HIRE Act Focuses on Disclosure and Reporting by Foreign Financial Institutions

HIRE Act Focuses on Disclosure and Reporting by Foreign Financial Institutions

H.R. 2847, the Hiring Incentives to Restore Employment Act (HIRE), was signed into law on March 18. This law contains provisions previously included in proposed legislation in the Foreign Account Tax Compliance Act of 2009 (H.R. 3933, S. 1934), known as FATCA.

FATCA

FATCA is intended to create transparency in the international investment community, so that U.S. persons may not escape the tax man by hiding behind foreign entities. To reach that goal, the new law focuses on disclosure and reporting by all "foreign financial institutions" (FFIs) and imposes a 30 percent withholding on most U.S. source payments made to an FFI that is not in compliance with FATCA. The term FFI is defined very broadly and includes not only foreign banks, foreign custodians, and foreign depositories, but also foreign entities primarily engaged in the business of investing, reinvesting or trading in securities, partnership interests, or commodities or any interest in such items. Accordingly, an FFI will generally include hedge funds and private equity funds formed outside the United States. The FATCA rules will not become effective until December 31, 2012, and the IRS is actively working to promulgate guidance with respect to the mechanics for compliance. Fund managers, however, should be aware of the broad reach of these new rules and should stay on top of the forthcoming guidance on this topic.1

Generally, the potential for FATCA's 30 percent withholding applies to any U.S.-source payment of fixed, determinable annual or periodic (FDAP) income, including interest (including portfolio interest and OID), dividends, rents, salaries, wages, premiums, compensations and remunerations, or any gross proceeds from the sale or disposition of property that can produce interest or dividends from U.S. sources (a Withholdable Payment). Effectively connected income is not a Withholdable Payment. In determining whether a payment is a Withholdable Payment, it does not matter whether the payment is for the benefit of a U.S. person. Payments made on obligations outstanding on March 18, 2012 should not be subject to these rules.

Existing law, which has been in place for a long time, imposes a withholding requirement on payments to foreign persons of FDAP, subject to reduction or elimination by treaty. The FATCA withholding greatly expands existing law by creating a withholding obligation on, among other things, gross proceeds from the sale of stock or a debt instrument which is generally not taxable to foreign persons and is not subject to withholding under current law.

FATCA's 30 percent withholding will apply to a Withholdable Payment made to all FFIs unless:

  • the FFI enters into an agreement with the IRS to disclose information regarding substantial U.S. account holders and investors, or
  • the FFI voluntarily agrees to subject itself to the full panoply of the 1099 reporting rules, as if it were a U.S. financial institution, or
  • the FFI does not accept U.S. accounts or investors. Procedures for such exemptions have to be developed.

In determining if an FFI that is a hedge or private equity fund has substantial U.S. account holders, there is no de minimis threshold of ownership. There are, however, certain types of entities that are excluded from the definition. These include, among others, REITs, mutual funds, publicly traded companies, tax-exempt organizations, individual retirement plans, and charitable trusts. Thus, a foreign feeder entity to a private equity or hedge fund (whether treated as a corporation or a partnership for U.S. purposes) may not have any substantial U.S. account holders because only tax-exempts, retirement plans and foreign persons invest through the feeder. Such a foreign feeder would therefore not be required to withhold on Withholdable Payments. A fund that accepts a variety of investors, however, will likely be subject to the withholding regime.

If an FFI with U.S. accounts or investors does not elect to be 1099 compliant, it must agree to report to the IRS the name, address, identification number, account balance or value, and gross receipts and withdrawal activity of the substantial U.S. owner or a U.S.-owned foreign entity as well as to comply with verification and due diligence procedures. Moreover, the FFI must provide additional information with respect to a substantial U.S. owner upon request. Under existing law only information reporting the identity of a payee is required (an appropriate Form W-8) and generally only a pass-through payee must report information with respect to its owners. FATCA adds transparency by requiring a foreign corporation to also identify its owner(s) and adds a significant amount of additional financial information to be reported.

If an FFI is unable to obtain the necessary information either because an owner does not provide, or is prohibited under foreign law from providing, such information (a recalcitrant holder), the FFI must withhold 30 percent on each Withholdable Payment to the recalcitrant holder, or elect to receive its Withholdable Payments subject to 30 percent withholding, or close the account of the recalcitrant holder. It is likely that foreign funds and foreign feeder corporations will require their account holders to certify whether they are U.S. persons or U.S.-owned foreign entities and provide the pertinent information if they are. Accordingly, the disclosure and reporting requirements will affect foreign entities that hold equity or debt, either directly or indirectly, in any foreign entity that has entered into an agreement with the IRS or makes an election to be treated as a U.S. FFI.

Implications: Consider an offshore fund of hedge funds that owns interests in hedge funds treated as foreign corporations for U.S. tax purposes. The fund of funds will not be required to enter into an agreement with the IRS because it will not receive Withholdable Payments. If one of the underlying hedge funds receives a Withholdable Payment and the underlying hedge fund enters into an agreement with IRS, it will be required to withhold on payments to the fund of funds unless the fund of funds provides the requisite information, which will include information on any U.S. person that owns an interest in it. The fund of funds will need to obtain certifications from all of its holders and if any of such holders are investing or trading vehicles, the information requirements continue up the chain.

Disclosure of Foreign Financial Assets

The HIRE Act also includes an additional reporting requirement for U.S. individuals. The U.S. individual will be required to report their interests in foreign financial assets with an aggregate value in excess of $50,000. There is an asset value presumption of greater than $50,000 and an individual must demonstrate that the foreign financial assets have a value of $50,000 or less to rebut the presumption. The term foreign financial assets includes non-publicly traded debt and equity of a foreign financial institution, and therefore includes equity in a foreign private equity fund, foreign hedge fund and foreign investment vehicle. This reporting requirement becomes effective beginning in 2011. This reporting requirement is in addition to reporting requirements under the Foreign Bank and Financial Account Reports (FBARs).

The penalty for failing to comply with the HIRE Act's new reporting requirements in any tax year is $10,000. If the failure to disclose continues for more than 90 days after notice by the IRS, an additional $10,000 penalty will be imposed for each 30-day period after such 90 day period, with a maximum penalty of $50,000.

PFIC Reporting

The HIRE Act has added a requirement that each U.S. shareholder of a passive foreign investment company (PFIC) file an annual report containing any information required by the IRS. The HIRE Act does not provide the information that shareholders are required to report. Pursuant to Notice 2010-34, issued on April 6, 2010, no incremental PFIC annual reporting is required for tax years beginning before March 18, 2010. Thus, this will generally not be effective before 2011 and taxpayers should continue to report on Form 8621, as required pre-HIRE Act. Prior to the HIRE Act, PFIC shareholders were only required to report distributions from, dispositions of an interest in, or certain elections with respect to, a PFIC.

Endnotes

1 Similar rules apply to non-financial foreign entities with certain exceptions included in the HIRE Act and the authority for Treasury to provide additional exceptions.

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This article is republished with permission of Pepper Hamilton, LLP. Further duplication without the permission of Pepper Hamilton, LLP is prohibited. All rights reserved.