Impact of FATCA on the private equity industry
May 2012 | 10QUESTIONS | PRIVATE EQUITY
FW speaks Nick Matthews at Kinetic Partners, about the impact of FATCA on the private equity industry.
FW: Briefly, could you provide a broad outline of the FATCA regulations and its intended aims?
Matthews: The Foreign Account Tax Compliance Act (FATCA) is US legislation which will require non-US financial institutions (FFIs), including investment vehicles, to report to the Internal Revenue Service (IRS) details of all US account holders or investors, including income which they receive. Unlike other bilateral tax treaties, the IRS has made it clear that FATCA is not intended to raise revenue but rather to provide the IRS with information about US taxpayers, and their overseas assets and income. In circumstances where an account holder or investor refuses to provide that information or to consent to its disclosure, the FFI will be required first to apply withholding tax of 30 percent on US-source income and, ultimately, terminate the relationship.
FW: To what entities does FATCA apply?
Matthews: The burden of FATCA falls primarily on FFIs, defined essentially as non-US deposit-taking banks, custodians, investment businesses – essentially, investment funds – and certain insurance companies. Crucially, in the investment funds context, including the private equity industry, it is the fund and not the manager or general partner that will be the FFI. Although much of the commentary on FATCA has been concerned with the impact on non-US financial firms, US financial firms are also affected as FATCA imposes obligations on them to ascertain the FATCA status of recipients of any US sourced income, in order to determine whether to withhold 30 percent.
FW: Why do private equity firms need to consider the implications of FATCA for their own operations?
Matthews: FATCA is likely to affect private equity firms in a number of ways both directly and indirectly. Most obviously, FATCA imposes administrative obligations on firms, requiring them to be able to identify US and US-owned investors and report their details to the IRS. Participating – FATCA-compliant – funds whose investors are unwilling to provide the information or to permit disclosure must be prepared to withhold 30 percent of any US-source income to those recalcitrant investors and, ultimately, terminate the relationship. This may influence the fund’s policy on permitted investors, perhaps avoiding US or US-owned investors, or their choice of investment – again, avoiding US assets. Participating funds of funds might choose only to invest in other FATCA-compliant funds in order to avoid the risk of an investee fund being withheld-upon. Similarly, a non-participating fund of funds may find itself precluded from admission into funds whose policy is to deal only with compliant investors.
FW: Is a PE fund affected by FATCA even if there it has no US investors or carry-holders or no direct US investments?
Matthews: Yes, even if a PE fund has no US investors and no direct US investments, it is still likely to be effected of FATCA. Funds with indirect exposure to the US, through investee funds or entities, will carry the risk of being withheld upon as the obligation of every paying agent that participates in FATCA is to withhold on any non-participating investor fund regardless of whether the investor fund has, in fact, no US investors. As such, when determining if the PE fund should participate with FATCA, consideration must be given to whether the ultimate source of any income originated in the US and whether any paying agents have themselves committed to complying with FATCA. The risk of suffering withholding as a consequence of not participating in FATCA may deter potential investors from subscribing to a non-participating fund and may also limit the fund’s choice of investments.
FW: What if the PE fund’s investors are all US institutions or individuals?
Matthews: Although the final reporting format has yet to be determined, a PE fund with only US or US-owned investors will be required to provide details of those investors to the IRS. That disclosure will ultimately include standing data such as the name, address, tax identification number and investor balance, as well as the income attributed to each specified US investor. The reporting requirements will apply regardless of whether the investor is resident in the US or elsewhere. A wholly or largely-US investor base may make for a simpler investor take-on process, as provision of a Form W-9 will satisfy the evidential requirements for FATCA purposes.
FW: FATCA contains a provision for “deemed compliance” status. What does this involve and how can a PE fund meet this requirement?
