Red might be a festive color for the approaching holiday season, except for the red ink many fund management shops are facing in cost overruns complying with the Foreign Account Tax Compliance Act (FATCA), foisted by the US Internal Revenue Services on financial institutions around the world.
With the end-of-year deadline for arranging new budgets coming up fast, it looks like operations, technology, tax, and compliance officers will be visiting their superiors, hat in hand, to get a boost in their FATCA budgets. That is, if they haven’t faced the music already.
Geared to snaring tax evaders for the IRS, FATCA requires foreign financial institutions to report on US account holders that meet the broad regulatory criteria. If financial firms are unwilling to take the draconian step of eliminating or turning away US persons, they must conduct intense due diligence to confirm the identity of the firm’s investors, as well as whether the type of organization is exempt. That means financial firms will have to create FATCA-compliant onboarding policies and procedures for new customers, as well as digging into their records located in multiple repositories in disparate formats or even in paper files and likely requiring additional information from existing account holders.
Despite early awareness that FATCA compliance was going to be expensive — in fact much more expensive to the financial institutions than any amount the IRS could expect to collect, according to some estimates — the reality of the work involved still apparently took many firms by surprise.
Join the Crowd
How many financial firms were off the mark in estimating their FATCA costs. Plenty. A survey of about 300 attendees to a recent webinar conducted by data giant Thomson Reuters found 55 percent admitting they under-budgeted for FATCA. The remainder were either on target or had allocated more than necessary.
So what can these folks expect when they go to the chief financial office or budget-controling executive for more FATCA funding? It depends. One operations executive speaking to FinOps got an easy, albeit unhappy, sign off on the additional budget. Another wasn’t so lucky. After a stern reprimand for the faulty original budget, he got the money. He also got a demand for a detailed explanation of where the original budget had gone and a plan to mitigate future FATCA expenses. There go his holidays.
Just who comprised the 55 percent of under-budgeters at the webinar? Thomson Reuters didn’t break them out by industry sector, but some fund managers suspect that the big fund administrators might have budgeted more realistically for FATCA than they did. The reason: the service providers started hiring and prepping early on to do the work for their fund clients. In addition, they have more of a global reach, which has turned out to be more important than anyone anticipated.
“When FATCA was first discussed we thought that we could ask our fund administrator and custodian to handle the responsibilities, especially repapering the existing accounts,” one global fund management operations specialist tells FinOps. “We didn’t realize how big this was going to become, or how complicated it would get.”
The Cost of Coping
So where did it start to go wrong? For one, the implementation of FATCA was delayed twice until July 2014, which looks on the face of it like a good thing for firms attempting to prepare. In reality, they barely had time to think about the guidance on due diligence released on late 2013, much less have mature, tested policies and practices in place to identify US persons when FATCA went live, explains Laurence Kiddle, managing director for the tax and accounting business of Thomson Reuters.
Making matters more complicated, the US agreed to sign intergovernmental agreements (IGAs) with several dozen other countries, which was intended to ease the reporting burdens. With IGAs, foreign financial firms don’t have to monitor and report US persons to the US Internal Revenue Service, but to their own tax authorities. Granted those governments have plenty of rules in common with the IRS, but financial firms must still understand and complete different forms depending on the market in which they operate. The expense will also grow incrementally depending on the amount of due diligence work required.
“The higher the number of shareholders the higher the costs. Therefore, hedge funds with fewer investors would likely have far lower costs than large global mutual funds,” explains Dermot Mockler, group head of regulatory affairs, compliance and anti-money laundering at TMF Global Fund Services, a global fund administrator in Dublin.
But the rocket driving FATCA costs upward could something no one saw coming — common reporting standards, or CRS. “It’s a game changer,” says Kiddle. The word “common” is misleading. Granted, the type of information and formats for reporting might be standardized and that’s an obvious boon. However, such bilateral CRS agreements have a big kicker for the financial firms. What they’re really about is loading on more countries that want their own errant taxpayers tracked. With the globalization of FATCA, it acquired the new nickname of GATCA.
Were the costs of complying with GATCA already being factored into budgets by the respondents to the Thomson Reuters phone poll? Coincidentally, the poll was conducted the day after the UK announced that bilateral CRS agreements had been signed by 51 nations and another 48 had announced intentions to sign. It is unlikely the firms had time to prepare a cost calculation. It could be that the 55 percent overspent their budgets on complying only with the US FATCA, and the costs and complications of full-blown GATCA have yet to be factored in.
In the meantime, fund managers are wondering who is most likely to be suffering cost overruns. Butler suggests that fund managers who outsource FATCA compliance work to fund administrators are more likely to stay in budget, because they negotiated a preset fee schedule they could afford. Of course, that assumes the fund manager didn’t wait until the last minute to negotiate those fees, when the fund administrator would have had a stronger hand in negotiations. It also assumes that fund administrator was better at anticipating the real costs of FATCA than the fund manager.
One operations manager at a fund management shop tells FinOps that its administrator has increased their fees twice, so far. “We thought the price was set in stone, but apparently it wasn’t,” he said.
Just how much was the difference? The operations manager didn’t cite hard numbers in dollars and cents or euros, but said it was somewhere between ten percent and twenty percent. And that’s just for 2015 alone. It’s likely that the work of researching existing investors will run well into 2016.
FATCA specialists at two fund administration firms contacted by FinOps confirm that they have been forced to tell their fund management clients that they underestimated the fees and need to charge more. They don’t exactly admit they miscalculated the costs. “We told clients that because of the regulatory delay and intergovernmental agreements we would have additional work which was not initially anticipated,” says one fund administration specialist.
Even so, some FATCA specialists are advising fund managers that outsourcing most of their due diligence and reporting work is less expensive than going it alone. The funds that keep all the work in-house will see larger cost overruns, predicts Peter Stafford, director of the FATCA team at DMS Offshore Investment Services, a Cayman Islands-headquartered provider of FATCA compliance services. The reason: additional unanticipated expenses related to adding staff, consulting services for technology selection, auditing and legal interpretations. “If they don’t have the expertise or capacity in-house, they cannot scale up as cost effectively,” says Stafford.
No matter how they feel about the greater FATCA expense than they anticipated, fund management firms have to grin and bear it. The alternative is facing cost-prohibitive penalties from regulators with zero tolerance for errors. And let’s not forget reputational or headline risk.
There is one saving grace for those dealing with under-funding, notes Kiddle from Thomson Reuters. The firms that are smart enough see this as a learning opportunity will use the questions it raises to fine-tune customer onboarding and to monitor policies. Not exactly reason to break out the bubbly, but it may help to control costs in the long run.