Fund Managers and FATCA: Behind the Curve Or Just Being Prudent?

The Foreign Account Tax Compliance Act (FATCA), which aims to help the US Internal Revenue Service catch potential tax evaders outside its radar, has always been viewed as a difficult regulation for financial firms to follow and with key deadlines close at hand some fund managers still apparently overwhelmed.

They are so overwhelmed that they are massively unprepared for the multitude of tasks they must complete, says a new industry study. Those tasks will cost them a lot more than they anticipate and even by the most conservative estimates, fund managers and their sell-side brethren could end up spending far more than the IRS expects to collect in otherwise unpaid taxes. 

Whether or not fund managers — a good chunk of the multi-thousands of firms across the globe which will have to comply with FATCA —  should lose any sleep if they are behind the curve is a matter of debate. Asset servicing and other third-party software providers apparently are burning the midnight oil warning fund managers they aren’t waking up to smell the coffee fast enough, while tax experts say that such concerns are a bit overblown given there is no one-size fits all approach. Fund managers will be affected to different degrees and some might not be impacted at all.

Still, better safe than sorry appears to be a sound modus operandi. “Fund managers are greatly underestimating the complexity of the regulation and my message is don’t wait any longer to get a handle on this,” warns June Oakes, director of regulatory and compliance solutions for the investment manager services division of SEI in Oaks, Pennsylvania which has come out with some alarming statistics on just how poorly fund managers are faring when it comes to preparing for FATCA’s requirements.

Of the 58 C-level executives of fund management firms surveyed around the world, more than a third say they haven’t established a gameplan or have yet to decide the details of how they will handle investor due diligence. They have until July 1 this year to have FATCA-compliant customer onboarding procedures ready for new investors and phased deadlines through June 30, 2016 to complete due diligence on pre-existing accountholders. If they don’t meet these deadlines, they face an automatic 30 percent withholding tax on all US-sourced income.

Nearly half of the respondents to SEI’s survey did not even know about the first deadline — May 5. That’s when foreign financial institutions (FFIs) must register with the IRS to obtain a global intermediary identification number (GIIN) so they can be included in a list the IRS will publish in June. More than two-thirds of the respondents also appear to have seriously underestimated the costs of complying with a series of requirements for FATCA, such as investor due diligence, legal documentation and advice, as well as the costs of relying on a dedicated responsible FATCA officer.

While the IRS wants everyone to pay their fair share of taxes, it has put fund managers, broker-dealers and banks in the unenviable role of enforcement agents. They have to now keep track of assets and income, as well as report and deduct the appropriate taxes for investors in US-sourced income who might be located abroad and until now have managed to skirt the IRS’ long arm.

Saying they don’t have any investors with US-sourced income won’t be enough for FFIs. They have to prove it beyond a reasonable doubt. Meeting the challenge requires changes to operational workflow — particularly when it comes customer onboarding and monitoring. Even before that takes place, they must register with the IRS to obtain identification codes verifying they will meet FATCA’s rules. Making compliance even more challenging is that the IRS has either signed intergovernmental agreements (IGAs) or will sign IGAs with multiple countries allowing financial firms to file any necessary reports with their local tax authorities, rather than the IRS directly. Reporting standards and technical requirements may vary among localities.

Oakes recommends that fund managers hurry to register their offshore entities as foreign financial institutions (FFIs) with the IRS, assess their in-house expertise, craft agreements with relevant service providers who may assist with due diligence and reporting, and develop a comprehensive plan, if they don’t have one already. They must also appoint a FATCA reponsible officer personally responsible for the firm’s compliance with FATCA but simply handing off the task to an existing chief compliance offer may not do, unless the officer has the internal clout to enforce FATCA requirements.  Investment funds –such as those domiciled in the Cayman Islands which has signed a so-called Model One IGA — don’t have to appoint an FCO, per se, but they do  need an authorized person to carry out the registration process with the IRS and comply with local rules.

Although the findings of SEI’s survey– conducted with Cayman Islands-headquartered DMS Offshore Investment Services — sound alarmist, all fund managers don’t need to be terrified they will find themselves in the IRS’ line of fire. It’s no surprise that the dire result of the survey make a business case for the use of services, like those offered by SEI and DMS, to handle investor due diligence and classification, withholding analysis, and reporting for FATCA compliance.

A similar survey conducted earlier by technology giant SunGard and research firm Aite Group revealed that 74 percent of fund managers they interviewed viewed FATCA as their biggest regulatory challenge, putting it ahead of the US Form PF and the European Union’s AIFMD. “Fund managers likely don’t have the same financial and technological resources as some of the larger banks and broker-dealers,” says Ken Hoang, chief executive of Strevus, a San Francisco-based regulatory compliance firm. “They have clearly underestimated the costs of compliance and need to meet a fast learning curve.”

But tax specialists see these concerns as too harsh. Fund managers may have good reason to wait, rather than make hasty decisions. “The decision of whether, when, and how to prepare for FATCA will depend on a fund’s domicile, structure, whether or not it has US-sourced income subject to FATCA withholding, and the profile of its investors,” explains Jay Bakst, a tax partner with the global accounting firm of EisnerAmper in New York.

Different Strokes

Fund managers, whose investors are individuals might be able to accomplish their investors’ FATCA documentation and due diligence far faster than those whose investors are entities, because individual investors do not have to register with the IRS and receive GIINs. Investors which are funds and other investment entities that have common ownership — particularly those with a corporate parent owning more than fifty percent — must be evaluated to determine whether they constitute an expanded affiliated group (EAG), says Bakst. That is because the logistics of the registration process for all entities will be focused accordingly.

Once EAG status is determined, one named entity must be designated as a “lead,” leaving the rest of the entities in the EAG to be registered as “members.” Of course, this analysis and the resulting logistics take time. The managers of the investor and investee funds must coordinate their respective FATCA registration processes. On the other hand, funds that are essentially stand-alone entities would simply register as such and are more likely to be able to move forward quickly.

All fund managers don’t have to meet the May 5th deadline — a recent delay from April 25 — to register as FFIs and obtain GIINs so they appear on the IRS first monthly list of FATCA compliant entities in June. For some fund managers, especially those with no US-sourced income, it will have little significance. Funds domiciled in countries that have signed a Model One IGA with the IRS do not need verifiable GIINs before the end of the year to avoid FATCA withholding tax as long as they make the proper representation to the US withholding agent.

Some fund managers may have been waiting to see if the countries in which they or their subsidiaries are domiciled will sign a Model One IGA, because registering with the IRS to receive a GIIN entails classification in that country as a Model One FFI. With the IRS publishing a list of countries that have agreed in substance to Model One IGAs, as well as those that have formalized the agreements, it is now allowing financial firms in those countries to register as Model One FFIs. They no longer have to delay the registration process until the agreement is signed.

The IRS also deserves some blame for delays in FATCA preparedness. Fund managers have been waiting for the US tax authority to publish a final version of new 8-page form W-8BEN-E with instructions specifically designed for entities and includes information necessary to comply with FATCA. This form is far more complex than its one page predecessor Form W-8BEN, which was used by all foreign persons — individuals and entities — for US tax-related reporting.

Redo Homework

Regardless of just how far along fund managers are in their preparations, for most repapering or remediating information on existing customers — those who invested in their funds before July 2014 — will likely be the most difficult challenge to overcome when it comes to complying with FATCA. Considering how difficult it may be to obtain responses to a new set of questions posed to investors around the globe, experts are advising fund managers to start sooner rather than later to meet the deadlines.

“The task is pretty onerous because they will need to send out brand new W8 forms and add data fields to their customer onboarding applications,” says Mahesh Muthu, associate principal of the financial services unit at eClerx, a financial operations outsourcing firm in New York. “Another factor firms need to consider is the domicile of the ultimate beneficial owner to determine whether IGAs cover the entity, as reporting of information to the IRS in these cases will pass through local tax authorities.”

Bottom line: global fund managers — those located in multiple markets — have to take into account the nuances of both US and foreign requirements. In fact, some fund managers say they are really complying with a global version of FATCA, they have coined GATCA. “The IGAs are really layering on top of FATCA so when fund managers are dealing with thousands of accounts they have hefty data validation work to do,” says Muthu. “Count on client onboarding and investor representative specialists to put in plenty of overtime.”

Hoang recommends that fund managers use an automated outreach approach with investors, at least for first contact. Of course, just sending out letters and emails to investors doesn’t mean they will have all of their responses back in a timely fashion or that new documentation will be completed correctly. “Ultimately, fund managers will have to rely on a combination of electronic documentation delivery, validation and audit trails to verify just who has completed what documentation and who needs to be contacted by customer management teams,” he says. “The 80-20 rule will apply so fund managers need to pay attention to the workflow process.”

They will have to prove to regulators they have done their best to track down investors, identify which are being recalcitrant, and where appropriate, that they are applying the 30 percent withholding tax or terminating the relationship. Many fund managers may be spending millions of dollars on tax withholding-engines, thinking that will guarantee their FATCA compliance. But that should only be their first line of defense. Just as important is establishing a systematic, client-centered communication program, says Hoang.

Whatever their level of FATCA readiness, what is certain is that fund managers can’t just outsource their work to their fund administrators or custodians and forget about it. They have the ultimate responsibility for complying with FATCA, or similar local regulations if applicable. If they do business with so-called US persons, the time to take action is now.