Understanding FATCA

by Pepper Hamilton LLP

[author: Joan C. Arnold]

This article originally appeared in the November 2012 edition of PE Manager, which can be accessed online at www.privateequitymanager.com. It is reprinted here with permission.

In late October PE Manager brought together four industry professionals (Joan Arnold, Pepper Hamilton; Kristy Trieste, Corsair Capital; Lori Evans, Birch Hill Equity Partners; and Jay Bakst, EisnerAmper) who must all in their own way address an unprecedented challenge: how private firms can possibly prepare for and comply with the complex (and still opaque) Foreign Account Tax Compliance Act (FATCA). In the U.S. government’s attempt to clamp down on overseas tax dodgers, foreign GPs caught by the act have been left struggling with how to verify investors’ tax documents, whether the bill forces them to breach local privacy laws by submitting information to U.S. tax authorities and even the question of who at the firm is ultimately responsible for managing FATCA compliance. Meanwhile U.S.-based firms wonder if FATCA will inspire other countries to make similar tax information demands on their foreign investors, which could open the door to an unimaginably complicated global tax information exchange network.

PE MANAGER: FATCA, due to enter force next summer, is an incredibly ambitious law. How do firms even begin coordinating their approach in meeting its demands?

Bakst: The first thing private equity firms need to do is internally educate people about the requirements of the law. Who will be in charge of overseeing FATCA developments and then ultimately the firm’s compliance? It’s likely going to be the chief compliance officer, perhaps supported by one or more individuals, who will be responsible for annually certifying that the fund maintains its compliance. And in that process, GPs need to determine to what extent they engage outside advisors. For example, your fund administrator may be responsible for tracking investors’ tax documents, general counsel perhaps verifies they are filled out properly, and the accounting firm is involved with the withholding and reporting. Firms need a plan for how these different parties will coordinate with each other.

Trieste: Our FATCA education process started with our audit firm. They were able to come in and run a session where we asked what kind of information we should be gathering from investors. We ask our tax advisors and outside regulatory consultants what they’ve seen other firms doing, and how we stand compared to them. Sometimes we’ll ask our peers directly, such as at a conference or industry event, how they’ve approached FATCA.

PE Manager: What happens if an investor does not (or is not able to) submit all their necessary tax information?

Arnold: The short answer is that investor faces a 30 percent tax on their share of any fund returns. It reminds me of a related case where a firm’s investor relations department actually took it upon themselves to hire outside help so that one of their LPs, who had not submitted all the right paperwork, would not suffer withholding tax.

Bakst: Once FATCA is here you might see more of this. The IRS is asking non-U.S. investors, who may not speak English very well or feel entirely comfortable entering into an agreement with a foreign government, to fill out a complicated U.S. tax form with all the proper supporting documentation.

Evans: And this can be a big struggle for some GPs. To the extent you’re a private equity firm with large sophisticated investors who have their own tax functions, this is largely a non-issue. But to the extent a GP has a lot of high-net-worth individuals or family offices in the fund, it can become a real challenge. Not so much because of liability concerns, but simply because the investors will say ‘I’m relying on you to help me with this’, which is already taking place.

Arnold: An important point to note is that a firm has to be careful with how much help they provide LPs because they could be taking on legal liability. So they might tell the LP ‘we’re not doing it, but here’s the right advisor that can do it for you.’

Trieste: We just finished fundraising so can speak to the challenge in collecting all the right tax documents from LPs. The way we’ve addressed it is by setting up an investor reporting portal that keeps track of each LP’s tax documents, and also reviewed by our legal advisors. That’s given us comfort because one particular LP might for example be a U.S. investor investing through a foreign entity, and so we have on file their Form W-8BEN ready for any kind of inspection.

Bakst: There’s a bigger issue here too, which is that the IRS is getting very tough on inaccuracies in the forms that document an investor’s tax withholding status. Something as trivial as an LP inadvertently checking the wrong box on what type of taxpayer they are can invalidate an entire form. The truth is few people have paid much attention to these kinds of details before in the private equity industry because the amount of money the sector earned which could be subject to U.S. withholding tax was relatively low and there is a general tendency to rely on investors’ status representations, even if poorly documented. FATCA changes all of that. What I would warn private equity managers who may have been lax on this is that many of your investors may be either undocumented or inadequately documented under current rules, which FATCA uses as a starting point in for its own new documentation requirements. If for example you have U.S. or foreign tax exempt investors, do you have on file a properly executed Form W-9 or W8-EXP that proves that status to the satisfaction of the IRS? The IRS is building up its staff to start auditing all the forms required under pre-FATCA law, in anticipation of it being a much bigger issue when FATCA comes along. In addition, it is imperative for the fund to not only furnish U.S. withholding agents with its investors’ documentation, but also to be proactive in obtaining confirmation from its U.S.

withholding agents that they accept the validity of the submitted forms and will withhold in accordance with fund and investor expectations. The last thing a fund wants from an investor relations standpoint is to have taxes withheld at the partnership level because of improper documentation that could have been remediated to avoid the withholding. That’s because the deadline for trying to getting back the 30 percent withheld at the fund level passes every 15 March – the IRS doesn’t have the authority to refund the money past that date and foreign investors would not want to file U.S. tax returns to obtain a refund of the withheld tax.

PE Manager: A more complicated issue may be how FATCA defines a "Foreign Financial Institution" (FFI), the term describing which non-U.S. entities must keep U.S. tax authorities informed regarding financial accounts held by U.S. taxpayers. Surely the definition covers a buyout fund itself, but what about entities like feeder funds or holding companies?

