Financial institutions outside the US  will soon feel the weight of the US tax authorities following new proposals to effectively make them shop US citizens in their employment.  The latest step in the US effort to root out US taxpayers evading US taxes by hiding assets abroad saw the US Internal Revenue Service (the IRS) released long-awaited proposed regulations providing guidance on the implementation of the Foreign Account Tax Compliance Act  (FATCA)  in February.  The rules are extremely broad in scope and have far-reaching implications for financial institutions and entities, including for non-US private funds.

Report or Else

FATCA is, at heart, an information reporting regime that uses a 30 per cent withholding tax as its enforcement tool.  In general, under  FATCA, foreign financial institutions (FFIs) will be subject to a 30 per cent withholding tax unless they have entered into an agreement with the IRS (an FFI Agreement) in which they promise to identify their US account holders and to periodically report to the IRS information about these accounts. 
The withholding tax generally applies to payments of certain US source income or gross proceeds from the disposition of investments in US debt or stock (withholdable payments) and so-called “foreign passthru payments” (in essence, payments that are not themselves withholdable payments but are considered “attributable” to withholdable payments).
Under the FFI Agreement, participating FFIs must also agree to withhold and to pay to the IRS a 30 per cent withholding tax on withholdable payments and foreign passthru payments made to other FFIs that have not entered into their own FFI Agreements, as well as to “recalcitrant” accountholders (generally accountholders that fail to comply with information requests).

Non-US Funds Beware

FATCA generally treats non-US private funds (including private equity and hedge funds) as FFIs.  Non-US private funds, even those with minimal connections with the United States, will need to consider compliance with FATCA because (i) they may receive withholdable payments, (ii) the foreign passthru payment rules, once elaborated in future guidance, may subject the funds to additional tax and (iii) the funds may find that that their counterparties in transactions require FATCA compliance (for example because the counterparties are themselves complying with FATCA).
As a practical matter, private funds will need to liaise with their investors to obtain information they need to comply with their FFI Agreements.  Some non-US private funds have started to include specific provisions in their operative documents requiring investors to provide information and to comply with FATCA.

Proposed Regulations

The nearly 400 pages of proposed regulations, while not final, provide the most complete guidance to date on how the IRS interprets FATCA, and provide some relief and clarity in the context of implementing a complex compliance regime, including the following items of particular relevance to non-US private funds:
1. Deferral of the Effective Date for Withholding.  Consistent with prior guidance, the proposed regulations defer the effective date for FATCA withholding on US source income until January 1, 2014 and for gross proceeds withholding until January 1, 2015.  However, to be in compliance with FATCA when the withholding regime goes into effect for US source income on January 1, 2014, non-US private funds that invest in the United States will need to enter into FFI Agreements by July 1, 2013.  The proposed regulations defer the effective date for FATCA withholding by participating FFIs on foreign passthru payments until January 1, 2017.  As a result, foreign funds that do not intend to invest in the United States may be able to defer entering into an FFI Agreement.
2. Due Diligence Requirements to Verify Compliance.  The proposed regulations provide greater clarity on the due diligence and verification procedures that will be required under an FFI Agreement in order to come into compliance with FATCA.  Additionally, under the proposed regulations, responsible officers of FFIs that have entered into FFI Agreements will be required periodically to certify that the FFI is in compliance with its agreement.
3. Phase-in of Information Reporting.  The proposed regulations set a new timeline for when different types of information reporting will begin to be required of FFIs.  In 2014 and 2015, FFIs’ reporting obligations will be limited to certain identifying information with respect to their US investors (for calendar years 2013 and 2014).  Beginning in 2016, the reporting obligations will be expanded to include income paid with respect to US investors.  Beginning in 2017, full FATCA reporting will be required.
4. Additional Categories of Exempted and Deemed Compliant FFIs. The proposed regulations expand the types of FFIs that are exempt from FATCA withholding.  Fund investors that may be exempt from FATCA withholding because of their status include, among others, foreign governments and their wholly-owned agencies, certain international organizations, certain foreign retirement and pension plans and foreign charitable organizations.

Intergovernmental Approach

The United States has also announced that it has agreed to explore entering into bilateral agreements with France, Germany, Italy, Spain and the United Kingdom to provide for the reciprocal automatic exchange of information on financial accounts.  Under these agreements, FFIs in these countries would generally not be required to enter into individual agreements with the IRS.  Instead, these FFIs would provide the information required to these governments which in turn would transfer the information to the United States. We understand that the US Treasury is also discussing reciprocal arrangements with other foreign countries.  While an FFI may prefer to deal with its home country authority rather than the IRS, it is not clear that any home country FATCA rules that are developed will be less onerous or complex.

Matthew Saronson is a partner at US law firm Debevoise & Plimpton