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The Impact of FATCA on U.S. and Non-U.S. Private Equity & Hedge Funds

Global financial services industry



The Foreign Account Tax Compliance Act (“FATCA”) regime signifies the U.S. government’s extensive effort to encourage foreign financial institutions, including offshore investment vehicles, to assist it in enforcing the information reporting of U.S. taxpayers with respect to assets held offshore. After almost three years of notices, announcements, and proposed regulations, the Internal Revenue Services (“IRS”) and the U.S. Treasury published the final FATCA regulations on January 17, 2013. The implication of the FATCA regulations on private equity and hedge funds is significant. Virtually every private equity and hedge fund will have to comply with the regulations because such funds will likely be considered either a U.S. withholding Agent (“USWA”) or a foreign financial institution (‘FFI”) under the rules.

“Private equity funds and hedge funds are facing increased scrutiny over regulatory, compliance and tax issues as investors and regulators take a closer look at the industry’s practices. Given the potential reputational harm that can come from an enforcement case, compliance is now an even more important component of private equity funds’ and hedge funds’ culture.”

Enacted in 2010, FATCA encourages non-U.S. entities to report U.S. investors and counterparties to the IRS by imposing a new 30% withholding tax on U.S. source payments to non-cooperative foreign entities. To avoid the withholding, FFIs that are not exempted or “deemed-compliant” must generally enter into FFI agreements with the IRS or, if subject to a model 1 Intergovernmental Agreement (“IGA”), register with the IRS as a reporting model 1 IGA FFI. The IGAs are agreements between the U.S. and foreign jurisdictions to implement FATCA compliance. To avoid the withholding tax, non-financial foreign entities (“NFFEs”) that are not exempted in the final regulations will be required to provide information to the withholding agents relating to their U.S. owners who have a substantial ownership stake.

The final regulations provide exceptions and exclusions to withholding requirements and suggest a broader framework of international cooperation seeking to ease the challenges faced by foreign entities in complying with FATCA. Moreover, the regulations attempt to harmonize many of the FATCA requirements with the current U.S. income tax withholding rules and model IGAs. The IGAs in particular represent another significant step forward in the global exchange of information to combat tax evasion. The U.S. government is still negotiating agreements with numerous nations around the world, including various offshore jurisdictions like Jersey, Isle of Man, Guernsey and others. Discussions are also ongoing with several Caribbean countries to conclude IGAs, including the Cayman Islands. Finally, Treasury is also exploring intergovernmental options with Bermuda, Saint Maarten and other similar jurisdictions.

Industry impact

Hedge funds and private equity funds will likely have to undertake substantial work and overcome significant implementation challenges to comply with the new regulations. Failure to take necessary actions could implicate various business, investor relation, and reputational risks. Moreover, many FATCA compliant counterparties (including banks, broker/dealers, custodians, etc.) and U.S. withholding agents (including correspondent banks, brokers, custodians, etc.) will be less likely to transact business with non-FATCA compliant funds.

U.S. funds

Domestic funds normally include U.S. stand-alone or feeder funds formed within the United States, including master funds and certain other fund entities. These domestic funds will not be required to enter into an FFI agreement. However, they will be required as USWAs to conduct enhanced due diligence and obtain documentation with respect to their payees who receive withholdable income. They will also be required to comply with new and enhanced reporting and withholding responsibilities.

Non-U.S. funds and the definition of an FFI

Non-U.S. funds will need to be analyzed under the regulations to determine whether they fall under the FFI definition. Of particular relevance for private equity and hedge funds are the FFI definitions of an investment entity, holding company, and treasury center. The final regulations modify the definition of an “investment entity” to more closely align with the definition provided in the IGAs. The final regulations define investment entity as an entity that primarily engages in a business of trading financial products for customers, performing portfolio management, or investing, administering, or managing funds, money, or financial assets on behalf of customers. Under these revised rules, fund managers, investment advisers, and general partners are now generally regarded as financial institutions because they either trade in financial products for customers or they provide portfolio management. Thus, to the extent such entities are foreign, they are likely to be FFIs that will need to enter into FFI agreements unless they qualify as deemed-compliant FFIs, or, should an IGA be in place, they comply with their local country IGA. Passive foreign entities that are not professionally managed, however, will generally not be treated as financial institutions (primarily intended to apply for small family trust and certain personal investment companies).

