It is now plain that FATCA is merely the vanguard of a concerted global initiative by the leaders of the major economies to create something that resembles a global system of personal taxation, to be policed by the institutions that invest much of the wealth of the world: fund managers.

The Foreign Account Tax Compliance Act (FATCA) is the purest expression of decadent democracy yet. It was smuggled into a piece of legislation whose vectoral nomenclature is positively Orwellian (the Hiring Incentives to Restore Employment (HIRE) Act). Worse, it subverts serious discussion of the causes of the fiscal disaster (extravagant public expenditure, especially on ruinous wars abroad) by scapegoating one unpopular social group (wealthy Americans who have allegedly failed to pay their share of income tax) while requiring another unpopular social group (fund and wealth managers) to incur the opprobrium that must accompany a remarkably intrusive assault on liberty.

No wonder this ingenious measure is proving such a popular model for other democracies. In the apparently innocent disguise of the Common Reporting Standard (CRS), released in its final form in July this year by the Organisation for Economic Co-operation and Development (OECD), the G20 is building a standardised model for the exchange of previously confidential information between national tax authorities. Like FATCA, the CRS will require fund managers around the world to share information about their investors with the tax authorities.

This desire to imitate FATCA explains why so many governments around the world are happy to surrender sovereignty to the United States by signing Intergovernmental Agreements (IGAs) that turn national tax authorities into tax collection agents of the Internal Revenue Service (IRS). They are banking on the IRS to return the favour once the CRS takes effect, and are not-so-secretly delighted by the aggressive approach of the American authorities to financial intermediaries alleged to have helped taxpayers avoid their obligations.

UBS, for example, was made the subject of grotesque allegations of conspiring to defraud the United States of tax revenue by creating more than 17,000 Swiss bank accounts for American taxpayers. Among the more lurid allegations was a claim that a bank employee had smuggled diamonds for a clients by stashing them in a toothpaste tube. To make amends for its transgressions, UBS was forced not only to disclose the identities of its American clients, but to pay $780 million in fines.

On top of that lavish sum, UBS reached a further settlement of $200 million with the Securities and Exchange Commission (SEC), on grounds it had acted as an unregistered broker-dealer in the United States. Paying the thick end of $1 billion was an expensive way of persuading the American authorities to drop further charges in 2010, but provided an ideal background for unveiling FATCA that same year as a means of garnering (according to the July 2008 Congressional staff report to the United States Senate, Tax Haven Banks and U.S Tax Compliance) a further $100 billion of tax revenue without troubling the great mass of American voters.

Six and half years on from that Senate report, and nearly five years on from its initial unveiling, FATCA is at last due to come into effect on 1 January 2015. On paper, compliance is straightforward. It requires financial institutions (FIs) and foreign financial institutions (FFIs) to disclose details of accounts held by United States persons (US persons) in order for the Internal Revenue Service (IRS) to identify whether they are paying the right amount of tax. However, matters quickly get complicated.

First, the definition of an FFI is broad. It encompasses any organisation that accepts deposits or holds financial assets on behalf of others, entities engaged in investing, trading or reinvesting in securities, commodities, derivatives or interests in partnerships. It includes not just banks and private banks but insurance companies, broker-dealers, central counterparty clearing houses (CCPs), trust companies, fund managers, private equity managers, wealth managers, pension funds, securitisation vehicles and investment vehicles.

There are exemptions, but these are rare. They apply to institutions that are perceived to represent a low risk of tax evasion only, or which are based in a single jurisdiction and closed to foreign customers. Institutions with low value account-holders such as credit unions are also exempted from FATCA, as are some retirement schemes, non-profit organisations and government institutions. The predictability of the members of the list of exempt institutions is one of the most depressing aspects of FATCA.

For the rest, there is no escape. The definition of a US person encompasses United States citizens (including those with dual nationality), non-citizens resident in the United States for tax purposes, domestic partnership and corporations, any estate other than a foreign estate and any trusts either subject to the control of the United States courts or controlled by one or more people who are American citizens.

