The unintended consequences of Fatca

The unintended consequences of Fatca

Negative feeling towards the financial sector is rife at the moment as a wave of occupation protests has spread across the US and over to the UK. At time like this, being accused of harbouring US tax evaders is the last thing asset managers need.

But that is exactly what the Foreign Account Tax Compliance Act (Fatca) - a subsection of the Hiring Incentives to Restore Employment Act of 2010 – implies.

This piece of US tax regulation is intended to enforce the disclosure of US taxpayers and therefore capture all potential tax revenue that is payable on the worldwide income of US citizens, and it requires all firms earning income on US assets to report on this fact, or else face a 30% withholding tax.

For asset managers across the globe, they have to know exactly when, where and how they are earning revenue on US assets.

The cost of compliance is a concern for asset managers globally. The general sentiment is Fatca is onerous and impacts many funds that have never before been associated with US tax evasion.

According to Jean-Michel Loehr, chief of industry and government relations at RBC Dexia, the burden of Fatca goes beyond what the US is aiming to achieve.

“Fatca’s scope is extremely large, which is why the costs will be disproportionate to the expected outcome,” he says.

Additional revenue

During the 2008 campaign, US President Barack Obama predicted the introduction of Fatca would generate $100bn in additional revenue annually. But when the Joint Committee on Taxation investigated these claims, it slashed this projection to a mere extra $870m a year.

In these times of austerity every billion counts, even for a country which is projected to run a $1.6trn deficit in 2011, according to the White House’s Office of Management and Budget. But the billion dollars figure just counts increased tax receipts and not the compliant costs for companies.

And according to Kerry White, managing director, global product management at BNY Mellon Asset Servicing, these costs are significant.

“One would hope that when new rules like FACTA are being designed, there is a concern for the cost of compliance” says White, but instead she feels the rule makers are influenced by populism rather than economic reality.

“For better or worse, these are the kinds of the things that sometimes become popular legislation in the US when people think ‘the rich are getting richer’ or that ‘overseas US investments are escaping the tax code’”, she says.

Moreover she fears Fatca could catch on in other parts of the world.

“When you see such a large number floating out there as potential tax leakage, it makes me think that there’s nothing to stop the EU or any other jurisdiction from bringing in their own type of similar legislation. In this day where many sovereign entities are struggling with their budgets and balance sheets, cracking down on current tax evaders may seem a lot more palatable than raising taxes on other classes,” she says.

Failure to comply

Under Fatca, foreign financial institutions (FFIs) will need to enter into agreements with the US Treasury by June 30 2013. An FFI includes any foreign entity that accepts deposits, holds financial assets on behalf of others, or is engaged in investing or trading in securities.

In order to comply with these agreements, FFIs will need to certify whether or not they have US investors. If they fail to do this, the 30% flat withholding is enforced.

Those that enter an FFI agreement, participating FFIs (PFFIs), are required to find out which – if any – of the accounts maintained by such institution are US accounts, and transmit this information to the Internal Revenue Service (IRS).

If account holders fail to provide the PFFI with the requisite information, or refuse to sign a waiver permitting PFFIs to disclose account information under the statute, PFFIs will be forced to collect the 30% withholding tax on these accounts and eventually close them.

“The plumbing required to achieve that could be quite complicated,” says Richard Hinton, of KPMG's UK Fatca team.

One particularly challenging aspect of the agreement is the monitoring of ‘pass-thru payments’ (see box). Here a PFFI is required to deduct and withhold on any pass-thru payment made to a non-participating account.

It is intended to regulate the flows of US payments and looks at what element of any payment that an asset manager would be making, is related to US investment activity.

Pass-thru payments
The aim is to eliminate the chance that entities can create a screen behind which US taxpayers can sit, and, according to Hinton, the anti-avoidance element of pass-thru payments sits at the core of Fatca.

Box: Pass-thru payments
In April 2011, the US Inland Revenue Service adopted a rule that treats a portion of each payment to a non-participating account as a pass-thru payment subject to withholding. This portion is based on the foreign financial institutions (FFI’s) ‘pass-thru percentage’, which is determined by dividing the PFFI’s US assets by its total assets.

If a PFFI has some US assets, a portion of any payment to a non-participating FFI, or account, will be subject to withholding even if it is not actually paid directly from the participating FFI’s US investments.

Each PFFI will be required to make its pass-thru percentage publically available and a PFFI that does not publish its pass-thru percentage as required will be deemed to have a pass-thru percentage of 100%. 

“If you make a payment to someone within the regime you need to publish the amount of that payment that has US sourced income in it so that the receiving entity can say if it has a customer that it should withhold taxes on. It can go down the distribution chain to the ultimate beneficiary and it creates a contagion effect because the entities end up policing each other. It becomes harder and harder for a tax evader to avoid scrutiny under this regime,” he says.

It introduces a more indirect element to the withholding tax. And as well as including any firm holding US debt and equity, it would also pick up on payments that are US sourced such as rent, royalties, service charges, and commission.

“This has never been part of operations before. The legislation requires that each entity in a chain of payments to look to the next entity to enforce compliance, which means there is going to have to be a lot of transfer of information that has never previously taken place. Plus some of the parameters don’t line up with existing anti-money laundering customer identification procedures, so the process introduces a whole new regime for asset managers,” says Rob Bridson a partner in PricewaterhouseCooper’s (PwC) financial services tax team.