Matthews: “Deemed compliance” status provides qualifying FFIs with effective equivalence with fully-participating FFIs, thus enabling deemed compliant FFIs to interact with participating FFIs and USFIs without the compliance burden of full participation. Truly local (domestic) entities may qualify as deemed compliant, but of most relevance to the PE investment industry are the registered deemed compliant categories of “qualified investment vehicle” and “restricted fund”. Both categories apply to registered investment funds whose investors are entirely non-US. Qualifying investment vehicles will only have participating FFIs, deemed compliant FFIs or other exempt beneficial owners as investors; restricted funds may have other non-FFI investors provided that strict restrictions are maintained on distribution to avoid any direct or indirect US investment. Registered deemed compliant FFIs will be required to renew their registration every three years, but will avoid the need to report annually to the IRS or to withhold or be withheld upon, and will therefore be in a less burdensome position than under the annual reporting requirements imposed on participating FFIs.
FW: Who will be responsible for the compliance of a PE fund?
Matthews: Since the PE fund itself is the FFI, it is the fund, acting through its directors, that is responsible for signing-up to FATCA and ensuring its ongoing compliance. In practice, I would anticipate FATCA implementation and ongoing oversight to be delegated to the investment manager or general partner who will need to give assurance to the directors before they execute the FFI agreements with the IRS. In many instances, the FATCA implementation project is likely to be further outsourced to the fund administrator, if there is one, who may already be putting the necessary systems and controls in place to facilitate FATCA compliance on behalf of their fund clients.
FW: Do you believe FATCA will have significant, long-term implications for the private equity asset class? Will it change the way certain things are done?
Matthews: Although rooted in tax, FATCA is essentially an operational challenge for firms. It may lead to changes to investor on-boarding procedures and may encourage outsourcing. For some PE funds, FATCA may also lead to a change in investment strategy or marketing activities. In the interests of convenience, however, I anticipate widespread compliance with FATCA, as full participation or deemed compliance will greatly ease the administrative burden by simplifying the report to the IRS and reducing the need to withhold on payments. The operational costs associated with systems and procedures changes, however, should not be underestimated.
FW: What steps should a PE fund take now to ensure they achieve compliance with FATCA at the time of its implementation in 2013 and beyond?
Matthews: While FATCA is being phased-in, PE funds need to decide whether to ignore it, participate, or seek deemed compliant status. A PE fund will need to review the FATCA status of institutional investors and carry holders as well as other investors. This process will identify any need to obtain further information or upgrade systems and controls for client take-on and data analysis. Managers should liaise with service providers to understand their preparedness for FATCA implementation. There should be clarity as to who is responsible for what, and who will sign off the FATCA project. Where tasks are delegated to an administrator, the service agreement may need amendment to reflect this additional work. Offering documents may need to be updated to reflect the post-FATCA strategy, such as any decision to restrict the fund to non-US assets and/or investors only.
FW: How can PE funds overcome domestic legal restrictions, such as on information sharing, in order to comply with FATCA?
Matthews: The US Treasury acknowledges that some jurisdictions place restrictions on the disclosure of personal financial information. The legislation anticipates that a waiver may need to be obtained from an investor to permit such disclosure, with failure to do so sufficient to classify the investor as recalcitrant, exposed to withholding and, ultimately, account closure. Proposed international cooperation protocols envisage foreign jurisdictions collecting FATCA information on the IRS’s behalf, to be transmitted inter-governmentally through bilateral tax treaties. As a sweetener, the IRS has promised mutual information exchange. One such initiative involved the UK, Germany, France, Spain and Italy. The need for domestic and European quasi-FATCA legislation to effect such arrangements means that it is still early days.
Nick Matthews is a senior member of the Forensic and Corporate recovery practice of Kinetic Partners LLP. He has over 16 years of forensic accounting, litigation support and liquidation experience, with an emphasis on financial services clients. He has led significant international projects in the UK, Europe, Caribbean and the US. A particular focus of his work has been financial crime, and anti-money laundering (AML) advisory services. Mr Matthews is a fellow of the Institute of Chartered Accountants in England and Wales (FCA). He can be contacted on +44 (0)20 7862 0821 or by email: firstname.lastname@example.org.
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