The consequences of failure to comply are savage. “The operational and business costs for FATCA compliance are high, but the costs of non-compliance are worse,” says Meredith Moss, co-founder and chief operating officer at Finomial Corporation, a technology vendor. By this, Moss means that the United States Treasury will impose a 30 per cent withholding tax on payments from the United States to “non-participating” FFIs (NPFFIs). Such is the tyranny of the climate of opinion created by this measure that NPFFIs can be confident that no respectable investors would be prepared to place any business with them.

To be fully compliant with FATCA, FFIs must identify which of their clients are US persons. This is not as straightforward as the definition suggests. “Fund managers and other FFIs must ask their investors for a W-8 form,” explains Ross McGill, managing director of GlobeTax in London. “This is not just a routine Know Your Client (KYC) exercise. Firms must conduct thorough due diligence on their underlying clients to clarify whether they are indeed US persons or not, as defined under the rules. Most people would believe a passport should suffice to clarify this. However, this is not the case. Under the FATCA rules, an individual who holds a mailing address within the US, or has power of attorney of account in the US, or who has lived in the US for a substantial time, could fall under the FATCA definition of a US person. If an individual has not properly revoked their Green Card, they too could be ensnared. An individual living outside of the US but whose parents were born in the US could even be caught out. In other words, Winston Churchill, for example, would have been deemed an American under FATCA.”

FATCA has even spawned an ugly neologism - “indicia” - to describe the list of criteria by which a person might be deemed a “US person,” including an American birthplace, residence, telephone number, mail-holding address, or even a standing order or power of attorney to pay money into an American bank account. “The reach of the US tax authorities is far more extensive than most realise and there are many things that create a link to the US tax authorities, known for FATCA purposes as US `indicia,’” says Dermot Mockler, group head of regulatory affairs, compliance and Anti-Money Laundering (AML) at TMF Custom House Global Fund Services in Dublin. “I am hearing anecdotally of a lot of individuals revoking their old Green Cards, for example. Until it has been formally revoked by the US authorities, those individuals can be caught out by FATCA.”

Identifying whether an investor qualifies as a US person could be even more challenging if the client has a complex holding company or family office structure. “Firms will have to review any pre-existing investors in addition to those that they on-board now,” says Gareth Davies, associate director at Augentius, a private equity and real estate fund administrator based in London. “If the investor is a family office or high net worth individual with personal holding companies, the private equity fund manager will need to conduct a thorough look-through on those companies. There is a lot of data for private equity fund managers to digest now.”

His warning is a telling on, since most informed observers see compliance with FATCA as a more straightforward exercise for private equity funds. They typically recruit investors every three to four years at the most, whereas hedge funds are usually open to new investments throughout their life cycle. “Unlike a hedge fund, which can often be open to new investors all of the time, private equity funds are typically closed-ended, and will only fund-raise once every few years,” says Karen Haith, operations director at IPES in Guernsey. “This means they do not need to constantly conduct new client checks for FATCA purposes as and when they on-board a new client.”

Those checks are intrusive. The IRS expects FFIs to obtain the name, address and US taxpayer identification of US persons that hold accounts with them, the balance in the account, the amount of income credited to the account, and the total gross amount paid or credited to the holder of the account. It would be surprising if fund managers did not run into resistance. Indeed, FATCA has anticipated the “recalcitrant account holder” that fails to comply with requests for information, or fails to supply details of US persons, or even fails to produce a waiver of any local laws (such as client confidentiality) preventing the firm from disclosing information to the IRS. These account-holders pay the 30 per cent withholding tax.

Dealing with recalcitrant or uncooperative clients is likely to be awkward for financial institutions. “Obtaining sensitive data from clients is not without its challenges,” explains Haith of IPES. “Many private equity firms have existed for a number of years now, and some may simply not have adequately detailed data on clients. Other investors may be sensitive to disclosing this sensitive data, even though it is the law.”

