The Importance of Understanding FATCAThe Foreign Accounting Tax Compliance Act ("FATCA") is a 2010 US tax law which has implications forboth hedge fund managers and investors. Tax is an area that unfortunately causes many investors eyesto glaze over during the operational due diligence process. The goal of analyzing tax structures duringdue diligence is not to necessarily develop a formal tax opinion as would be received from an investorstax advisers (i.e. - tax counsel or accountant) but rather to gain a better understanding of whether ahedge funds trading activities could potentially generate negative tax consequences for its investors.Examples of common tax hedge fund and private equity tax issues which can fall into this classificationinclude an analysis of whether or not a fund may have generated or anticipates generating unrelatedbusiness taxable income or effectively connected income, more commonly referred to as UBTI and ECI.Furthermore, as with most things related to operational due diligence, the way in which a hedge fundmanager approaches detailed issues such as tax structuring can provide valuable operational insightsinto the ways in which it approaches its larger business infrastructure.What is FATCA?FATCA, was formally enacted in March 18, 2010 with thegoal of preventing US citizens from tax evasion throughhiding income or assets abroad in foreign businesses. FATCAapplies to many different types of firms including hedgefunds and private equity funds both within the US andinternational. FATCA technically classifies these non-US fundmanagers, sometimes referred to as passive foreigninvestment companies or PFIC in IRS jargon, as so-calledForeign Financial Institutions or FFIs.The US is seeking to work in cooperation with internationalgovernments to enforce FATCA. In 2012, the US Treasury and the IRS released a statement alongsideFrance, Italy, Germany, Spain and the US stating as much. The IRS master plan is to allow non-US fundmanagers to deal more directly with international tax authorities and then the IRS would step in tocollaborate.Although FATCA was signed into law in 2010, it does not technically take effect until January 1, 2013.Withholding for FATCA, what in IRS speak is known as so-called fixed or determinable annual orperiodical payments or FDAP, will not begin until January 1, 2014.How do hedge funds and private equity funds comply with FATCA?In order to comply with FATCA, fund managers must provide US Internal Revenue Service ("IRS") withdocumentation on its investors. Specifically, those investors that have more than $50,000 investedoutside of the US. Similar to anti-money laundering documentation, these documents include certainclientbalances, receipts, withdrawals and account identification numbers.
Why do investors need to understand FATCA?Although FATCA will not take effect until 2014, there are a number of reasons why investors need toinquire now about their fund managers plan to comply with FATCA. The penalties for non-complianceare steep. If a fund manager violates FATCA, they will be penalized by a 30% withholding tax beingplaced upon the foreign financial institution’s US assets or sourced income. This is a materially negativeconsequence and could have large negative implications for both investors and the fund.Additionally, because FATCA is effectively a US tax regulation which has international implications, thereare privacy concerns raised. For instance a hedge fund may be required under FATCA to make FATCArelated disclosures to the Canadian regulators. Under Canadian privacy it is unclear whether suchdisclosures may be mandated or voluntary in nature. Furthermore, a hedge fund manager which makessuch disclosures may be subjected to potential liability for violating privacy concerns.Investors can often obtain some guidance in regards to how their hedge funds and private equity fundsapproach FATCA by asking their fund managers how they plan to develop a plan to comply with FATCA.Typically, most fund managers seeking to develop a plan to comply with FATCA will work with externalaccountants and legal counsel to address this issue. Some key questions investors can ask to gauge if afund manager has thought about FATCA and has developed a plan for compliance include: Does the fund manager, or operations personnel, understand what FATCA is? Do they understand the timeline by which they need to comply? Has the fund spoken to their accountants and lawyers about FATCA? What advice did they give the fund? Has the fund begun to think of the specific details of FATCA compliance including: (i) Identifying so-called "Responsible Officers" who must certify FATCA compliance (ii) Developing a plan for fund offering memorandum and subscription documents with FATCA disclaimers (iii) Analyze internal AML/KYC procedures as well as the work with the funds administrator to ensure AML/KYC procedures will be appropriately in compliance with FATCA (iv) Classify investors into FATCA groups and ensure FATCA compliant documentation on each investor is maintainedDuring the operational due diligence process investors should take measures to effectively vet theapproach their fund managers take to FATCA before the IRS shows up at their door.