Although FATCA (“Foreign Account Tax Compliance Act”) has a laudable goal—establishing an information reporting regime that prevents U. S. taxpayers from evading U.S. tax through offshore accounts—it will create many headaches and administrative burdens for private equity, hedge and other investment funds and their investors.  Fund sponsors should be preparing now for the implementation of the FATCA rules because the deadlines are approaching:  FATCA registration for non-U.S. funds will begin later in 2013 and the 30% FATCA withholding tax on certain types of U.S. source income will go into effect on January 1, 2014.

While dividends, interest, rents and certain other types of income from U.S. sources that are paid to non-U.S. persons are already potentially subject to 30% U.S. withholding tax, the 30% FATCA withholding tax has a substantially broader scope because, in addition to U.S. source income, it applies to gross proceeds from the disposition of U.S. stock and debt instruments on or after January 1, 2017.  It will also apply to so-called “foreign passthru payments,” which the final regulations issued by the IRS earlier in the year (the “Final Regulations”) reserve on, but which may eventually pick up certain types of non-U.S. source income.

There is some good news lurking in the FATCA scheme.  Because it is designed as a reporting regime, no withholding tax will apply to payments if recipients comply with the FATCA information reporting rules.  The other good news is that the withholding tax rules are being phased in gradually.  Although the 30% FATCA withholding tax on U.S. source income begins for payments made on or after January 1, 2014, sponsors and funds have more time to address withholding on gross proceeds from the disposition of U.S. stocks and debt instruments, which will not apply to dispositions occurring before January 1, 2017.  In addition, under a grandfather rule, the 30% withholding tax on gross proceeds will not apply in relation to debt instruments and certain other obligations that are outstanding on January 1, 2014.  Withholding on foreign passthru payments will certainly not begin earlier than January 1, 2017, and may well be delayed further.

The painful news, however, is that the rules are extremely complex and some funds and investors may face practical difficulties complying.  Since the administrative burdens on funds and fund sponsors will likely be substantial, sponsors should be preparing now in order to deal with the new rules.  The Treasury Department is implementing an alternative approach to FATCA based on intergovernmental agreements (“IGAs”) that is significantly less burdensome than the regular FATCA rules in certain respects and, therefore, may provide relief to many non-U.S. funds and portfolio companies.  However, the IGA rules are in an early stage of development and are still evolving.  The private equity community is hopeful that once these IGAs are in place, the administrative burden on non-U.S. funds and portfolio companies will be substantially reduced.  Discussions with more than 50 governments are now underway.

Key Takeaways of the New Rules

A U.S. fund will be required to withhold a 30% withholding tax on any payments to its investors of dividends, interest, rents and other fixed and determinable income from U.S. sources, and gross proceeds from the disposition of U.S. stock and debt instruments (“withholdable payments”) unless the fund obtains appropriate information and certifications from their investors establishing an exemption from FATCA withholding.

A non-U.S. fund generally will be treated as a “foreign financial institution” (“FFI”) and, as a result, will need to register with the IRS in order to avoid being subject to the 30% withholding tax on any withholdable payments and foreign passthru payments that are made to the fund, when such withholding rules are in effect.  In addition, unless a non-U.S. fund is subject to an IGA, in order to avoid being subject to withholding, the fund or its sponsor generally will need to enter into an agreement with the IRS (an “FFI Agreement”) to undertake diligence procedures and to report information regarding the fund’s direct and indirect U.S. investors to the IRS.  The FFI Agreement will require the non-U.S. fund to withhold on withholdable payments to investors that do not comply with the FATCA rules or qualify for an exemption in a manner that is similar to a U.S. fund.  In addition, non-U.S. funds will be required to withhold on foreign passthru payments when those rules come into effect.

Regardless of where a fund is located, the fund should determine the extent to which its portfolio companies are included in the category of FFIs comprising non-U.S. holding companies, which under the Final Regulations include any non-U.S. holding company “formed in connection with or availed of by” a private equity fund, a hedge fund or similar investment vehicle.  All funds should also ascertain the extent to which their portfolio investments include such non-U.S. holding companies or are otherwise subject to the FATCA rules to avoid unexpected withholding.

Under the IGA approach, payments to a non-U.S. fund or other FFI that is resident in a country that has entered into an IGA with the United States generally will not be subject to FATCA withholding if the FFI satisfies identification and reporting rules regarding U.S. accounts adopted by the FFI’s country of residence.  The United States has announced that it is engaged with more than 50 jurisdictions regarding an IGA, including the Cayman Islands and other offshore jurisdictions.  An IGA has already been signed or initialed with the United Kingdom and several other countries.  The IGA approach may offer significant relief for non-U.S. funds and non-U.S. portfolio companies that are resident in countries that have entered into an IGA.  However, because only a modest number of IGAs have been signed or initialed and the non-U.S. jurisdictions subject to the IGA must enact implementing legislation, the extent to which funds and fund sponsors will benefit from the IGA approach is not yet clear.

Application of FATCA to U.S. Funds

A U.S. fund will be required to withhold 30% of any withholdable payment made to its investors and other payees (beginning in 2014 or, in the case of gross proceeds from the disposition of stock and debt instruments, 2017), unless the fund establishes that the recipient qualifies for an exemption from FATCA withholding.  A FATCA grandfather rule may afford protection for debt instruments and other obligations held by a fund that are outstanding on January 1, 2014, but there is no grandfather treatment for equity investments in portfolio companies.