Already, financial institutions are terminating relationships with clients simply because compliance with FATCA is to tiresome, let alone because account-holders are recalcitrant. “Some fund managers and banks will simply cull relations with a client that is recalcitrant so as not to incur the wrath of the IRS,” says Marc De Kloe, head of alternatives at ABN Amro Private Bank in Amsterdam, Holland. “I have heard anecdotally of some FFIs refusing to hold accounts on behalf of US customers in order to circumvent FATCA.”

This is obviously easier to do when a client is unimportant, and the United States remains an important source of capital for managers everywhere. “US investors are at the heart of the global funds industry,” says Jonathan Brose, partner at the tax group at Seward & Kissel. “While it is possible some fund groups may restrict access to US investors, I doubt this will occur on a widespread basis.” James Orrick, director at Private Equity Administrators in Guernsey, concurs. He says firms are loath to exclude prospects or terminate existing client relationships. “We have not heard of any private equity funds shutting out US investors because of FATCA whatsoever,” he says.

Indeed, it is precisely because it affects investors that FATCA is a higher priority for many managers than more complicated measures, such as the Alternative Investment Fund Managers Directive (AIFMD), the European Market Infrastructure Regulation (EMIR) or the second iteration of the Markets in Financial Instruments Directive (MiFID II). Despite the fact derivative trade reporting in Europe was due to start within four months, a survey of 40 hedge fund managers in October 2013 by SunGard and Aite Group found FATCA was their most pressing concern.

Yet it would be misleading to say anxiety has translated into action. A study published in March 2014 by SEI – As FATCA Deadlines Loom, What Managers Need to Know – found managers unaware, let alone unprepared. 48 per cent of managers polled told SEI they did not know about the deadline for registration with the IRS of 25 April 2014, which was essential to obtain their unique Global Intermediary Identification Number (GIIN). Fortunately, the deadline was extended by a month into May 2014.

The next step – working out which clients were likely to be US persons – was also badly behind schedule. More than a third of respondents to the SEI survey had not established an investor due diligence plan, and only two thirds of that group planned to put one in place on an appropriate timescale. Two fifths were undecided as to whether they could rely on existing due diligence documents or whether they would have obtain new W-8 or W-9 forms from their investors.

“Managers are not prepared for FATCA although the level of preparedness varies by geographical location,” says Ross McGill. “In Europe, perhaps 30 to 40 per cent of affected institutions are not prepared. Larger managers have got it together but the same cannot be said for the smaller players. The simplest way of approaching FATCA preparedness is to draw a line east from Washington DC. By the time you follow that line past eastern Europe, very few people have a clue about FATCA. Asia-Pacific is particularly behind the curve.”

The level of preparedness in the private equity industry is not always better. “It is a mixed bag,” says James Orrick. “We have got a broad spectrum of clients and there are some who are very prepared and have known for a long time about what FATCA entails. They have done all that is required of them so far- namely, appointing a FATCA Responsible Officer and obtaining a GIIN from the IRS’s FATCA registration portal. These firms are all on target to attain compliance in good time. Others still do not fully appreciate the implications that FATCA has.”

One problem is that some private equity managers are in denial: many struggled to convince themselves that FATCA actually applied to their industry. That said, there were real grounds for doubt. “The structure of a private equity fund can be very complex, so the question therein lies with who registers,” says Gareth Davies of Augentius. “Is it the partnership, the fund manager or a special purpose vehicle (SPV)? There are some exemptions within FATCA for limited scope entities, such as those devoid of US investors and meeting other conditions, for example.”

Karen Haith of IPES agrees that certain SPVs can claim an exemption from FATCA, although it is contingent on what the underlying investments are. “Some SPVs are exempt from FATCA,” she says. “Others are not. It all depends on the type of the SPV and the asset it is holding, in what can be quite a complex process. Is the portfolio company a financial asset or non-financial asset, for example?”

