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Nicole Gillikin, Hogan Lovells, New York
Nicole Gillikin works in the international tax practice of Hogan Lovells in New York.
Nicole Gillikin discusses certain provisions of the final FATCA regulations that are most critical to foreign investment funds with a focus on the types of institutions that are subject to FATCA or those that may be eligible for an exemption therefrom.
On January 17, 2013, the US Treasury and US Internal Revenue Service (the “IRS”) issued final regulations (the “Regulations”) to implement the US reporting and withholding rules commonly referred to as the Foreign Account Tax Compliance Act or “FATCA”. FATCA was initially enacted in March 2010. The Regulations modify, expand and update the previously proposed US Treasury regulations published in February 2012. In addition, on July 13, 2013, the IRS released Notice 2013-43, which extended certain timelines for FATCA implementation beyond the timelines provided by the Regulations. Additional FATCA guidance is still forthcoming from the IRS.
Following is a discussion of certain key provisions of the Regulations and subsequent guidance that are most relevant to investment funds (for example, hedge funds, private equity funds, and sovereign wealth funds), particularly foreign investment funds. The FATCA impact on investment funds may generally be twofold.
US investment fund vehicles will typically be considered withholding agents for purposes of FATCA. Foreign investment fund vehicles will usually constitute “foreign financial institutions” (or “FFIs”) for purposes of FATCA and will thereby be subject to a 30 percent withholding tax on certain payments unless they agree to and do report information about their “US Account Holders” (generally, US holders of the FFI's non-publicly traded debt and equity interests as well as substantial US owners of non-US account holders).
FATCA is intended to reduce the evasion of US tax by US citizens and US residents who hold offshore assets. To this end, FATCA incentivises FFIs to enter into an agreement with the IRS (an “FFI Agreement”) pursuant to which the FFI becomes a “Participating FFI” and thereby agrees to:
Under a grandfathering rule, FATCA withholding generally does not apply to payments in respect of, or gross proceeds from the disposition of, obligations (generally, instruments with a stated maturity date that are not treated as equity for US tax purposes (and associated collateral)) that are outstanding on July 1, 2014 and that are not materially modified thereafter. (Specifically with respect to Foreign Passthru Payments, the grandfathering rule applies to any obligation that is executed on or before the date that is six months after the date of publication of final regulations defining the term “foreign passthru payment“.)
FFIs will become Participating FFIs by registering with the IRS and agreeing to comply with the reporting and withholding provisions of FATCA through the FATCA Registration Portal. The IRS made the FATCA Registration Portal available for FFIs on August 19, 2013. During the remainder of 2013, the FATCA Registration Portal will be available only on a preliminary basis for FFIs to get familiar with as they begin to input and refine information. No registration will be treated as finalised before January 1, 2014. For a registration to be treated as finalised, the FFI must finalise it on or after January 1, 2014 (whether or not the FFI had previously indicated that the registration was final prior to that date). FFIs must finalise their registration by April 25, 2014 (but on or after January 1, 2014) to be included on the initial list of Participating FFIs which is expected to be published in June 2014. The list of Participating FFIs should then be updated on a monthly basis.
The IRS expects to issue global intermediary identification numbers (“GIINs”) to Participating FFIs as registrations are finalised in 2014. The FFI Agreement of a Participating FFI that receives a GIIN from the IRS on or before June 30, 2014, will have an effective date of June 30, 2014. Withholding agents generally will be required to implement new account opening procedures by July 1, 2014, or, in the case of a Participating FFI, by the later of July 1, 2014 or the effective date of its FFI Agreement.
FATCA also imposes a 30 percent withholding tax on Withholdable Payments to certain foreign entities that are not FFIs (a non-financial foreign entity or “NFFE”) unless the NFFE either provides certain information to a withholding agent regarding the NFFE's “substantial US owners” (generally, a US 10 percent stockholder) or certifies to not having any such owners (that is, an NFFE is generally not required to enter into an FFI Agreement to avoid FATCA withholding). An NFFE will generally not be subject to this disclosure or certification requirement regarding its substantial US owners, if it is:
a publicly traded corporation (or part of an expanded affiliated group containing a publicly traded corporation);
a foreign government; or
an “Active NFFE” (typically an NFFE with less than 50 percent passive income or assets).
The US Treasury Department (“Treasury”) has also developed an intergovernmental approach to the implementation of FATCA by entering into IGAs with governments in other jurisdictions. The Regulations were drafted to complement and coordinate with IGAs. The US has two forms of IGAs, referred to as “Model I” and “Model II”. Model I is a government-to-government approach, pursuant to which the partner jurisdiction adopts local laws requiring FFIs in that jurisdiction to report information about US accounts to the local tax authority which the local tax authority provides to the IRS. FFIs in Model I partner jurisdictions need not enter into FFI Agreements, but merely comply with local law, to be compliant with FATCA. Model II is the business to-government approach, pursuant to which the partner jurisdiction agrees to direct and enable FFIs in that jurisdiction to report information about US accounts directly to the IRS (notwithstanding bank secrecy laws and any other legal obstacles to FATCA).
The US has entered into Model I IGAs with the UK, Denmark, Mexico, Norway, Germany, Spain, France, Costa Rica, Cayman Islands and Ireland and has initialled Model I IGAs with Hungary, Poland, Malta. The US has entered into Model II IGAs with Switzerland and Japan and has initialled a Model II IGA with Bermuda. Final negotiations are underway for IGAs between the US and the Bahamas, Canada, Finland, Guernsey, Isle of Man, Italy, Jamaica, Jersey, and the Netherlands and discussions are ongoing with nearly 30 other countries. The US Treasury's website will list jurisdictions that are treated as having an IGA in effect (which will generally include jurisdictions for which an IGA has been signed but not yet brought into force). An FFI resident in a jurisdiction that is treated as having an IGA in effect will be permitted to register on the FATCA Registration Portal either as a “registered deemed-compliant FFI” (discussed further below), which would include all reporting Model I FFIs, or as a Participating FFI, which would include all reporting Model II FFIs.
The UK's tax authority, HMRC, has issued regulations implementing the US - UK IGA, together with guidance. There are significant differences between the UK IGA as implemented by the regulations and the stand-alone UK IGA, which means that it will be necessary for UK FFIs to refer to the position in the regulations for the purposes of FATCA compliance. It remains to be seen whether other jurisdictions will adopt a similar approach to IGA implementation.
The definition of an FFI is extremely broad and includes an “investment entity” which is an entity that:
primarily conducts (as a business on behalf of customers) trading in currencies or financial instruments, portfolio management, investing, or administering or managing funds, money or financial assets (that is, a fund manager);
has gross income primarily attributable to investing, reinvesting, or trading in financial assets and is managed externally; or
functions or holds itself out as a collective investment vehicle (including a mutual fund, exchange traded fund, private equity fund, hedge fund, venture capital fund, leveraged buyout fund, or any similar investment vehicle with a strategy of investing, reinvesting or trading of financial assets).
This “investment entity” prong of the FFI definition is broad enough to cover nearly all foreign funds, fund managers, master funds, and feeder funds.
The FFI definition also generally includes a holding company formed in connection with, or availed of by, an investment fund. For these purposes, a holding company is a company the primary activity of which is holding (directly or indirectly) all or part of the outstanding stock of one or more members of its expanded affiliated group (generally, one or more chains of corporations connected through a common parent where vote and value thresholds of more than 50 percent are met). As a result, a holding company formed by an investment fund to acquire a particular investment would generally constitute an FFI even if the investment were an active, non-financial portfolio company. In contrast, a holding company that is not formed in connection with, or availed of by, an investment fund is generally carved out of the FFI definition if it is a member of a “non-financial group” (that is, 25 percent or less of the group's income and assets are passive and 5 percent or less of the group's gross income is from FFIs within the group).
Certain passive, non-commercial investment vehicles (including certain family trusts) may be excluded from the FFI definition provided they do not conduct investment management activities for or on behalf of customers and are not professionally managed by an FFI (such entities will generally be classified as passive NFFEs).
To avoid FATCA withholding, most non-US fund vehicles will need to become Participating FFIs (or comply with an applicable IGA) unless, as discussed further below, they qualify as:
an “exempt beneficial owner” (payments to which are exempt from FATCA withholding); or
a deemed-compliant FFI.
Additionally, as many fund groups contain both US and non-US entities, while the non-US entities will generally be FFIs, the US entities will have the initial compliance obligations under FATCA as primary withholding agents for Withholdable Payments to the FFIs.
Although otherwise generally covered by the FFI definition, most foreign retirement funds, sovereign wealth funds and similar foreign government related investment entities should qualify as “exempt beneficial owners,” payments to which are not subject to FATCA withholding.
Foreign retirement funds that qualify as “exempt beneficial owners” include:
treaty-qualified retirement funds (that is, retirement funds formed in a US treaty partner jurisdiction which are eligible for the relevant US double tax treaty);
broad participation retirement funds (that is, retirement funds which, among other requirements, are regulated by the local government and do not have any beneficiaries with a right to more than 5 percent of the fund's assets);
narrow participation retirement funds (that is, retirement funds which, among other requirements, have fewer than 50 participants and do not have an investment entity or passive NFFE as their sponsoring employer); and
retirement funds that would qualify under section 401(a) of the Code if formed in the United States.
Exempt beneficial owners also include foreign governments and the integral parts, controlled entities, and political subdivisions thereof; however, payments to such FFIs will not be treated as payments to an exempt beneficial owner if derived from an obligation held in connection with a commercial financial activity of a type engaged in by an insurance company, custodial institution, or depository institution.
