Ever since the introduction of the Foreign Accounts Tax Compliance Act (FATCA) in 2010, private fund managers have experienced much headache trying to make sense of the complex US tax law. Stress levels have only heightened as the law’s July 1 effective date looms closer.
Put simply, FATCA requires those deemed to be a foreign financial institution (FFI), a term encompassing private investment firms, to report certain information about their US investors as a way of allowing US tax authorities to investigate any signs of tax avoidance; those that don’t face a hefty 30 percent tax penalty on certain US-connected income. This might seem a straightforward request, especially in the case of private equity, where unlike banks, only a handful of US investors may have to be accounted for, but things start to get messy when discussing the details embedded in the law (indeed, a recent FATCA update intended to merely clarify certain rules ran to more than 500 pages).
One area of much uncertainty involves figuring out exactly which entities in a private equity group’s structure fall within FATCA’s scope, and therefore need to meet its registration and reporting requirements as a FFI.
Originally, legal sources expected only the fund itself to report as a FFI. But it now seems that holding companies used by private equity firms to acquire target companies will hold this designation too, meaning they will have their own reporting and registration requirements to fulfill under the law.
If so, many GPs would have to manage a complex matrix of reporting relationships with various tax authorities. The US is in the process of signing and negotiating bilateral tax information agreements (known as IGAs) with scores of countries as part of FATCA. Many allow GPs to submit FATCA reports with local officials, who relay the reports to US officials on their behalf, but others will require fund managers to enter into a direct reporting relationship with the US government. If holding companies are in fact FFIs under the law, it would mean a GP might have to submit US investor tax information to the local tax authority where that holding company is based. And if the holding company is set up in a jurisdiction that has not signed an IGA, the GP may need to report directly to the Internal Revenue Service (IRS), according to at least one industry tax expert.
The solution here is for GPs to speak with local tax experts in the jurisdictions that they’ve structured, or plan to structure, a holding company, according to advisors. It may be the case that a jurisdiction doesn’t classify a holding company as an FFI. And the problem is that not every country that’s signed an IGA has published guidance on the matter, leading yet to more uncertainty around FATCA compliance.
In fact, how individual countries plan to enforce their IGAs at the local level is still a big mystery. There’s a worry that some private equity structures may not be able to benefit from an IGA because of issues around the concept of local “residency”.
In the UK, for instance, HMRC said only entities with tax residency in the UK are covered by its IGA (an entity is a UK tax resident if it is managed and controlled in the UK). But others, such as the Cayman Islands, have indicated an entity is “resident” where it is established. Theoretically then, a fund based in the UK but ultimately managed and controlled from a Cayman-based partnership would fall outside the scope of both countries’ IGAs.
Entities that “fall between the cracks of IGAs” like this will then be required to comply with the US’ domestic FATCA rules and establish a direct reporting relationship with the IRS, said John Forbes Anderson, international tax counsel at Debevoise & Plimpton. But here too experts say more guidance from tax authorities is needed before GPs can be sure they will be within the scope of an IGA.
ON THE CHECKLIST
Despite the considerable uncertainty, GPs still need to take certain actions before FATCA’s July 1 go-live date, advisors warn.
All GPs, regardless of whether they are covered by an IGA, need to be registered with the IRS by April 25, 2014. The US tax authority simplified the registration process by allowing GPs to register through an online portal which opened last August.
Even GPs that don’t have any income sourced from within the US will need to register, according to tax advisors, who caution that many IGAs require all financial institutions, even those without US investors, to identify themselves with the IRS.
However, tax experts are split on the virtue of registering early. Originally, the US said GPs could treat soon-to-be-signed FATCA IGAs as effective for all intents and purposes, but later changed course, stating the agreements must be inked into law before GPs can start relying on them.
“For a lot of FFIs, located in jurisdictions where IGAs are still being negotiated, there is little merit in registering early – they may as well wait until their IGA is in place,” advises Jenny Wheater, tax partner at Duane Morris, a law firm.
Indeed Debevoise’s Anderson adds that certain GPs have been left in limbo because of a lack of details in many countries’ IGAs. “You can’t really build out a program or compliance solution until you know exactly what you need to comply with.”
But in other areas, sources say there is no reason to delay FATCA preparation and registration.
A client alert from DMS Offshore Investment, an offshore fund services firm, said GPs should decide now who at the firm will take on the role of “FATCA Responsible Officer”, which is the person that accepts personal liability in the event of FATCA non-compliance and is accountable for FATCA registration and reporting.
GPs speaking to PE Manager say the firm’s compliance officer will likely take on this role but solicit help from third-parties such as fund administrators. If so, firms need to plan exactly which duties will be delegated to outside service providers while ensuring that the responsible officer retains sufficient oversight. Accordingly, a fund administrator may be responsible for tracking investor tax documents, while an accounting firm handles reporting, with the responsible officer signing off on their accuracy.
The responsible officer may also need to share certain individual tax reports with the authorities. For instance, they may need to submit Form 5471 for directors or officers of foreign corporations – a duty that no doubt presents a certain level of risk.
Fortunately though legal sources expect minor errors made by responsible officers to be met with understanding from regulators rather than harsh punishment. Only if a firm is deemed to be significantly non-compliant with FATCA will the US likely get in touch with a local regulator responsible for supervising FATCA compliance at the national-level or begin applying withholding tax.
HAVING YOUR PAPERS IN ORDER
Another step that should be taken before the July deadline is gaining contractual permission from limited partners that the GP has the right to access any information it requires to meet its FATCA obligations. Already GPs on the fundraising trails are presenting partnership agreements that feature language permitting this.
Initially though some GPs experienced investor pushback on the provision. Legal sources say the starting language was often worded too broadly, and LPs were worried that GPs would go on “fishing expeditions” for more information. As a compromise, GPs’ legal advisors are narrowing the scope of what information is accessible for FATCA compliance purposes.
In return LPs are demanding FATCA assurances too. It is increasingly common for investors to want the GP to guarantee FATCA compliance in the fund’s governing documents.
“It gets complicated. While you aim to be in compliance, as a GP you don’t want to give blanket assurance,” says Anderson. “You want to be tailored and objective and not overextend or commit yourself in legal language.”
LPs also want assurances that costs attributable to non-compliance by one investor will be born solely by that investor, and not shared with the group.
To pacify investors, the fund agreement should have the proper mechanics to trace withholding to a particular LP, says Scott Jones, a tax partner at law firm Proskauer. He adds most fund agreements already contain similar language for traditional withholding taxes, but notes that fund managers are revisiting these provisions to ensure that FATCA-related withholding taxes are covered as well.
The biggest advocates of FATCA assurances are typically the largest LPs who are better equipped to handle tax information demands. But they (as well as GPs) are concerned about smaller LPs being able to do the same.
Accordingly, smaller LPs, especially ones based outside the US, may need help with responding to FATCA information requests. But legal sources caution GPs not to get too involved in their LPs’ tax information preparation otherwise they risk taking on legal liability. A best practice appears to be sharing trusted tax advisor contacts instead.
But even with sound legals and proactive LPs, GPs remain bystanders to FATCA until further clarification arrives on certain rules and bilateral agreements.
If you do not receive this within five minutes, please try to sign in again. If the problem persists, please email: