The Importance of Understanding FATCA

The Foreign Accounting Tax Compliance Act ("FATCA") is a 2010 US tax law which has implications for both hedge fund managers and investors. Tax is an area that unfortunately causes many investors eyes to glaze over during the operational due diligence process. The goal of analyzing tax structures during due diligence is not to necessarily develop a formal tax opinion as would be received from an investors tax advisers (i.e. - tax counsel or accountant) but rather to gain a better understanding of whether a hedge fund's 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 classification include an analysis of whether or not a fund may have generated or anticipates generating unrelated business 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 fund manager approaches detailed issues such as tax structuring can provide valuable operational insights into the ways in which it approaches its larger business infrastructure. What is FATCA? FATCA, was formally enacted in March 18, 2010 with the goal of preventing US citizens from tax evasion through hiding income or assets abroad in foreign businesses. FATCA applies to many different types of firms including hedge funds and private equity funds both within the US and international. FATCA technically classifies these non-US fund managers, sometimes referred to as passive foreign investment companies or PFIC in IRS jargon, as so-called Foreign Financial Institutions or FFIs. The US is seeking to work in cooperation with international governments to enforce FATCA. In 2012, the US Treasury and the IRS released a statement alongside France, Italy, Germany, Spain and the US stating as much. The IRS' master plan is to allow non-US fund managers to deal more directly with international tax authorities and then the IRS would step in to collaborate. 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 or periodical 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") with documentation on its investors. Specifically, those investors that have more than $50,000 invested outside of the US. Similar to anti-money laundering documentation, these documents include certain client balances, 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 to inquire now about their fund managers plan to comply with FATCA. The penalties for non-compliance are steep. If a fund manager violates FATCA, they will be penalized by a 30% withholding tax being placed upon the foreign financial institutions US assets or sourced income. This is a materially negative consequence 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, there are privacy concerns raised. For instance a hedge fund may be required under FATCA to make FATCA related disclosures to the Canadian regulators. Under Canadian privacy it is unclear whether such disclosures may be mandated or voluntary in nature. Furthermore, a hedge fund manager which makes such 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 funds approach 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 external accountants and legal counsel to address this issue. Some key questions investors can ask to gauge if a fund 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 fund's 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 maintained During the operational due diligence process investors should take measures to effectively vet the approach their fund managers take to FATCA before the IRS shows up at their door.

Originally posted in the August 2012 edition of Corgentum Consulting's Operational Due Diligence Insights. For More Information

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Corgentum Consulting is a specialist consulting firm which performs operational due diligence reviews of fund managers. The firm works with investors including fund of funds, pensions, endowments, banks ultra-high networth individuals, and family offices to conduct the industry's most comprehensive operational due diligence reviews. Corgentum's work covers all fund strategies globally including hedge funds, private equity, real estate funds, and traditional funds. The firm's sole focus on operational due diligence, veteran experience, innovative original research and fundamental bottom up approach to due diligence allows Corgentum to ensure that the firm's clients avoid unnecessary operational risks.

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