Evans: These are the kinds of questions we’re still in the dark about and awaiting clarity. And I think there has been an inclination to kick the can down the road in preparing for FATCA in the hopes that the U.S. government recognises the benefit of each fund as a single filer, rather than, for instance, having a feeder structure created for one specific LP become designated a reporting FFI. There’s no benefit in doing that from a transparency standpoint, and only complicates the reporting process for both the industry and governments involved.

Arnold: This is going to be a major challenge because it’s not just funds that need to be considered but their investment structure. So for example, typically if a U.S. firm is making a European investment, you will have an aggregator on top of the structure, probably using the Caymans as a domicile, and then probably four Luxembourg companies below it, with the European target company below that. Well, each one of these entities needs to be analysed to see if it is an FFI (and thus have to enter an IRS agreement). Treasury estimates about 600,000 FFIs to be reporting under FATCA. But when you consider all these other entities that may be caught by the law, it’s going to be double that if not more.

Trieste: And jumping off Lori’s point, there’s also difficulty in knowing when to engage investors about FATCA compliance until these kinds of questions are answered. A catalyst would be further guidance from Treasury, but waiting too long for something like that means postponing a major compliance task that needs to be completed one way or the other.

Arnold: What’s happening here is that FATCA definitions are really more designed with banks in mind than private equity funds. For example in South America you look at their laws with respect to investment funds and wonder if an ‘entity’ so to speak exists at all, which is a real basic question. In South America you don’t form a partnership or trust, but a contract between multiple parties. So private equity managers in the area will now have to answer questions under FATCA they’ve never encountered before.

Bakst: I’ll echo that sentiment and add that more confusion for private equity firms stems from the fact that separate entities that are part of the same expanded affiliated group all need to be FATCA compliant in order for other members of the wider group to be given that recognition. If you have a corporate fund of funds investor for example that owns 51 percent of your fund, FATCA treats the fund and the investor as an affiliated group. That presents a weird scenario where two GPs from different private equity firms would have to communicate with each other, and for both to be compliant, would need to enter into registration with the IRS in conjunction with one another.

Arnold: The rules are ill-fitted for the private equity sector. If you look at the amount of consultation responses from the private equity world compared to the banking world, it’s a trickle. And Treasury knows the banking world. They don’t know the private equity world as well. And part of the issue is that "private equity" is not a monolith – there are as many variations to a standard structure as there are standard structures. I don’t think Treasury has seen the permutations. I personally think the industry could have done more about education on some of these specific issues.

PE Manager: There are fears that a foreign private equity firm submitting tax information to U.S. authorities could violate local privacy laws. A solution has been the idea of an intergovernmental agreement (IGA) that allows a foreign funds home government to relay tax information on their behalf. Are IGAs then the way forward?

Evans: In Canada it’s less of a problem because private equity firms here are not subject to strict banking privacy laws, but a general privacy regime that is not sector specific. That’s largely predicated on consent. So if you’ve got the right terms and consents in your limited partnership agreement – and provide appropriate disclosures to investors and stakeholders with respect with how their information is being used – we think we’ll be in a position to be compliant. Other jurisdictions and organisations that are subject to more sector-specific regimes could have a bigger problem on the issue.

Bakst: I think the overwhelming majority of funds out there are not going to be located in jurisdictions that are going to come under IGAs, unless places like the Caymans and Guernsey enter into IGAs with the IRS, which they expressed an interest in doing, but don’t expect them to be signed in the coming weeks. The UK has signed an agreement, and may be a pretty good indication of what other so-called FATCA partners end up doing. At any rate Treasury is facing a big challenge, because it seems like they’re trying to synchronise what they’re doing with multiple FATCA partners into their final regulations and FFI agreement, but at the same time continue to confirm that the final regulations and online registration process will be available by 1 January. It seems like the IRS will have to establish a cutoff at some point in the near future if it is to meet this deadline. So I think one of the worst things that funds can do is sit back and not do anything to prepare for FATCA in the hopes their local government is going to enter into an IGA.

Arnold: I’ll echo that advice because the U.S. government says you need to be compliant with these regulations, period. If an IGA eventually is put in place for a FFI’s home government, at that point can you switch your reporting processes. It’s backwards, but something firms need to deal with.

PE MANAGER: The model IGA agreement the U.S. released earlier this year says it will aim for ‘equivalent levels’ of information exchanged with FATCA partners. Should U.S. private equity firms then be worried about facing similar FATCA-inspired reporting burdens from foreign governments? Does this pave the way for a global tax information exchange network?

Bakst: As of right now the United States will only provide partner countries information that is already being collected under the current U.S. tax law. But both the model IGA and the signed UK IGA agreement provide that the United States is committed to pursue the adoption of legislation and regulations that achieve equivalent levels of reciprocal automatic exchange with the partner country. Obviously an important point because the United States is demanding more information than it is currently required to provide FATCA partners.

Arnold: On the question of whether or not these FATCA agreements can lead to some type of world information exchange network, there’s been a suggestion that the Organisation for Economic Co-operation and Development (OECD) should pick up the mantle on a project of that scope. The OECD isn’t necessarily geared for that kind of mission, but it is an organisation that has the ears of many countries with respect to development of their tax laws, and so could become a respected enforcer of FATCA-like rules. Of course you can’t really predict whether this will play out, but there is that concern U.S. private equity firms could face their own FATCA challenges from more than just one country in the years ahead.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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