To avoid withholding on payments to investors of U.S. source dividends, interest and other withholdable payments, U.S. funds must establish procedures to identify their investors’ FATCA status and to collect relevant supporting documentation.  The IRS is currently revising the Form W-8 series to enable withholding agents to identify the FATCA status of a non-U.S. investor.

Although a U.S. fund will be subject to the FATCA rules as a withholding agent, and not as an FFI, U.S. fund sponsors should consider the effect of the FFI rules on any non-U.S. parallel funds, feeder funds and alternative investment vehicles, which generally will be treated as FFIs, and on their non-U.S. holding companies and portfolio companies which, as discussed below, also may be treated as FFIs under the Final Regulations.  If, and when, IGAs are in effect, the complications arising from fund entities that are resident in IGA jurisdictions may be mitigated.

Application of FATCA to Non-U.S. Funds and Non-U.S. Fund Managers

A non-U.S. fund generally will be treated as an FFI.  As a result, unless an IGA applies, the non-U.S. fund generally will be required to enter into an FFI Agreement, in order to avoid being subject to 30% withholding tax on any withholdable payments (beginning in 2014 or, in the case of gross proceeds from the disposition of stock and debt instruments, 2017) and on any foreign passthru payments (beginning no earlier than 2017) to the non-U.S. fund.  Although the IRS has not released a model FFI Agreement, the Final Regulations set forth the substantive requirements applicable to an FFI Agreement.

In order for a non-U.S. fund that has entered into an FFI Agreement to avoid FATCA withholding on any withholdable payments and foreign passthru payments to its investors, the fund must obtain appropriate information and certifications to identify its direct and indirect U.S. investors and to establish the identity of other investors under the FATCA rules, and also must obtain waivers of foreign law that would prevent information from being reported to the IRS.  As in the case of U.S. funds, it is anticipated that fund sponsors will collect this information using the revised Form W-8 series.

In addition to diligence, reporting and withholding obligations, there are several other requirements for maintaining an FFI Agreement that a non-U.S. fund should take into account.  In order to maintain its FFI Agreement, a fund must reduce over time investors that (1) fail to comply with information requests or fail to waive foreign laws preventing FATCA reporting or (2) are FFIs that do not comply with FATCA.  If foreign law prevents an FFI from satisfying its information reporting requirements, the FFI must seek a waiver of such law or otherwise close or transfer the account.  As a result, funds should consider including in their partnership agreements appropriate provisions requiring investors to provide information, certifications and waivers required for the fund and its affiliates to comply with FATCA, as well as provisions to protect the fund against investors that do not comply with FATCA.

To facilitate compliance with the registration and certification requirements for FFIs, the IRS will establish an online portal system where an FFI can register its FATCA status with the IRS and where a responsible officer will certify compliance with the FFI Agreement.  Treasury and the IRS have stated that the portal should be available by no later than July 15, 2013, and that the last date to register with the IRS to ensure inclusion on the December 2013 list of FATCA-compliant FFIs is October 25, 2013.

The Final Regulations add an option for a fund manager to be a “sponsoring entity” for some or all of its non-U.S. funds.  As a sponsoring entity, a fund manager performs the FATCA diligence, withholding and reporting obligations on behalf of some or all if its funds.  The Final Regulations also revise the definition of “financial institution” so that non-U.S. fund managers are also treated as FFIs, although equity interests in such entities generally are not treated as financial accounts subject to the FATCA diligence and reporting requirements.

Application of FATCA to Portfolio Companies

The Final Regulations provide that a non-U.S. holding company that is “formed in connection with or availed of by” a fund is treated as an FFI.  While the exact scope of this requirement is unclear, it appears that certain non-U.S. holding companies that are owned directly or indirectly by funds will need to register with the IRS.  As in the case of a sponsored non-U.S. fund, a fund manager can undertake the registration, diligence, reporting and withholding requirements for a non-U.S. holding company as a “sponsoring entity.”  The Final Regulations provide a limited exception to FFI status for certain non-U.S. holding companies that are members of a participating FFI group and that do not maintain financial accounts or make or receive payments outside of such group.

A non-U.S. holding company or portfolio company that is treated as an FFI but does not comply with FATCA may be subject to adverse consequences unless an IGA applies, including 30% withholding on withholdable payments and on foreign passthru payments paid to the company by other FFIs.  In addition, dividends and interest paid by a non-U.S. company that is a participating FFI could be subject to foreign passthru payment withholding.  In light of these issues, sponsors should review the FFI status of their non-U.S. holding companies and portfolio companies to determine whether these companies may be treated as FFIs that are required to register or enter into an FFI Agreement, and whether an IGA may apply.

With careful planning and clear communications with investors, fund sponsors should be able to satisfy the requirements of FATCA, although compliance with the FATCA rules will vastly increase the amount of administrative effort expended by both the fund sponsors and their investors.  Funds not organized in the U.S. will want to stay abreast of the progress of IGAs in their jurisdiction of organization, which may alleviate some of the particular burdens placed on non-U.S. funds by FATCA.