Likewise, holding companies or treasury centers in private equity structures or similar investment vehicles structures will be generally considered FFIs. Under the proposed FATCA regulations, a holding company or treasury center was included in the definition of an investment entity. Because the definition of investment entity was modified to exclude certain small, non-professionally managed entities such as trusts, holding companies and treasury centers fell outside the definition.

As a result, a new FFI category for holding companies and treasury centers was included in the final regulations.

Holding companies and treasury centers are treated as FFIs if they are formed in connection with, or availed of by, a collective investment vehicle, hedge fund, private equity fund, venture capital fund, leveraged buyout fund, or any similar investment vehicle that is established for the purpose of investing, reinvesting, or trading in financial assets. Although an exclusion exists for certain holding companies or treasury centers in a nonfinancial group, hedge fund and private equity groups will generally not qualify as a nonfinancial group. Interestingly, this category of companies has not been included in any of the IGAs signed to date, potentially subjecting them to a different set of rules depending on their country of organization.

In assessing the impact of FATCA on an individual fund or other investment entity, much of the analysis will involve determining whether any exceptions apply and whether the requirements are mitigated by various rules in the final regulations. The “deemed compliant” rules discussed below will lessen the burden for many companies.

Minimizing the FATCA burden – Deemed-compliant statuses

The final regulations introduced several new deemed-compliant statuses that will be of particular interest to private equity and hedge funds to help minimize the burden of FATCA. In both the certified and registered deemed-compliant status categories, the IRS introduced a concept of allowing a sponsoring entity to register with the IRS to undertake the FATCA responsibilities on behalf of sponsored entities. In the registered deemed-compliant category, the “sponsored investment entity” applies to an investment entity FFI that agrees with an FFI, whereby the FFI acts as a sponsoring entity for the FFI, registers the FFI, registers itself as a sponsoring entity, and generally fulfills the FATCA requirements of the sponsored investment entity FFI. In the certified deemed-compliant category, the “sponsored, closely held investment vehicles” applies to an investment entity FFI that has contractual arrangements with certain sponsoring entities registered with the IRS that agree to fulfill all of the sponsored FFI’s FATCA responsibilities. Generally, the sponsored FFIs in the certified deemed compliant FFI category can only have twenty or fewer individuals owning all of the debt and equity interests in the FFI. Both categories will enable private equity and hedge fund managers and similar FFIs to better manage the FATCA requirements for the funds they sponsor.

The final regulations also retain from the proposed regulations certain other deemed-compliant categories relevant to private equity and hedge funds. Under the registered deemed-compliant category, which still requires IRS registration and responsible officer certifications among other procedural requirements, the nonreporting member of a participating FFI group, qualified collective investment vehicle, and restricted fund categories remain. The “nonreporting member of a participating FFI group” can generally apply to any FFI that is a member of a participating FFI group that implements policies and procedures to avoid maintaining U.S. accounts or accounts held by recalcitrant account holders or nonparticipating FFIs. This category can be useful for private equity and hedge funds by transferring all reportable accounts to an affiliate that is a participating FFI, reporting model 1 FFI or U.S. financial institution within the group that can perform the required FATCA reporting to lessen the reporting burden.

The remaining two deemed-compliant categories are also useful to lessen reporting; however, the requirements to comply are fairly restrictive and essentially leave no accounts to be reported even if the entity were a participating FFI. The “qualified collective investment vehicles” category generally applies to a regulated investment entity FFI in a FATCA-compliant expanded affiliated group (e.g., participating FFIs, deemed-compliant FFIs, etc.), but certain restrictions apply to direct debt interests in excess of $50,000. The “restricted fund” category generally applies to a regulated investment entity FFI in a Financial Action Task Force (“FATF”)-compliant jurisdiction that generally redeems or transfers interests in the fund through the fund (other than bearer obligations issued prior to 1/1/2013) or through participating FFIs, registered deemed-compliant FFIs, nonregistering local banks, or restricted distributors. Restricted distributors have additional strict guidelines to meet.

