PE and FATCA: Complain but comply

You're an Asia-focused private equity fund. You don't have any US shareholders and you haven't and don't intend to invest in any companies in the US. The US Foreign Account Tax Compliance Act (FATCA) still impacts you, however, as increasing numbers of Asian GPs have begun to realize during the past six months.

In February, the US Internal Revenue Service (IRS) issued a draft of the regulations, which require foreign financial institutions (FFIs) - including most private equity firms - to declare all US investors in their funds to the IRS. Should they fail to do so, they will be labeled a "recalcitrant account holder" and the IRS will withhold 30% of any payment travelling to the fund outside the US, i.e. almost a third of the portfolio company dividends payable to LPs.

Until recently, though, most Asian GPs thought they were beyond FATCA's reach. "The general thought process for Asian investors is: I'm not investing in the US, so what are they going to withhold on?" says Charles Kinsley, tax principal at KPMG China. "In theory that works, but your biggest implication here is whether the FFIs you do your banking through will continue to deal with you if you're not FATCA-compliant."

The risk that non-compliant funds take, therefore, regardless of whether they have US-based investments, is that banks will not be permitted - or decide not to - allow them to be their clients. Similarly, private banks and placement agents might decline to take mandates from GPs looking to raise capital for non-compliant vehicles.

"They don't want to be in a situation where they possibly have to explain to their clients later on why this PE fund is suddenly subject to withholding and why their investors are suddenly getting a reduced return," adds Kinsley. Non-compliance could also conceivably affect participation in - or the pricing of - deals if the buyer or seller requires compliance or sees non-compliance as a potential liability.

Anonymous LPs

Another complication that arises for Asian funds in particular is that they may have US shareholders and not even be aware of it. While most funds that evaluate their LPs rely on a Securities Law definition of a US person, according to FATCA, US persons for tax purposes include those with US passport or a Green Card.

"Especially in Asia, you have all these people who have two passports - in Hong Kong it's almost a fashion to have Hong Kong and something else. So that's going to take people by surprise," points out Karl J. Paulson Egbert, a Hong Kong-based partner at law firm Dechert.

"Even in the deepest, darkest heart of China, there are going to be people that have gone back and forth between China and the US, so if you're soliciting an investment in the middle of China, that could come from a US person for the purposes of FATCA."

Asian GPs may benefit from one small advantage, however. While the 10+1+1 lifespan of the majority of funds - coupled with the effect of the global financial crisis - means that many European and Canadian firms are still nurturing assets within vehicles launched in the 1990s, Asia's relatively younger PE players are generally dealing with a smaller number of LPs, reducing the chances of one of them being recalcitrant. These younger vehicles also boast more modern documentation and closer contact with investors than some of their older counterparts.

Tax havens

On the flip-side, though, Asia appears to be home to a disproportionate number of LPs who want to take advantage of the relatively liberal taxation policies pursued by the likes of Hong Kong and Singapore. Many seek to hold their money in complex offshore structures involving discretionary trusts and offshore companies - and these are the very individuals who could cause difficulties for PE firms when it comes to establishing the true identity of the LPs in their funds.

"The classic example is PRC investors wanting to hold money through British Virgin Islands holding companies," explains Dechert's Egbert. "They do that for a number of reasons, none of which relate to US tax evasion. It might have a lot of do with the PRC's tax system, as you don't really have very clear rules over there about what is taxable and what isn't."

Indeed, getting Chinese high net worth individuals with offshore money to reveal their identity may be especially tough at the present moment, not least due to the fall-out from the scandal involving Bo Xilai, the Communist Party secretary of Chongqing. Last year, Bo's wife, Gu Kailai, allegedly arranged for large sums of money to be moved abroad, using a British businessman as an agent. The two are said to have fallen out and Gu is currently in detention on suspicion of ordering the man's murder.

"The recent high-profile incidents make it fairly high risk if rivals or the state find out you've been hiding money somewhere," says Egbert.

What, though, can PE firms do if their investors refuse to disclose who they are? Most existing fund structures don't have a way of expelling unwanted LPs, which means the withholding tax investors are subject to - for choosing to remain anonymous - becomes a cost for the fund. Other investors may be forced to subsidize this.

Ultimately it will impact the return the GP can generate. Because of this, funds that are currently being raised or structured are now looking for ways to oblige investors to provide thorough information regarding their identity from the get-go. They're also making sure they have the ability to terminate their agreement with the LP, or restructure their investment so that it is channeled through a US vehicle instead.

