The FATCA Provisions and Hedge Funds

On March 18, 2010 President Obama signed the Hiring Incentives to Restore Employment (HIRE) Act. Also known as the “Jobs Bill”, the Bill is designed to provide payroll tax breaks and general tax credits as incentives for businesses to hire unemployed workers. In order to offset the cost of the Bill, new rules have been designed to combat offshore tax evasion. These rules are collectively known as the Foreign Account Tax Compliance Act (FATCA) provisions, and are expected to raise around $8.5 billion over 10 years. Several of the FATCA rules can create new onerous reporting requirements for hedge funds and other investment vehicles having offshore funds.

The new withholding rules under FATCA become effective beginning January 1, 2013, and are included in the newly created Internal Revenue Code Sections 1471-1474. The new laws impose a 30% withholding tax on U.S. persons holding offshore accounts on certain “withholdable payments” to “foreign financial institutions” which do not provide information about their U.S. accounts to the IRS. A “withholdable payment” is generally any U.S. source income, such as interest, dividends, rents, royalties and other fixed or determinable income (FDAP). It also includes U.S. source gross proceeds from sales of property that produce interest and dividend income. This is different than the withholding rules on foreign persons, which provide an exception for capital gain from the sale of securities. FATCA legislation defines “foreign financial institution” as an entity that either

• accepts deposits in the ordinary course of a banking or similar business,
• holds financial assets for the account of others (eg broker-dealers), or
• is engaged primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, or any interest in such securities, partnership interests or commodities.

The third category above includes mutual funds, funds of funds, exchange-traded funds, hedge funds, private equity and venture capital funds, and other investment vehicles. In order for an offshore fund to avoid withholding, it must enter into an agreement with the U.S. Treasury to identify its U.S. investors, if there are any. The fund, among other reporting requirements, must

• obtain information for each holder to determine which are U.S. accounts,
• report annually certain information (name, address, TIN, account numbers, balances, gross receipts and withdrawals,)
• deduct and withhold 30% from payments to non-compliant U.S. account holders, and
• comply with IRS requests for additional information on U.S. accounts,

Another provision under FATCA relates to foreign-targeted bearer bonds. Under current law, the 30% withholding on foreign persons generally doesn’t apply to portfolio interest income. To qualify for the portfolio interest exemption, the underlying obligation must be in registered form, except that an obligation need not be in registered form if it is foreign-targeted. The new provision will eliminate the exception for these foreign-targeted bonds. The provision will apply to debt obligations issued after March 18, 2012, and will impact many offshore funds having foreign investors, and earning U.S. source interest income.

FATCA also closes a tax loophole that investors have commonly used to avoid the 30% withholding on payments to foreign persons. Even though actual dividend payments made by U.S. corporations to foreign investors are subject to withholding tax, hedge funds and other investors have contended that dividend-equivalent payments with respect to total return swaps (TRSs) are not subject to withholding. FATCA now will impose withholding tax on U.S. source payments with respect to TRSs, effective for payments made on or after September 14, 2010.

Another FATCA rule affecting hedge funds is enhanced PFIC reporting, which requires any U.S. shareholder in a passive foreign investment company (PFIC) to file an annual report. Under previous law, annual reporting on IRS Form 8621 only applied if the U.S. person received a distribution from, or disposed of its interest in, the PFIC, or made certain elections. This additional reporting is effective beginning March 18, 2010.

Finally, there is an additional reporting requirement under FATCA for an individual with specified foreign financial assets (foreign stocks, securities etc.) if such assets exceed the value of $50,000. Effective March 18, 2010, this information will be provided as an attachment to the individual’s tax return, and is in addition to the Foreign Bank Account Reporting (FBAR) filing. The individual must disclose the name and address of the institution where the assets are held, the account number, the name and address of the issuer and information to identify the stock or security. Failure to make the required disclosure will result in a $10,000 penalty.

In the near future hedge funds will be affected in one way or another by FATCA, and the question will be how to minimize compliance costs. An offshore fund that caters only to non U.S. investors, or does not have U.S. source FDAP income or capital gain on sale of securities, will not be affected by the new withholding requirements on U.S. accounts. However, in today’s interconnected global economy, an offshore fund is more likely than ever to rely on the U.S. markets. Additionally, when structuring their investments in swaps and debt obligations, hedge funds should consider the changes in rules for withholding on foreign investors.