Preparing for FATCA – Cayman domiciled investment funds

In March 2010, the Foreign Account Tax Compliance Act of 2009 became US law. FATCA significantly changes the current system of withholding and reporting on payments made to non-US entities.

The changes are intended to allow the IRS to better detect tax evasion by US persons who use offshore arrangements to hide their identities and US tax status from the US government.

FATCA is wide-reaching legislation that is expected to impact non US investment funds, virtually every other financial institution, and even many non financial entities.

Any Cayman fund which does not become FATCA compliant bears the risk of having significant withholdings applied to their income and sales proceeds. However, it is important to note that FATCA’s impact will not be unique to Cayman and its funds industry, and in fact most countries, including their particular funds industries, will also be affected by FATCA.

The creation of FATCA is the result of many US tax investigation cases related to non-US banks and other financial institutions, which harboured US persons who were not declaring their foreign income. FATCA may be viewed as an overreaching attempt to counter this purported behaviour. Although the specific application of these rules is highly dependent on additional guidance to be issued by Treasury in the form of regulations, the investment management industry must now start planning for the implementation of FATCA.

FATCA will impose additional information reporting and withholding requirements on non-US companies, partnerships and trusts, including Cayman domiciled investment funds, by treating them as “foreign financial institutions”. Failure of the FFI to enter into an agreement with the IRS (FFI agreement) would result in the withholding of 30 per cent of the payment to the FFI of US source income and the gross proceeds on disposition of a security that generates US source interest or dividends. This withholding would also apply even if the US investment was sold for a loss. Such withholdings would make most US investments uneconomical, and if a fund has any material turnover, the withholding tax could readily exceed the fund’s net asset value. As a result, it is anticipated that Cayman funds, with any US investments, will enter into the FFI Agreement with the IRS. These new reporting and withholding provisions will be phased in commencing 1 January, 2014. The original effective date had been 1 January, 2013, which was revised when additional regulations were issued in July of this year.

The FFI agreement

The FFI agreement commits the FFI to certain US tax documentation, verification, due diligence, withholding and reporting obligations. Specifically, the FFI agreement will obligate the FFI, such as the Cayman fund, to obtain more information on each investor in order to determine which investors are considered US investors. As a result, the fund will be required to perform due diligence/verification procedures, including searching its records to determine status of the investors.

The fund will likely need to seek waivers from its US investors for any applicable bank secrecy, confidentiality, data privacy, or other information disclosure restrictions that would otherwise limit the fund’s ability to share information with the IRS regarding its US investors.

Finally, the fund will need to comply with any and all IRS information requests.

The FFI agreement will create an additional compliance burden for funds in gathering information on US ownership from investors, drafting withholding agreements with the IRS and ongoing maintenance of agreements – including compliance audits of the overall withholding processes.

Some funds will need to make substantial changes to their processes, including client on-boarding, technology, and internal governance to handle the expected increase in due diligence procedures and compliance.

The FFI agreement will also require a series of certifications from the chief compliance officer, or equivalent level officer, that will have to make such certifications under penalty of perjury. The CCO will also need to certify that the FFI’s personnel are not involved in providing FATCA avoidance advice.

Many of the provisions of FATCA will require final Treasury guidance on how they will be implemented before they become effective in the coming years. In order to avoid possible withholdings commencing on 1 January, 2014, the FFI must enter into the FFI Agreement with the IRS by 30 June, 2013.

What does this mean for a Cayman fund?

A Cayman fund that enters into an FFI agreement will need to determine whether its investors are US persons, non-US persons, an FFI which is either participating (it has its own FFI agreement) or not, a non financial foreign entity or a recalcitrant investor, an investor who does not provide the required information for the fund to make a determination. In many cases, this process will require significant efforts. Once the Cayman fund has gathered the necessary information about its investors, the FFI agreement will require the fund to report information on US persons, and deduct and withhold a 30 per cent tax on payments, such as dividends and redemptions, to investors who are non compliant with the FATCA rules (a non participating FFI investor such as a fund of fund investor or foreign financial nominee investor who does not have their own FATCA agreement) or who are recalcitrant investors.

From an operational point of view, compliance with FATCA may cause some funds to compulsorily redeem certain investors when it is not able to obtain the necessary investor waivers as noted above, while other funds may experience voluntary redemptions resulting from indirect US investors who begin to understand the consequences of FATCA.

Getting ready

Given the significance of FATCA, directors and managers of investments funds should now be developing business plans to deal with the possible implementation effects.

These business plans will need to consider:

the completion of a compliance assessment, which should focus on the various business risks including those arising from third-party distribution intermediaries through which indirect investors hold interests in their funds;

training for internal stakeholders including internal counsel, compliance, information technology and investor relations personnel;

the business and legal issues raised by FATCA (eg, adequacy of current subscription documentation, tax indemnity provisions, service agreement provisions, etc);

the five step process outlined in the regulations for reviewing pre-existing accounts to identify US persons;

investor relations issues, including the possible need to contact existing clients to request additional information;

the changes to the client on-boarding processes;

the possible involvement and assistance of the fund’s administrator;

potential technology enhancements;

possible changes to roles and responsibilities within the organisation, and related changes to policies, procedures and governance structures;

a process for implementing the highly complex and unnatural pass through payment rules which may be applicable to certain withholdings.

Finally, on a positive note, the US Treasury and IRS intend to issue guidance under which certain offshore funds will be treated as “deemed-compliant” with FATCA if they comply with standards and procedures prescribed in final regulations which will be designed to ensure that such funds do not have US investors.

Although “deemed-compliant” funds will need to obtain certification status from the IRS, they will not need to enter into the FFI agreement. However, these funds will still be subject to certain obligations which will likely necessitate changes to their marketing and on-boarding, accounting and reporting policies and processes.

Therefore, each and every fund manager and director, regardless of the size of their fund groups, should begin to assess FATCA’s impacts on their funds and management company affiliates without delay.

Although many of the rules introduced by the Foreign Account Tax Compliance Act will depend on regulations issued by Treasury, the investment community must start planning for FATCA now, writes PwC Partner Colin Hanson.