Managers of all kinds could also claim that the United States Treasury Department sowed confusion. Before the embarked on me-tooism via the CRS, national governments initially objected to the extra-territorial ambitions of the earliest versions of FATCA. This prompted the Treasury Department to allow FFIs to report on accounts of US persons not to the IRS, but to the tax authorities in their own country, which would then pass the information on to the IRS.

This approach was enshrined in IGA Model 1 – introduced in July 2012 – which also offered a more relaxed timetable and an extended list of exempt institutions. Most importantly from the point of view of the signatories, Model 1 establishes reciprocal arrangements by which the United States will now supply to the tax authorities of the co-operating country details of accountholders in American financial institutions. With absolutely no sense of irony, some American politicians criticised the reciprocity arrangements as an invasion of the privacy of American financial institutions.

Less blameworthy is that minority of countries which continue to regard privacy as a political virtue. IGA Model 2, introduced in November 2012, aims to deal with those jurisdictions (such as Switzerland) whose national laws make it difficult for financial institutions to share information about their account-holders with the tax authorities of a foreign power. They will share directly with the IRS information on compliant US persons, and aggregate information only on “recalcitrant” account-holders.

Of the 196 countries in the world, 88 have either signed or agreed to sign an IGA Model 1 agreement, and a 13 further have either signed or agreed to sign a Model 2 agreement. This extensive but still limited coverage, the varying status of bi-lateral agreements with one country or another, and the delays while even the earliest signatories translate agreements into national law, have provided ample opportunity for financial institutions to delay preparations for FATCA until the details become clear.

Though it is worth noting that every major fund domicile (BVI, Cayman, Ireland, Luxembourg, and the Channel Islands) has signed an IGA Model 1, and the IRS has published guidance on reporting under IGA Model 1 and Model 2, as late as September this year that still left 154 countries where the outcome was uncertain and the IRS could offer no concrete advice. Among those countries that have agreed to sign, questions inevitably arise as to how their FFIs should deal with FATCA until it actually happens. Should they do nothing or comply as if an agreement is in place?

For FFIs which operate out of several jurisdictions, the uncertainty is compounded by the prospect of being saddled with multiple reporting requirements. “If a firm has businesses across several jurisdictions, some with differing IGA models, then they will have to comply with the rules in each and every jurisdiction in which they have operations,” says Jonathan Brose of Seward & Kissel. “The IRS has said it will not allow FFIs to supply a streamlined report. I suspect most fund managers will outsource the due diligence and investor reporting work to their fund administrators although it is essential they keep an eye on these outsourced relationships otherwise complications could arise.”

Dermot Mockler of TMF Custom House Global Fund Services says the uncertainty does account for the dilatory approach by managers to FATCA deadlines. “The IGAs have unwittingly complicated matters for managers,” he says. “While we have been speaking with our investment fund manager clients since the middle of 2013 about FATCA compliance, those that have yet to fully prepare do attribute this to the ongoing confusion around IGAs and general lack of clarity from the IRS. However, fund administrators are preparing their systems and due diligence procedures to deal with the reporting rules.”

Gareth Davies of Augentius sees the IGAs as a mixed blessing. “IGAs in our opinion have made FATCA more straightforward,” he says. “It requires fund managers to report to their local tax authorities and they need not worry about withholding, which makes the world far simpler. The complexity lies with the number of regulatory bodies fund managers have to report to. The guidance being issued by different jurisdictions is being made public at a different pace while some jurisdictions have not implemented the IGAs into local legislation.”

Unhappily, the IGAS are a portent of a future in which the exchange of personal tax information between the tax authorities of different countries becomes a matter of routine. The CRS may well morph into a global version of FATCA (GATCA). “GATCA is being increasingly discussed,” notes Dermot Mockler. “The initiative towards global tax transparency has been on-going for several years now, and with the passage and implementation of FATCA in the US, this will only intensify. The United States has basically taken the lead. Given the severity of the punishments imposed for non-compliance, not to mention the importance of the US dollar in capital markets, FATCA was always going to succeed, as it has teeth and it is leading to a knock-on effects elsewhere.”