There are two types of deemed-compliant FFIs:
registered deemed-compliant FFIs, and
certified deemed-compliant FFIs.
Both types of FFIs are deemed to be compliant with FATCA without having to enter into an FFI Agreement. Nevertheless, registered deemed-compliant FFIs are required to:
register with the IRS to obtain a GIIN;
certify their registered deemed-compliant status to the IRS every three years; and
maintain certain records and report status changes to the IRS.
Certified deemed-compliant FFIs are subject to somewhat lighter procedural requirements as they are required merely to provide a certification of their deemed-compliant status to the withholding agent.
The category of registered deemed-compliant FFIs includes qualified collective investment vehicles that are “regulated as an investment fund” and owned solely by Participating FFIs, registered deemed-compliant FFIs or certain other institutional investors (but not individuals) payments to which are not subject to FATCA. In general, a fund is considered to be “regulated as an investment fund” if:
it is regulated as such in its country of organisation;
it is regulated as such in all countries in which it is registered or operates; or
its manager is regulated with respect to the fund in all countries in which the fund is registered or operates.
The Regulations do not provide further guidance on what it means to “operate” in a country and, in particular, whether investing or trading constitutes “operating”.
Certain “restricted funds” are considered registered deemed-compliant FFIs. A restricted fund is generally a fund that is “regulated as an investment fund” (as described above) and takes steps to ensure it is not held by specified US persons (other than certain exempted US institutional investors), Non-Participating FFIs, or passive NFFEs with substantial US owners. A restricted fund generally cannot provide for secondary market sales (that is, only direct issuances, redemption of interests by the fund and sales through certain distributors such as Participating FFIs or registered deemed-compliant FFIs). This exemption is rather limited as it could apply to a foreign fund with all foreign owners but would not be available to any foreign fund in which a US person (including a US manager) had an interest. In addition, restricted funds must also meet additional account review, certification, withholding and other requirements including implementing policies and procedures to ensure it generally does not open or maintain accounts for the specified US persons.
The Regulations introduced a new category of registered deemed-compliant FFIs, called “sponsored investment entities”, which regime offers groups of commonly managed investment funds a more streamlined option for meeting registration and compliance procedures. This regime allows certain fund managers (whether US or foreign) of families of funds to act as “sponsoring entities” and thereby assume and perform all of the FATCA requirements that would have otherwise applied to the funds (or “sponsored investment entities”) if they were Participating FFIs (for example, diligence, withholding, and reporting). To assume this role, the sponsoring entity must be authorised to manage, and to enter into contracts on behalf of, the sponsored investment entities and must register itself and each sponsored investment entity with the IRS. The sponsored investment entities will not be required to enter into their own FFI Agreements with the IRS but will remain liable for their FATCA obligations if the sponsoring entity fails to perform them (in which case the manager's status as a sponsoring entity may be revoked).
In addition to the regime discussed immediately above, certain “sponsored investment entities” may also be eligible for certified deemed-compliant status where the sponsoring entity is a Participating FFI, reporting FFI under a Model I IGA, or a US financial institution and the sponsored investment entities do not hold themselves out as investment vehicles for unrelated parties. In addition, twenty or fewer individuals must own all of the debt and equity interests in the sponsored investment entities (other than debt owned by Participating FFIs or deemed-compliant FFIs or equity owned by a 100 percent owner that is itself a sponsored investment entity).
Certain trust vehicles that are formed to hold a limited type of debt obligation until maturity or liquidation (that is, a collateralised loan obligation issuer or “CLO”) may have trustees with powers that are too limited to be able to register the vehicle as a Participating FFI. In recognition of this fact, the Regulations treat certain vintage CLOs (referred to as “limited life debt investment entities”) as certified deemed-compliant FFIs until January 1, 2017 (even if the entity does not enter into an FFI Agreement). This is the case so long as:
the entity is not a depository or custodial institution or an insurance company;
the entity was formed before December 31, 2011 and, pursuant to its organisation; documents which cannot be amended absent an agreement by all investors, is required to liquidate on or before a set date;
the entity was formed to purchase and hold specific types of debt, with limited reinvestment;
all payments to investors are cleared through a clearing organisation or made through a trustee that, in either case, is a participating FFI or a US person; and
the entity's organisational documents cannot be amended without the agreement of all investors and do not authorise the trustee or other fiduciary to cause the entity to comply with FATCA.
As a result of these requirements, CLOs not already in existence will not be afforded deemed-compliant status. Additionally, after December 31, 2016, CLOs that initially qualify for this status must find another way to comply with FATCA requirements.
Nicole Gillikin is Associate in Hogan Lovells' International Tax Practice, based in the New York office and may be contacted by email at firstname.lastname@example.org or by telephone at +212 909 0629.
This discussion has been prepared for general informational purposes only and is not intended to constitute legal advice. Any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of avoiding tax penalties and is not intended to be used or referred to in promoting, marketing, or recommending any entity, plan or arrangement.
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