"Let all men know how empty and worthless is the power of kings. For there is none worthy of the name but God, whom heaven, earth and sea obey.”
According to legend, 1,000 years ago Viking King Canute the Great made this statement upon realizing he was powerless to command the tides of the sea to retreat. Today, many financial institution executives and foreign governments might soon start feeling much the same way about the rising tide of FATCA — the U.S. Foreign Account Tax Compliance Act — which is finally reaching their shores after its initial enactment in 2010.
FATCA compliance will have practical implications for U.S. and non-U.S.-based investment managers, their funds and fund investors and, of course, for the professionals, financial institutions and withholding agents that serve or transact with them.
FATCA is designed to combat offshore tax evasion and requires foreign financial institutions, or FFIs, to report to the IRS information about financial accounts held — or that might be held — by U.S. taxpayers either directly or through substantial ownership of certain foreign entities.
FFIs include investment entities and non-U.S. custodial institutions. Investment entities are defined very broadly to capture any entity — i.e. legal person or legal arrangement such as a trust or partnership — that conducts as a business investing, administering or managing funds or money on behalf of other persons, and also any entity that is professionally managed by another entity. These non-U.S. professionally managed investment entities include, for example, hedge funds, private equity funds, and securitization and repackaging special purpose vehicles. Collectively, FFIs' clients include tax-exempt and taxable U.S. and non-U.S. investors that may be either individuals or entities. Investors in offshore investment entities typically are hedge funds of funds, foundations, endowment plans, public and private pension funds, wealth and asset managers, family offices, high-net-worth individuals and their holding companies.
On May 2, 2014, the U.S. Department of the Treasury and the Internal Revenue Service gave FFIs an additional six months to register on the IRS FATCA Registration System to obtain their global intermediary identification numbers, or GIINs, and otherwise prepare to comply with FATCA. Treasury also promised the soft opening would apply to the enforcement obligations of any foreign governments with which the U.S. has bilateral FATCA treaties called intergovernmental agreements, or IGAs. The July 1 to Dec. 31, 2014, grace period has come and gone; Jan. 1 marked the hard close for many FFIs and foreign governments that have not accepted FATCA's reality.
Institutional investors can be indirectly affected if the investment managers and custodial entities with which they do business are not FATCA compliant. As such, institutional investors should, in the first instance, check to ensure their request for information has a GIIN. They can also check the RFI's governing and offering documents to see whether it is empowered to segregate potential FATCA withholding tax only to those investors that triggered the liability.
Any side letter obtained by the investor from the RFI as a condition for the investment could include a representation that the RFI is not subject to any adverse regulatory action or investigation, for example, regarding FATCA. If not already addressed in the offering memorandum, the side letter could also confirm the RFI has implemented policies and procedures to ensure compliance with FATCA and other international tax obligations.
The strength of FATCA compliance is based on dominance of the dollar in investing transactions.
Why have 147,044 FFIs from 225 jurisdictions — listed as of Jan. 1 in the IRS FATCA Foreign Financial Institution list — committed to FATCA compliance by obtaining GIINs from the IRS? Simply put, they are caught by the “dollar trap.” Foreign governments and private investors are heavily dependent on dollar-denominated financial assets because “there are no alternatives that offer the scale and depth of U.S. financial markets.” As Cornell Professor Eswar Prasad explained in a paper, “The Dollar Reigns Supreme, by Default,” published March 2014 by the International Monetary Fund, the dollar holds sway because it is the predominant store of value. The U.S. dollar's “exorbitant privilege” has long allowed the U.S. to pay low interest on its debt to foreigners incurred to finance sizable current account deficits, Mr. Prasad wrote.
The U.S. dollar was on one side of an astounding 87% of the global foreign exchange market average daily turnover in April 2013, according to the Bank for International Settlements' Triennial Central Bank Survey on foreign exchange turnover. These include spot transactions, outright forwards, foreign exchange swaps, currency swaps and foreign exchange options. Collectively, the euro, yen, renminbi, British pound, Australian dollar, Swiss franc, Canadian dollar and Mexican peso all issued by jurisdictions with IGAs, were on 91% of one side of global foreign exchange transactions. This leaves very little room for capital and trade to flow beyond FATCA's reach. Institutional investors, hedge funds and proprietary trading firms were on at least one side of 22% of all foreign exchange transactions.
