US ‘FAT CAT’ tax may hit foreign funds

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The US House of Representatives today passed a new bill – which is now being debated in the Senate – that would have a significant impact on non-US private equity funds that have income from US investments.
If it is passed by the Senate and signed into law, The Foreign Account Tax Compliance Act of 2009, already nicknamed the “FAT CAT” bill, would impose on non-US fund managers a 30 percent withholding tax on all US-source income and any gross proceeds from the sale of assets that would produce US interest or dividends – unless fund managers sign on to an agreement to report such information as the Treasury might require about US account holders.
The act is part of the US government’s ongoing efforts to reduce tax evasion. President Obama and Treasury Secretary Timothy Geithner both spoke on the record in support of the bill the day it was introduced, which seems to indicate it has a high likelihood of passing into law in close to its current form, notes law firm King & Spalding in a recent client memo. 
The withholding tax would apply to all foreign investment entities, which are defined as any entity not formed under the laws of the US that is “engaged primarily in investing or trading in securities, partnership interests, or commodities”. Most private equity, venture capital, and hedge funds would fall into this category, according to the King & Spalding memo. Government entities such as sovereign wealth funds, however, would be excluded.
“[The bill] is full of language that is somewhat misleading. It says that it’s targeting financial institutions in order to deter US tax avoidance,” said John C. Taylor, a US tax lawyer with King & Spalding. “But it’s not just targeting banks. It deems investment funds to be banks for this purpose. The rules for investment funds are more strict than the rules for everyone else because there is no minimum ownership trigger.”
Those entities would have to pay a 30 percent tax on US source fixed, determinable, annual or periodic income, as well as any gross proceeds from the sale of property that can produce US source interest or dividends. 
The bill changes several parts of US tax law in order to make sure that fund managers can’t avoid this tax. Previously, fund managers could have relied on “portfolio interest” withholding exemptions, but this is no longer the case under the new bill. Fund managers also would have paid tax on net gain rather than gross proceeds from the sale of property, but this too would change under the bill.
“One of the problems with this bill is that it imposes a broad based 30 percent withholding tax on just about everything paid to a non-complying ‘financial institution,’” Taylor said. “The idea is that everything will be withheld upon and then you’ll get to sort it out later. Only the IRS won’t owe you any interest on these overpayments for a long time. Even in the best case scenario, they are getting an interest free loan of your money for quite a bit of time just because you, or someone in the chain between you and your investment, didn’t agree to these new obligations.”
To avoid the tax, foreign fund managers must sign on to an agreement with the Treasury to report the identities, account balances and account transaction activity of account holders that are US persons or have US persons as substantial owners. Whereas for banks and financial institutions, the substantial owner threshold has been set at 10 percent, there is no threshold for investment fund managers – any direct or indirect ownership by a US person is enough to qualify a fund as “US owned”. 
Given this expansive definition, foreign managers could find themselves bound to report information on many of their LPs and lenders. For instance, King & Spalding points out in its memo, a feeder fund or blocker corporation investing in a foreign investment fund could itself have substantial US owners, and that ownership would then be attributed through to the foreign fund.
Though private equity and hedge funds aren’t often vehicles for tax evasion, some LPs may not like their information being reported to the US government. Even those managers for whom privacy isn't a primary concern may want to avoid making US investments.
“Even if you’re a fund manager and you couldn’t care less about privacy, complying with all of these rules, and determining when you have US direct or indirect owners, and all of the other obligations that these provisions impose on you, may not be a great idea,” Taylor said. “If you get it wrong you’ve got the IRS standing over your shoulder, and they can penalise you for getting it wrong. It’s essentially a minefield that you’re having to step into.”
The FAT CAT bill was passed simultaneously with the Tax Extenders Act of 2009, as many of the measures proposed in the former are intended to pay for the extension of some tax breaks included in the latter. While there is a possibility that the Senate could vote on the whole package of tax legislation by the end of the year, it is unlikely, said Paul Hastings tax partner Andrew Short.
“There is extreme doubt as to whether the Senate will pass this year because they are busy with health care,” he said. “There is skepticism as to whether the bill in this form is appropriate given that many Republicans are against permanent taxes to fund short term extenders and others believe there could be a significant disproportionately adverse consequence to publicly traded real estate partnerships.”