The United Kingdom has already unveiled ambitions for a FATCA of its own (originally dubbed the UK FATCA) in the national budget of March 2013. It presently consists of agreements to automatically exchange information agreements with the Crown Dependencies and Overseas Territories (Jersey, Guernsey, Isle of Man, Anguilla, Bermuda, the British Virgin Islands, the Cayman Islands, Gibraltar, Montserrat and the Turks and Caicos Islands) of the United Kingdom. These reciprocal agreements, which should be finalised this year, require financial institutions in the Crown dependencies to provide information on UK accountholders to the Inland Revenue, and vice-versa.

China is also looking at FATCA-esque legislation via Foreign Asset Reporting Requirements (FARRs) intended to force wealthy citizens to publish details of their offshore holdings. But it is the CRS which is most threatening, not only in the sense that it is driven by the G20, but because it will normalise and institutionalise the sharing of tax information between jurisdictions. “The CRS is intended to facilitate the automatic exchange of information according to a common global standard,” says Mariano Giralt, managing director and head of Europe, Middle East and Africa (EMEA) Tax Services at BNY Mellon. More than 65 countries have already publicly committed to implementation of the CRS, and more than 40 of them have committed to a specific timetable leading to the first automatic exchanges of information in 2017.

Hundreds of bi-lateral tax information sharing agreements, even when they are governed by a common standard, is a daunting prospect for managers recruiting investors all over the world, especially when they are already struggling to make sense of the local implementations of the IGAs agreed under FATCA. “The best thing managers can do now is to just try and keep up with the market and stay up to date on any changes or updates as they occur,” says Eddie Russo, principal solutions consultant at Advent Software. “There is not really anything managers can do until other jurisdictions’ versions of FATCA legislation is finalised and approved as law.”

Optimists see FATCA as useful preparation for the CRS, and advise managers to tax a holistic approach to international tax reporting. “Managers will need to build on existing FATCA programs and technology changes to implement CRS,” says Mariano Giralt. At KPMG in Luxembourg, partner Charles Muller agrees. “A global FATCA is imminent so fund managers must build their systems and technology to deal with multiple tax reporting requirements and not just FATCA,” he says. “A lot of countries are formulating their own FATCA-esque rules and it is essential managers ensure their systems can deal with all of these rules and reporting obligations.”

One way to make FATCA, CRS and the national variations more palatable would be the creation of a data utility to store and update information about investors, including their tax status. “Such a utility would minimise the operational challenges of compiling different data reports for fund administrators,” says Gregory Robbins, chief operating officer at Mesirow Advanced Strategies, the $14 billion Chicago-based fund of hedge funds. “A consolidated data utility where the formatting of reports is consistent for all investors would ease the operational burden that reporting entails. Such a utility would capture all of the data investors provide and store it in one place. It would enable investors to have a uniform subscription document. Investors have to supply so many reports and having a standardised data utility would be a huge benefit. From an investor point of view, there is an enormous amount of information we need to provide managers. We need to provide hedge funds with data because of FATCA, for example.”

Data utilities are certainly a fashionable idea, with a number launched or in development or proposed for KYC, AML and sanctions screening and reference data. The Depository Trust and Clearing Corporation has launched one which could well develop tax information capabilities (see sidebar), and it is not hard to see why exhausted and exasperated fund managers would find it useful. They know now that FACTA is not the end, or even the beginning of the end. “FATCA is just the tip of iceberg,” says Jonathan Brose of Seward & Kissel. “It is the first step in a process that is likely to herald a global information exchange of tax data. While firms should take into account that tax information sharing will become more commonplace globally, it will be very hard for them to implement the technology and processes to ensure compliance with these various proposals as the rules are still unclear.” Handing the management of that uncertainty to a utility has an undeniable appeal.

Guide type:
regulatory reporting

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