From the IRS' perspective, FATCA is certain to produce a mother lode of information on foreign accounts and might well deliver substantial government revenue of one form or another. On the other hand, foreigners will find FATCA onerous, complex and risky as compliance will require substantial investment of time and money by governments and FFIs. It is not difficult to see why FFIs might decide to close smaller accounts purely for economic reasons. And smaller funds, including institutional investment management firms, might well find that FATCA compliance reduces performance by several additional basis points relative to larger competitors that have a similar number of investors and investment strategy.
Yet 45 partner jurisdictions already have signed an IGA with the U.S. and another 51 have agreed IGAs in substance. These 96 jurisdictions will be regulated by and report to their domestic tax authority, which will exchange tax information annually with the IRS on entities and persons affected by FATCA. The IGAs might make the compliance obligations easier for institutional investors. For example, a Cayman fund may rely upon its institutional investor's Entity Self-Certification suggested by the Cayman Islands Tax Information Authority, instead of the more complex IRS W-9 or W-8 withholding certificates.
In contrast, 128 jurisdictions — including Switzerland, Japan, Austria, Bermuda, Hong Kong and Taiwan — which are represented so far on the IRS FFI list, will be regulated by and report directly to the IRS, which makes them subject to U.S. law and to the jurisdiction of the U.S. courts, an extraordinary submission of national sovereignty on tax matters. For example, while the IRS FFI list has no FFIs from Burma, Cuba, Iran or Syria, it does include more than 1,000 FFIs from Libya, Russia, Venezuela and certain other countries on the list of the Treasury's Office of Foreign Asset Control's sanction programs, which do not have IGAs with the U.S, according to the Department of the Treasury. Those Libyan, Russian and Venezuelan FFIs now will be regulated directly by the IRS as they have entered into FFI agreements as a condition of registration on the IRS FATCA Foreign Financial Institution Registration Portal.
At this point it would be unwise for FFIs to bet that FATCA will go away, such as by a Republican-led Congress repeal, because they could then be seriously out of step with their own financial institutions and counterparties and domestic law. Regardless of whether the U.S. enacts the reciprocal aspects of the IGAs in U.S. law, various key jurisdictions that have signed IGAs with the U.S. have already enacted IGA-enabling domestic legislation. A case in point is the Cayman Islands, where FATCA compliance is mandatory as a matter of domestic law via the Tax Information Authority (International Tax Compliance) (United States of America) Regulations, 2014 of the Cayman Islands.
This means FFIs in those jurisdictions would break domestic law if they fail to comply with that legislation. In addition, U.S. financial institutions and other U.S. withholding agents must comply with the U.S. Treasury FATCA regulations. This has a practical effect on all investors transacting with the U.S. and non-U.S. financial institutions that already are compelled to comply with U.S. Treasury regulations or IGA-enabling domestic legislation, as the case may be.
FFIs can have their deemed-compliant status revoked if they fail to comply with their due diligence, reporting and, where applicable, withholding obligations.
FATCA expands the scope of withholdable payments on U.S. source income, generally interest and dividends, by removing the portfolio interest exemption under the Internal Revenue Code. Any institutional investor that is considered to be either a non-participating financial institution or a “recalcitrant” investor, which include investors that fail to provide the requisite FATCA due diligence documentation, will be subject to 30% withholding tax on portfolio interest under FATCA.
Starting in 2017, gross proceeds from the sale of property producing U.S. source income also will be subject to withholdable payments. In addition to U.S. withholding agents, all FFIs subject to an FFI agreement with the IRS will have withholding responsibilities to the IRS. Withholding agents will be liable to the IRS for any failure to collect and pay FATCA withholding tax to the IRS up to four times monthly on any amounts exceeding $2,000.
As of this year, very few FFIs will be able to continue business as usual unless they have taken steps to become FATCA compliant. And so it appears that FATCA takes the U.S. dollar's “exorbitant privilege”' to an entirely new level, making FATCA the ultimate dollar trap. Institutional investors should take care. n
Peter Stafford, a Cayman Islands attorney-at-law, is director on the tax information services team of DMS Offshore Investment Services.