Tax News
FATCA and Foreign Funds
March 01, 2011
I was reading an article today by Lee Sheppard titled “Danilack Warns Multinationals on FATCA and GRAs.”   In the article, Ms. Sheppard reports on deputy commissioner (international) Michael Danilack’s views on FATCA and raises some questions along the way.  What intrigued me was the question about the holding company rule.  Ms. Sheppard asks “What if private equity funds are making U.S. investments through a foreign holding company?”  Then few more thoughts on Ms. Sheppard’s part follow and the discussion ends with Mr. Danilack’s answer -  “the government does not want the holding company exception to be too broad, because such companies could be used to funnel dividends to U.S. investors. He said the definition may have to be more subtle than the notice implies.”

Well, I for one thought that the holding company rule was relatively straight forward. In fact, in a recent FATCA/fund podcast with Lexis, I mentioned the rule but I was hesitant to say that it has a direct implication to funds. What does the holding company rule say?  It provides that a foreign entity the primary purpose of which is to act as a holding company for a subsidiary or group of subsidiaries that primarily engage in a trade or business other than that of a “financial institution,” will be excluded from the definition of financial institution.  The rule then goes on as follows: “This class of excepted entities will not, however, include any entity functioning as an investment fund, such as a private equity fund, venture capital fund, leveraged buyout fund or any investment vehicle whose purpose is to acquire or fund the start-up of companies and then hold those companies for investment purposes for a limited period of time.” (See Notice 2010-60).  So the above Notice narrative speaks of the holding company not being a fund and having an investment purpose. Well, literally read, a multi-purpose blocker set up by a fund could be out of this narrative because the blocker’s purpose is to block ECI and reduce reporting requirements for offshore investors.  While I appreciate the argument, I am not sure whether it makes the purpose and thrust of the holding company rule less obvious.  It seems clear to me what Treasury meant – financial entities, such as funds, that hold businesses as an investment do not get to rely on the rule.  Long story short, I am not sure whether the rule needs to be more subtle or be more or less of anything than what it already is.

My view on these issues is that the IRS should spend more time thinking about how some of these drastic FATCA rules would apply in practice and to ameliorate some of the problems that could put the industry in a serious predicament, and more importantly, lead to the loss of revenue and investment activity.  To give an example, Sec. 1471 has a secrecy jurisdiction rule that requires a fund to attempt to obtain a waiver from its investors and if such waiver is not obtained, to kick the investor out. For existing private equity funds this could be a major problem. First, it is arguable whether kicking a foreign investor out of the fund because the investor did not want to sign a waiver that was not initially stipulated in the fund agreement is legal.  Second, if you are to kick the investor out, how do you pay him/her?  Private equity funds usually have excess cash-flow when investments are sold.  Third, what kind of a reputation would a fund/sponsor have if it kicks out its investors because the U.S. Government thinks that U.S. law is more important and should de facto trump other laws?  I can only hope that Treasury is thinking about all of this and some of this will be covered in upcoming guidance.
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Tags: FATCA, FATCA and funds, FATCA and private equity, FATCA compliance, FATCA implementation