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FATCA Proposed Regulations Battle for the Top Spot at the Apex of Regulatory Complexity
March 15, 2012
Administrative Actions
So, while I was in the hospital and on medical leave, Treasury released the much-anticipated proposed FATCA regulations. I came home and I was welcomed by a 400-page thicket of what appears to be one of the most significant Treasury regulatory projects in many years.  By the time I am writing this, most law and accounting firms have released summaries of the regulations and have offered their 2 cents on the issues arising from FATCA. Trying not to overlap with what others have said, I would like to add a few policy observations and some points that are specifically pertinent to investment funds.

First, to those that for some reason are not familiar with the Foreign Account Tax Compliance Act (FATCA), I would like to summarize it in a very few words. It is an enforcement mechanism conceived by the United States whereby foreign investment funds will be required to keep track of U.S. investors and provide information to the U.S. government on such investors under the jeopardy of a 30% withholding on most payments derived by the fund from the U.S. This of course is an oversimplification, but I believe it encompasses the gist of FATCA, a law that aims to induce foreign entities that are otherwise outside the jurisdiction of the U.S. to cooperate in catching American tax cheats.

In light of these regulations, which appear to be close to their final form, I would like to make a few policy observations. As the title of this blog entry suggests, the first thing that stands out is the size of the pronouncement. At close to 400 pages (granted, counting the preamble), these regulations are voluminous even by U.S. standards. It begs to note that the entire tax codes of many countries with fiscal and enforcement systems that satisfactory do the job do not amount to 400 pages. It is difficult, at least to me, to reconcile this regulation with the current push on the Hill for simplification and reduction of complexity in our tax system. On one hand we have the President’s Framework for Business Tax Reform that announces that America’s system of business taxation is in need of reform, one reason being the system’s complexity, and on the other hand we have a 400 page regulation that would require thousands upon thousands of productive hours to master.

The second interesting policy point is about the efficacy of this 400 page regulation and the FATCA law in general. So, the point of the law is to facilitate the capture of tax cheats and to serve as a deterrent to those who would attempt to harm the Treasury. The law does that by essentially exporting the concept of the domestic double-reporting system (taxpayer and payor submit information which is later matched by the IRS) onto foreign institutions.  But U.S. taxpayers with foreign investments are already buried by an insurmountable number of reporting obligations that carry a number of severe monetary penalties and criminal exposure.  Apparently, this has been deemed not sufficient because of cases such as UBS.  However,  how could one ascertain whether the added exponential cost burden would commensurately bolster the enforcement of the self-reporting system? In other words, a tax cheat that is not frightened by the impending criminal exposure under pre-FATCA law would arguably not be deterred by any reporting obligation that a foreign fund may be encumbered with. Moreover, what is to stop such a cheat from investing in a non-FATCA participating private equity foreign fund that has no investment nexus with the United States and does not derive payments from FATCA participating foreign financial institutions? To me, the policy equation looks like this – on one hand it seems certain that the FATCA law and these regulations would (i) add significant cost and administrative complexity for funds, particularly foreign funds, (2) change the landscape for U.S. investors in foreign funds, and (3) change the desirability of the U.S. as a destination for foreign investments; on the other hand we have some unascertained and un-quantified benefit to anti-evasion enforcement that would hopefully deter, or help to catch after the fact, a person that is already set on scheming the U.S. government. I hope I am wrong and these regulations will in large part solve the international tax evasion problem the Government is so concerned about.   If the prevalence of tax cheats that operate in purely local U.S. context is any indication of the efficacy of the double-reporting system in countering evasion, I am somewhat skeptical that the result will be any different in the international context. Only time will tell.

My policy observations, however, would hardly change the course of the impending FATCA implementation. Thus, funds need to be concerned with these regulations and need to be proactive to the extent they are not invested in dealing with FATCA yet.  What are some of the practical implications for funds that could be deduced from these regulations and the FATCA guidance thus far:

-          Both international and domestic funds are affected: The regulations make it clear that the scope of any exceptions from FATCA are very limited.  The typical private equity and hedge fund clearly falls within the purview of FATCA. Domestic funds could be affected in their role as withholding agents and foreign funds are affected in their role as participating foreign financial institutions.

-          Funds should talk to their administrators: This goes for both foreign and domestic funds.  My sense is that very few funds would have the capacity to tackle FATCA on their own. Many third party fund administrators such as Citco are on the forefront of FATCA developments and building systems to comply with FATCA.  Such administrators would bear the brink of the heavy intellectual lifting, which ultimately would come at the expense of the fund. As it may be, funds should at a minimum talk to their current administrator and try to gauge to what extent the administrator is familiar with FATCA and has developed compliance procedures that could smoothly be amalgamated with the funds existing compliance procedures.  This being a material world we live in, funds should also discuss the cost of these added services and shop around if need be. Presently FATCA is a hot issue and many administrators and accounting firms are developing products specifically designed for private equity and hedge funds. In other words, there is a lot of competition among providers out there to grab a share of this new FATCA business which hopefully will lower the cost to funds somewhat.

-          Consider amending deal precedent, governance and other documents: For example, loan agreement precedent has largely been amended throughout the community to reflect the implications of possible FATCA withholding on interest payments by U.S. borrowers. As the proposed regulations have fleshed out in a greater and more definitive detail certain terms, more documents will have to be amended. For example, the regulations clarify that the sale of the shares of a U.S. corporation is a withholdable payment subject to FATCA regardless of whether the U.S. corporation has ever paid a dividend. Thus, a fund purchasing the shares of a U.S. corporation may want to have specific representation and warranties in the agreement that the seller has complied with FATCA and also a requirement for a FATCA certificate that could alleviate the buyer-fund from its withholding agent responsibility under Prop. Reg. § 1.1471-2. Other documents such as fund operating agreements may also have to be amended.

-          There is time, but funds should not procrastinate: The proposed regulations extend the relevant dates of various payments, reporting obligations and definitions. For example, the definition of grandfathered obligations was changed from including obligations outstanding on March 18, 2012 to those outstanding on January 1, 2013.  Also, information reporting will start to phase in beginning in 2016 instead of the previous 2014 date. Lastly, withholding will not be required with respect to foreign passthru payments (other than passthru withholdable payments) before January 1, 2017, in extension of the previous January 1, 2015 date. This may seem like a lot of time, but there is a reason for these extensions; after prolonged discussions among the Treasury and significant stakeholders it was determined that the implementation would be that much more difficult and would require additional time.

-          Some important issues are still up in the air: Ultimately, although these regulations are probably a good indication what the final product will be, they are nonetheless only proposed regulations.  Thus, things can change, and probably will, which unfortunately adds more stress to investment funds and their administrators.  One notable outstanding issue is the definition of a passthru payment. The definition of passthru payments is very important to foreign funds because it will determine the extent to which the foreign fund will have to withhold from payments to recalcitrant investors.  Many commentators, including myself on this blog, mused that it seems inequitable to define such payments based on percentage of U.S. assets held by the investment fund. It seemed that tracing approach is doable and more precise.  The proposed regulations reserve the definition of foreign passthru payment but judging by the preamble and some of the references to passthru payment percentage in the body of the regulations, it does not appear that Treasury is ready to abandon the percentage concept. We will find out how this issue comes out as more comments trickle in.
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Tags: FATCA, FATCA and funds, FATCA and private equity, FATCA compliance, FATCA implementation, fatca proposed regulations