanding bank secrecy laws and any other legal obstacles to FATCA).

As of June 19, 2014, the U.S. had entered into Model I IGAs (or reached agreements in substance on the terms of an IGA) with over 50 jurisdictions, and this list will continue to grow. As of the same date, the U.S. had entered into Model II IGAs with Switzerland, Japan, Austria, Bermuda, and Chile, and had reached agreements in substance on the terms of IGAs with Armenia and Hong Kong.

The U.S. Treasury’s website lists jurisdictions with which the U.S. has entered into an IGA as well as jurisdictions that are treated as having an IGA in effect. In this regard, jurisdictions that have reached agreements in substance on the terms of an IGA but have not yet brought the IGA into force may consent to being on the Treasury’s IGA list, in which case the IGA will be treated as being in effect. For example, as of June 19, 2014, the IGA between Brazil and the U.S. had not yet been signed, but, because an agreement had been reached in substance and Brazil consented to being included on Treasury’s list, Brazil is treated as having an IGA in effect as of April 2, 2014.

FATCA Provisions Relevant for Investment Funds

Scope of the FFI Definition

The definition of an FFI is extremely broad, and includes an “investment entity,” which is an entity that:

• primarily conducts (as a business on behalf of customers) trading in currencies or financial instruments, portfolio management, investing, or administering or managing funds, money or financial assets (that is, a fund manager);

• has gross income primarily attributable to investing, reinvesting, or trading in financial assets and is managed externally; or

• functions or holds itself out as a collective investment vehicle (including a mutual fund, exchange traded fund, private equity fund, hedge fund, venture capital fund, leveraged buyout fund, or any similar investment vehicle with a strategy of investing, reinvesting or trading financial assets).

This “investment entity” prong of the FFI definition is broad enough to cover nearly all foreign funds, fund managers, master funds, and feeder funds.

The FFI definition also generally includes a holding company formed in connection with, or availed of by, an investment fund. For these purposes, a holding company is a company the primary activity of which is holding (directly or indirectly) all or part of the outstanding stock of one or more members of its “expanded affiliated group” (which generally includes one or more chains of corporations connected through a common parent where vote and value thresholds of more than 50 percent are met, as well as any entity other than a corporation (such as a partnership) that is controlled by members of the group). As a result, a holding company formed by an investment fund to acquire a particular investment would generally constitute an FFI even if the investment was in an active, non-financial portfolio company. In contrast, a holding company that is not formed in connection with, or availed of by, an investment fund is generally not an FFI if it is a member of a “non-financial group” (that is, 25 percent or less of the group’s income and assets are passive and 5 percent or less of the group’s gross income is from FFIs within the group).

Certain passive, non-commercial investment vehicles (including certain family trusts) may be excluded from the FFI definition, provided they do not conduct investment management activities for or on behalf of customers and are not externally managed by an FFI (such entities often will be classified as passive NFFEs and, therefore, will still be required to document their U.S. ownership).

To not be subject to FATCA withholding, most non-U.S. fund vehicles will need to become Participating FFIs unless, as discussed further below, they qualify as:

• an “exempt beneficial owner” (payments to which are exempt from FATCA withholding); or

• a deemed-compliant FFI (including by complying with an IGA).

Additionally, as many fund groups contain both U.S. and non-U.S. entities, while the non-U.S. entities will generally be FFIs, the U.S. entities will also have compliance obligations under FATCA as primary withholding agents for Withholdable Payments to FFIs and other foreign persons.

Foreign Retirement Funds and Sovereign Wealth Funds

Although otherwise generally covered by the FFI definition, many foreign retirement funds, sovereign wealth funds and similar foreign government-related investment entities should qualify as “exempt beneficial owners,” payments to which are not subject to FATCA withholding.

Foreign retirement funds that qualify as “exempt beneficial owners” include:

• treaty-qualified retirement funds (that is, retirement funds formed in a U.S. treaty partner jurisdiction which are eligible for the relevant U.S. double tax treaty);

• broad participation retirement funds (that is, retirement funds which, among other requirements, are regulated by the local government and do not have any beneficiaries with a right to more than 5 percent of the fund’s assets);

• narrow participation retirement funds (that is, retirement funds which, among other requirements, have fewer than 50 participants and do not have an investment entity or passive NFFE as their sponsoring employer); and

• retirement funds that would qualify under Section 401(a) of the Internal Revenue Codeif formed in the U.S.

Exempt beneficial owners also include foreign governments and the integral parts, controlled entities, and political subdivisions thereof. However, payments to such FFIs will not be treated as payments to an exempt beneficial owner if derived from an obligation held in connection with a commercial financial activity of a type engaged in by an insurance company, custodial institution, or depository institution.