"For a new fund now, if you're a US person and refuse to allow them to disclose it, they may not take you on as a new investor," says KPMG's Kinsley.

In any case, though, as the situation currently stands, GPs in certain countries are unable to reveal the identity of their LPs due to local secrecy laws. Some jurisdictions have attempted to circumvent these laws by forming co-operation agreements with the US. In February, five European nations - France, Germany, Spain, Italy and the UK - announced that they would work together to try and come up with some kind of government to government solution, while last month the first of the Asian countries became involved, and Japan and Switzerland signed their own separate deals.

Following the agreement, PE firms based in Japan will still need to do all the reporting required under FATCA - but they won't have to pass any LP names directly to the IRS. The IRS will instead request that information from the Japanese tax authorities, who will in turn request them from the PE firm. The benefit of the arrangement to local GPs will be limited. Although it gets around Japan's secrecy laws, local PE firms will still incur the full cost of compliance and will still need to disclose all their shareholders.

Government inertia

Despite Japan's efforts, there's been very little apparent involvement from other governments in Asia Pacific. For Jim Calvin, global tax managing director of the asset management practice at Deloitte, this gives cause for concern. "Countries that do not enter an agreement [with the US] place funds domiciled in those jurisdictions at a competitive disadvantage because the conflicts of law will not be resolved and the funds will likely not be compliant with FATCA," he says.

Given Beijing's privacy laws, this would certainly be the case for China-based GPs, but it is unknown how much progress the nation has made towards intergovernmental co-operation. The sense is that while the Chinese state would be interested in finding out what its nationals are doing in the US, it would not be so keen on sharing such data itself.

The biggest issue for most individual firms right now seems to be the uncertainty. What hasn't helped is the repeated delays in establishing the exact nature of the Act: the so-called FFI Agreement, under which FFIs agree to comply with FATCA reporting requirements, was due to be published in the second quarter but has been delayed; and the final regulations were due out in the summer, but are now expected in the third quarter.

"Even though the government is doing its best to delay the implementation, you're seeing these hybrid approaches of intergovernmental approaches which is making things even more complex," says Remmelt Reigersman, a partner at law firm Morrison & Foerster and a member of the firm's tax department. "If you're a fund, how do you plan for it if you don't know what it's going to look like a year or two from now?"

One course of action GPs should take is to contact the government - specifically the tax administrator, finance ministry or treasury - in the country where their fund is domiciled and in the countries in which they invest, and discuss the potential that these agencies can negotiate an agreement with the US to eliminate any conflicts of law.

As Deloitte's Calvin says, "There may be many variations of these agreements which could, for multi-national institutions, severely complicate compliance. However, for a fund treated as resident in a single country, the agreements are likely to be a favorable development."

SIDEBAR: Joining hands with the IRS

Advisory firms are urging PE clients to try and persuade their governments to enter into FATCA co-operation agreements with the US. The main impetus for striking these deals is to overcome national secrecy laws which prevent firms from revealing the identity of their shareholders to the US Internal Revenue Service (IRS).

"The US government has been pretty tough on the secrecy laws," says Remmelt Reigersman, a partner at Morrison & Forester. "They're not saying: ‘Well in that case, don't worry about it', they're saying: ‘Go to parliament and get your law changed so that it's no longer illegal to give us info about your clients'."

Asian nations might have slightly bigger obstacles to entering into these agreements than some of their European counterparts, however. Hong Kong and Singapore, for example, do not have double taxation treaties with the US, and while that's not a prerequisite for entering into these agreements - as emphasized by several IRS officials last month - it does help establish the framework for them. A bigger hurdle, though, is once again likely to be local secrecy laws. In order for Hong Kong to share tax information, the jurisdiction would need to change domestic law to allow the release of such information to the US.

It is questionable whether this would be a beneficial move from the Hong Kong government's point of view, though, because while it would be required to monitor and enforce the disclosure of US investors in the region, the only thing it would get in return is information about Hong Kong investments in the US. "Given that Hong Kong is unlikely to tax the income on those investments, what's the benefit to Hong Kong?" asks KPMG's Charles Kinsley, who helped a joint FATCA working group write a Hong Kong submission to the IRS earlier this year.

There may however be pressures from a commercial standpoint for the government to entertain the solution for the good of the broader community, Kinsley concedes, meaning that a Hong Kong-US alliance on FATCA might not be such an unlikely circumstance after all.

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