The web of complexity that this creates has been met with confusion among asset managers. Just how this would work in practice and what fund structures are caught by this, is not yet clear.

The IRS does not even have all the answers yet, reflected by the fact that it recently announced that the issue of pass-thru payments would not be decided upon until next year.

“No doubt it is because they are having as much difficulty with this as everyone else,” says Fiona Bantock, of the Brussels’-based lobby group, European Fund and Asset Management Association (Efama).

The distribution problem

Asset managers may be under the cosh but despite by nature being more opaque institutions, hedge funds will not be so challenged by Fatca.

“It is because they have fewer customers to worry about so the total amount of due diligence required is less and they generally know their customers quite well too so they feel they can manage it,” says Hinton at KPMG.

In comparison, the regime poses a real threat to those asset managers that distribute their products through 1000s of independent financial advisors. There are varying degrees of visibility to the underlying beneficiaries which operationally makes implementing the regime hard.

The distribution issue is a huge one for asset managers to tackle, and Loehr at RBC Dexia says it not realistic to believe that the asset management industry will be able to sign up 1000s of intermediaries and make them Fatca compliant.

He says that if it becomes difficult for distributors they may turn to other products or fund managers.

Problems could also arise when firms are forced to stop relationships with non-compliant distributors, as they may be tied into legal agreements.

Nowhere to hide

As Fatca currently stands it has been created in a way that for those who want to have US investors or invest into the US, it is unavoidable.

Bridson at PwC believes it goes too far and includes funds not previously associated with tax evasion.

“Widely held investment vehicles that would not have been a typical tax evasion strategy prior to the regulation will be caught by Fatca. The feeling is these vehicles would never been used for tax evasion historically, so why would you force them to comply with an onerous regime?” he says.

Based on this principle, Efama has lobbied heavily for exemptions for ‘deemed compliant funds’, (see box).

Deemed compliant funds are those where all direct unit holders are participating foreign financial institutions (PFFIs) – defined as those that enter into agreements to withhold as a result of pass-thru payments, deemed compliant FFIs or, broadly, low risk investors. For example, a German mutual fund.

Other exemptions are being sought for ETFs, funds that already exclude US investors, and low risk investors, in particular retirement plans. 

The association argues that protections already in place under existing regulations, such as the exclusion of US investors from UCITS funds, or funds that are unlikely to have US investors, such as a local retirement funds, should warrant an exemption

Along with Efama, White at BNY Mellon does not believe the legislation takes into account regional nuances and pre-existing regulation. For example, the sharing of information across borders is in conflict with some non-US data protection and privacy laws.

As well as conflicting with local laws, in some cases Fatca actually replicates existing tax legislation such as the European Union (EU) Savings directive, which like Fatca, imposes obligations on financial intermediaries requiring paying agents to report information on interest income paid to individual investors to tax authorities.

Duplicate approaches

Rather than duplicating the reporting required under both directives, the European Commission has engaged in discussion with the IRS to consider exploiting possible synergies and expand the scope of the EU Savings Directive, so that both jurisdictions can achieve their common goals in a cost-effective and business friendly way.

White says these issues are evidence that analysis of local conflicts has not gone far enough.

 “It isn’t really written in a global way. When you read between the lines, you realise it is going to hit people globally, not just those that invest in the US and those that want to attract US investors. It’s very sweeping,” she says.

White is concerned that this is a sign that some foreign investors may divest away from US. She says this would be the worst case scenario.

“It’s an extreme scenario but some investors could conceivably exit the US. That would be the worst of all unintended consequence of this legislation. We are concerned about that but I don’t know to what extent writers of the rule may have considered the possibility,” she says

However, while smaller firms may be squeezed out of the US market, this is not an option for the bigger firms that rely on the US market. 

“When you are a big player you cannot ignore the US. You can’t cut yourself out of the market because all the big players will be driven to work with compliant counterparties. There will be top down pressure to be compliant,” says Loehr at RBC Dexia.

And Hinton at KPMG calls it “a license to operate” because any amount of withholding will be too commercially challenging for firms to ignore.

It seems for now, firms have their hands tied by Fatca, but just how much the grip can be loosened, remains to be seen.

Box: Europe fights back

The European Fund and Asset Management Association (Efama), is seeking to minimise the impact of Fatca through identifying so called ‘deemed compliant’ categories for certain types of funds. These funds would be subject to limited or no reporting and no pass-thru withholding obligation at the fund level. 

Efama’s most recent submission to the Inland Revenue Service on 7 October 2011, proposes a model for restricted funds, which would permit distribution via local distributors and simplified compliance distributors (SCDs).

The proposed ‘restricted funds’ category would be relevant for funds which already choose to exclude US persons as investors for US securities law reasons. This would resolve the problem of many distributors being unwilling or unable to enter into a full PFFI agreement by excluding US investment into the fund through contractual commitments agreed to by distributors.

The proposed ‘local distributor’ deemed compliant category would enable distributors that act as FFIs, and present a low risk of attracting US investors through the geographic nature of their business, to be treated as deemed compliant FFIs, provided that they self-certify their status either directly to the IRS or indirectly via the restricted fund or distributor with which they have a direct account relationship.

‘SCDs’ would enable restricted funds to continue to deal with certain distributors which do not qualify as local distributors and are not registered as PFFIs. Such distributors would need to sign up with the IRS and agree to comply with a light touch Fatca compliance regime, which would be broadly similar to that applying to restricted funds.


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