Grandfathered obligations - Derivatives and related transactions

The final regulations and Notice 2013-43 define grandfathered obligations as any obligation outstanding on July 1, 2014, that is not significantly modified on or after that date. This provision covers most financial instruments, except, notably, those that are treated as equity for U.S. tax purposes or that lack a stated expiration or term. The final regulations exempt grandfathered obligations from FATCA withholding. The final regulations and Notice 2013-43 extend and describe the grandfathering rule by clarifying the term “obligation” as any legally binding agreement or instrument including:

  • A derivatives transaction entered into between counterparties under an ISDA master agreement that is evidenced by a confirmation by June 30, 2014. However, a master agreement will not be considered a grandfathered obligation;
  • Obligations (total return swaps on U.S. equity) that give rise to withholdable payments through future regulations under section 871(m) related to dividend equivalent payments. Such obligations are grandfathered obligations to the extent that the obligations are outstanding at any point prior to six months after the implementing regulations are published; and
  • Collateral obligations securing a grandfathered derivative or other obligation, even if the collateral itself is not a grandfathered obligation. For ISDA collateral agreements (or a pool of collateral) that secures both grandfathered obligations and obligations that are not grandfathered, the collateral securing each must be allocated pro rata by value to determine the outstanding obligations secured by the collateral for FATCA withholding purposes.
FATCA’s impact

FATCA will have an impact on non-U.S. funds that do not have either U.S. investors or U.S. investments. Funds with no U.S. investors must determine the status of direct investors and investors that are non-U.S. fund intermediaries (e.g. distributors and nominees) to determine if there are any indirect U.S. investors. However, that information may not be easily obtainable. Funds with no U.S. investments will still need to be aware of the eventual implementation of the foreign pass thru payment requirements (i.e., a portion of foreign sourced payments from a non-U.S. entity could be treated as U.S. source), as well as any future changes in investment strategy by their investment managers. The definition of FFI is quite broad, and appears to include virtually all non-U.S. investment vehicles, including foreign feeder funds, foreign stand-alone funds and blocker corporations as well as most foreign alternative investment vehicles.

The impact of FATCA to U.S. domiciled private equity and hedge funds is not as onerous as the impact to non-U.S. domiciled entities, particularly given the existing policies and procedures for chapter 3 and 61. However, U.S. funds are required to identify their investors, obtain necessary documentation or FFI registration information to confirm compliance of the investors and counterparties, withhold on investors or counterparties that are non-participating FFIs or non-compliant NFFEs, and perform FATCA 1042-S payment and Form 8966 U.S. owner reporting. In cases where the fund has outsourced their information reporting and withholding responsibilities to a third party transfer agent or administrator, the fund can likewise outsource their FATCA compliance responsibilities; however, the responsibility for compliance and financial liability for non-compliance remains with the fund.

Bottom line

To be FATCA compliant by July 1, 2014, most U.S. and non U.S. private equity and hedge funds will still need to undertake substantial work and overcome significant implementation challenges. The immediate next step should be to update any initial planning and/or implementation that occurred based on the proposed regulations and then to continue planning and solution development based on the final regulations. The impacted funds should also design future state operating models and implementation roadmaps, and identify the functionalities of technology systems that will need to be updated. Moreover, private equity and hedge fund sponsors should explore implementation options that utilize the various deemed-compliant rules and other compliance options to better streamline FATCA implementation.
FATCA compliance will likely be considered one of the top tax priorities for funds given the increased regulatory burden and push by investors for additional transparency. There is a general awareness in the fund community of the need to fortify compliance policies, procedures, and personnel to stay agile and responsive in this dynamic regulatory environment. This awareness extends to the need by hedge funds and private equity funds to maintain adequate oversight of service providers, who are taking on more responsibility in performing these regulatory functions.

Important FATCA dates in 2013 and 2014 

August 19 FATCA registration portal will be accessible for registration
April 25 Last date an FFI can register with IRS to ensure inclusion in the June 2, 2014 IRS FFI list
June 02 IRS scheduled to publish first “GIIN” list
July 01 Grandfathered obligations cutoff
July 01 USWA & FFI to begin new account onboarding
July 01 Begin income withholding (excluding certain offshore payment of U.S. source income)
Deember 31 FFI & USWA to complete documenting/remediating preexisting accounts that are considered “prima facie FFIs”

** Other Withholding/Reporting requirements phase in from 2015 through 2018

To learn more

The final regulations are extensive, and complicated, and the changes from the proposed regulations are substantial. This document attempts to highlight certain important provisions of the final regulations which generally impact private equity funds, hedge funds, and the asset management industry and do not represent a broad-based summary of all of the changes. If you are directly or indirectly affected by the compliance obligations of the final regulations, you will likely want to take affirmative steps soon with respect to FATCA implementation. If you wish to discuss the final regulations or any FATCA-related matters, please contact one of our FATCA contacts listed on the following page.

Full article is available for download. For more information please contact a Deloitte FATCA Leader or click here.

As used in this document, “Deloitte” means Deloitte Tax LLP, a subsidiary of Deloitte LLP. Please see for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting.

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