Registered Deemed-Compliant FFIs

Registered deemed-compliant FFIs are deemed to be compliant with FATCA without having to enter into an FFI Agreement, but are nevertheless required to:

• register with the IRS to obtain a GIIN;

• certify their registered deemed-compliant status to the IRS every three years; and

• maintain certain records and report status changes to the IRS.

Registered deemed-compliant funds include “qualified collective investment vehicles,” “restricted funds” and certain “sponsored investment entities,” each discussed further below.

Qualified Collective Investment Vehicles

Qualified collective investment vehicles are “regulated as an investment fund” and owned solely by Participating FFIs, registered deemed-compliant FFIs or certain other institutional investors (but not individuals), payments to which are not subject to FATCA. In general, a fund is considered to be “regulated as an investment fund” if:

• it is regulated as such in its country of organization;

• it is regulated as such in all countries in which it is registered or operates; or

• its manager is regulated with respect to the fund in all countries in which the fund is registered or operates.

Restricted Funds

A restricted fund is generally a fund that is “regulated as an investment fund” (as described above) and takes steps to ensure it is not held by specified U.S. persons (other than certain exempted U.S. institutional investors), Non-Participating FFIs, or passive NFFEs with substantial U.S. owners. A restricted fund generally cannot provide for secondary market sales (that is, only direct issuances, redemption of interests by the fund and sales through certain distributors such as Participating FFIs or registered deemed-compliant FFIs). This exemption is rather limited, as it could apply to a foreign fund with all foreign owners, but would not be available to any foreign fund in which a U.S. person (including a U.S. manager) had an interest. In addition, restricted funds must also meet additional account review, certification, withholding and other requirements, including implementing policies and procedures to ensure it generally does not open or maintain accounts for the specified U.S. persons.

Certain Sponsored Investment Entities

Groups of commonly managed investment funds may take advantage of a more streamlined option for meeting registration and compliance procedures by having fund managers (whether U.S. or foreign) act as “sponsoring entities” and thereby assume and perform all of the FATCA requirements that would have otherwise applied to the funds if they were Participating FFIs (for example, diligence, withholding, and reporting).

To assume this role, the sponsoring entity (i.e., the fund manager) must be authorized to manage, and to enter into contracts on behalf of, the sponsored investment entities (i.e., the managed funds) and must register itself and each sponsored investment entity with the IRS. The sponsored investment entities will not be required to enter into their own FFI Agreements with the IRS, but will remain liable for their FATCA obligations if the sponsoring entity fails to perform them (in which case the manager’s status as a sponsoring entity may be revoked). For payments made prior to January 1, 2016, a registered deemed-compliant FFI that is a sponsored FFI must provide the GIIN of its sponsoring entity to the withholding agent if the sponsored FFI has not yet obtained a GIIN. Note that certain sponsored investment entities may qualify as “certified deemed-compliant FFIs” (discussed below) if a more stringent set of requirements is met, including that the sponsored investment entities do not hold themselves out as investment vehicles for unrelated parties.

Certified Deemed-Compliant FFIs

Certified deemed-compliant FFIs are also deemed to be compliant with FATCA without having to enter into an FFI Agreement, and are subject to somewhat lighter procedural requirements than registered deemed-compliant FFIs, as they are required merely to provide a certification of their deemed-compliant status to the withholding agent. One example of a certified deemed-compliant FFI is a limited life debt investment entity (discussed further below).

Limited Life Debt Investment Entities

Certain trust vehicles that are formed to hold a limited type of debt obligation until maturity or liquidation (that is, a collateralized loan obligation issuer or “CLO”) may have trustees with powers that are too limited to be able to register the vehicle as a Participating FFI. In recognition of this fact, the Regulations treat certain vintage CLOs (referred to as “limited life debt investment entities”) as certified deemed-compliant FFIs until January 1, 2017 (even if the entity does not enter into an FFI Agreement). This is the case so long as:

• the entity is not a depository or custodial institution or an insurance company;

• the entity was formed before December 31, 2011, and, pursuant to its organization documents which cannot be amended absent an agreement by all investors, is required to liquidate on or before a set date;

• the entity was formed to purchase and hold specific types of debt, with limited reinvestment;

• all payments to investors are cleared through a clearing organization or made through a trustee that, in either case, is a participating FFI or a U.S. person; and

• the entity’s organizational documents cannot be amended without the agreement of all investors and do not authorize the trustee or other fiduciary to cause the entity to comply with FATCA.

As a result of these requirements, CLOs not already in existence will not be afforded deemed-compliant status. Additionally, after December 31, 2016, CLOs that initially qualify for this status must find another way to comply with FATCA requirements.

Nicole Gillikin is an Associate in Hogan Lovells’ International Tax Practice based in the firm’s New York office. She may be contacted at nicole.gillikin@hoganlovells.com.

This article is for general informational purposes only and is not intended to constitute legal advice. Any tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of avoiding tax penalties, and is not intended to be used or referred to in promoting, marketing, or recommending any entity, plan, or arrangement.