US taxpayers have long been required to file a “Report of Foreign Bank and Financial Account” (FBAR) form if they have holdings of more than $10,000 in foreign banks. In the past, this requirement hasn’t traditionally been enforced for holdings in foreign funds, including hedge funds and private equity funds. In recent months, however, the US government has been increasing its scrutiny of foreign holdings as part of a concentrated effort to stop what it deems to be “tax haven abuse”. As part of this campaign, the Internal Revenue Service has issued a “clarification” that investors in foreign funds are required to fill out an FBAR as well – a move that has taken many LPs by surprise.
“Taxpayers who hide income offshore and fail to comply with the FBAR filing deadline face criminal prosecution, jail time and steep fines,” acting Assistant Attorney General John DiCicco has said. Those who fail to file could be hit with a fine of $100,000 or half the value of the account, whichever is larger.
That deadline for this year was originally set for 30 June, but was extended to 23 September after a recent conference call by IRS officials created more questions than answers about the scope of the reporting requirements. While the IRS had previously stated unofficially that foreign private investment funds would not be treated as reportable foreign “financial accounts”, and tax attorneys had advised offshore hedge and private equity investors that they didn’t have to file an FBAR, the IRS announced during the call that it was abruptly changing course and requiring such disclosures.
Rushing to file
Not surprisingly this led to an uproar among hedge fund and private equity investors, with industry group the Managed Funds Association (MFA) calling for its members – which includes a number of major hedge funds – to be excluded because most of its members are non-US persons or US entities such as pension funds that are tax exempt. Hedge fund assets in offshore havens reportedly represent more than two-thirds of the $1.3 billion industry.
“The continued absence of guidance on such a fundamental question creates a continuing level of uncertainty that seems inappropriately and unacceptably high given the penalties for non-compliance,” MFA president Richard Baker wrote in a letter in June.
This has led to a rush to find out who has to file, says Leonard Schneidman, Of Counsel at Pepper Hamilton. Under the new IRS position, he says, those that will be required to file an FBAR include:
- A US investor in an offshore investment fund
- A US investment fund (such as a Delaware limited partnership) with an ownership interest in an offshore investment fund
- A US investment fund that maintains an offshore bank or brokerage account
- A US feeder fund with more than a 50 percent interest in an offshore master fund that maintains a foreign bank or brokerage account
- Any US person who, by virtue of holding a position with a management company, has signature authority over any offshore bank or brokerage account; if the management company is based in the US, it may be required to report the account
- A US investment fund that owns more than 50 percent of an offshore company that is an operating entity or the holding company of an operating company that has a foreign bank or brokerage account
Among the developments causing the most confusion is the inclusion of commingled funds, including mutual funds, under the definition of “financial accounts”, and the designation of an offshore hedge fund as a foreign financial account, said Brendan Radigan, a corporate law partner at Edwards Angell Palmer & Dodge.
“Everyone is scratching their head as to the FBAR reporting obligations going forward, given the lack of clarity around these new developments,” he said. “If the definition of “foreign financial accounts” now generally includes private offshore funds, many investors in hedge funds and private equity funds organized under foreign law who haven’t previously been regarded as being subject to FBAR filing now will be.”
He said if the IRS was to offer clarification, one measure that would make sense would be to distinguish offshore investments that are liquid from those that are not.” Under this approach, foreign mutual and hedge funds that don’t have minimum investment periods would be regarded as financial interests that have to be reported, while a typical private equity investment would likely not attract a reporting obligation due to a lack of liquidity,” he said.
Meeting the deadline
Those that do have to fill out the FBAR (which can be found at www.irs.gov/pub/irs-pdf/f90221.pdf) will have to include information about each financial account they own either separately or jointly, including maximum account value, the type of account, the name of the financial institution and the account number. “It’s a pretty straightforward form, but if you have a complex structure of accounts it does require time to gather the information,” Radigan said.
Those filing on the 23 September deadline will also have to include a letter of explanation for why they were not able to gather the proper information sooner, as well as a copy of their tax returns, which were not required for the 30 June deadline. This additional work is doable but still a burden for funds whose size requires multiple filings.
“There is a hope that the [IRS] will clarify its position with regard to commingled funds, and a lot of people won’t have to do this,” Schneidman said. “But if nothing changes there are all kinds of potential FBAR filings on the fund itself, on the managers and investors and on and on, and the more complicated the fund the more complicated the FBAR questions. This is clearly a work in progress but the FBAR is here to stay, because it has become a significant investigative tool for the [IRS].”
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