FATCA for Hedge Funds: Eight Common Pitfalls

Sep 1 2015 | 10:56am ET

By Keith Diamond, Director and AML Compliance Officer, Kaufman Rossin Fund Services

For hedge funds in most jurisdictions, the first wave of registration and reporting deadlines surrounding the Foreign Account Tax Compliance Act (FATCA) is now in the rearview mirror, but a significant amount of work likely remains.  Due to the staggered approach regarding the definition of a reportable investor in 2014 versus 2015 and the increasing complexities of future reporting, it’s a great time for investment managers to review where they stand in regards to FATCA compliance.  Additionally, for those launching funds in 2015 and beyond, there are many lessons to be learned from the experience thus far.

FATCA in review: No one-size-fits-all approach

The common structures for hedge funds that allow them to attract U.S.-taxable, U.S.-tax-exempt, and foreign investors (e.g., mini masters, master-feeders, or parallel funds) may create confusion for fund managers trying to understand how FATCA affects each of these vehicles. Unfortunately, there is not a one-size-fits-all FATCA reporting approach because each jurisdiction has its own set of agreements, rules, local registration requirements, reporting framework and deadlines. 

While most fund vehicles are likely affected by FATCA regardless of the jurisdiction, management companies and investment advisor entities typically fall under the “deemed compliant” definition, which exempts these entities (whether formed in the U.S. or abroad) from registration and certain reporting requirements.  

Eight common pitfalls investment managers should try to avoid:

1. Overlooking U.S. domiciled funds

A common misconception for U.S.-domiciled funds is that because there is no IRS registration requirement, there is nothing to be concerned about in regards to FATCA. 

However, some general rules do apply, including performing due diligence to verify that all investors have submitted complete, current tax withholding certificates, and identifying U.S. indicia (and “curing” it if necessary) when an investor declares itself as foreign. In fact, issues identified during this due diligence process may be more onerous on a U.S.-domiciled fund.  

For example, a U.S. fund is required to withhold 30% on certain U.S.-source payments made to foreign entities if it is unable to document such entities for purposes of FATCA.  Fund managers should review their investor records for up-to-date tax forms and take a closer look at any foreign entity investors in regards to verifying their Global Intermediary Identification Number (GIIN)  or conducting indicia searches where applicable.

2. Underestimating technology needs 

Some jurisdictions (including the U.S., Mauritius and Singapore) are requiring data to be transmitted in Extensible Markup Language, or XML.  In addition, the IRS (via IDES) is requiring an Secure Sockets Layer (SSL) certificate signed by a certificate authority.  Both of these transmission requirements warrant some technical know-how.  If you anticipate having reportable investors in these jurisdictions in 2015, understanding the respective jurisdiction’s reporting framework well in advance of any deadline is imperative.  

3. Not incorporating FATCA into an information security program

Data security is one of the hot button topics likely to grow louder in the industry. The data captured and required to be reported to each jurisdiction under FATCA consists of the “personally identifiable information” trifecta of an individual’s name, address and tax identification number (when the reportable investor is an individual).  The Securities and Exchange Commission has been ramping up its oversight of data security under Regulation S-P, and prior to that there were already federal and state regulations requiring organizations to protect this sensitive data with a sound information security program.  

Even if you have already built a robust information security program, you may need to take further steps to incorporate your FATCA program and reporting into these procedures. For example, if in a rush to complete FATCA reporting by the deadline, you use an unsecured system to prepare some of the required reports, you and your investors could be exposed to unnecessary risk.  If you haven’t yet established an information security program, it is advisable to do so, and if you’re outsourcing this work, then checking that the service provider has adequate controls in place is paramount.

4.  Confusing investors with multiple documentation requests

For many investors, there are few things they hate more (aside from poor returns, of course) than having to submit additional documentation – especially documentation that they don’t understand.  Unfortunately, documentation is the nature of FATCA, so it’s critical that funds obtain the requisite documentation right the first time.  Furthermore, it’s important for your staff to be adequately trained regarding FATCA requirements (while also being careful not to render tax advice if they are not qualified or engaged to do so). It may also be helpful to have your fund administrator assist with answering investor questions.  

Because U.S. W-8 series forms were primarily designed with U.S. FATCA in mind, some countries have rolled out additional self-certification forms to better assist with complying with both UK FATCA and US FATCA simultaneously.  Thus, it’s likely a U.S. W-8 form alone will not suffice for some foreign domiciled funds.  For example, if you manage a Cayman domiciled fund, beware of simply asking your investors to complete an updated W-8 form because you may have to sheepishly go back months later to ask them to complete a ”similar, yet different” self-certification form.  

The more you can capture up front in one communication, the better.  This starts with your subscription materials and due diligence requirements, so be sure to work with both U.S. and offshore counsel to have an understanding of the full set of requirements upfront.  This will hopefully lead to new investors entering your fund with all the correct paperwork up front.

5.  Not realizing you also have to deal with UK FATCA

On the offshore front, the key differences from a U.S.-domiciled fund – aside from the required IRS registration – include additional registration with the local jurisdiction (for Model 1 jurisdictions) such as BVI and Cayman) as well as annual reporting.

Additionally, any UK Crown Dependency jurisdiction (including Bermuda, BVI and Cayman) also has the equivalent “UK FATCA” provisions to deal with. This mirrors U.S. FATCA in that you are obligated to report UK reportable investors to the Cayman government (for example) for it to turn around and report them to the U.K. Another similarity is searching for UK indicia when someone declares they are not a UK resident.  Having to go back through all of your records a second time (and hence send second follow-up requests with your investors) is much less attractive then reviewing everything once for both regulations.  

The deadlines for UK FATCA reporting will be enforced in 2016, though the due diligence expectations began in 2014. This is where the aforementioned self-certification form comes into play, which can make the due diligence process more cumbersome and confusing for investors. Thankfully, many jurisdictions have been waiving the requirement for funds to file a “nil report” (when there are no U.S./UK investors to report), but again keep in mind that each jurisdiction is different and is subject to change.

6.  Trying to "go it alone"

Non-compliance can result in serious consequences, and it’s easy to get tripped up over the myriad of rules.  A manager might be able to handle FATCA compliance without service provider assistance in the early stages of a U.S. fund launch with just U.S. family and friends investing.  However the complications and distractions begin to mount quickly with institutional money and offshore investors.

For example, a foreign-domiciled fund that hasn’t registered for a GIIN with the IRS could have issues with banks and brokers. Those issues could be related to opening an account or being hit with the aforementioned 30% withholding. 

It remains to be seen how each jurisdiction will respond to funds that are expected to report but, for whatever reason, do not. Given all of these complex nuances, ongoing changes in many jurisdictions, and risks related to non-compliance, managers may want to lean heavily on their service providers for assistance. FATCA cuts across many service provider lines, including administration, tax and legal, and so managers should leverage them as resources whenever possible.  For example, legal counsel can review the offering documents for relevant disclosures and forms. 

In many cases, the fund’s administrator may be the service provider best positioned to assist with FATCA compliance. The due diligence procedures required under FATCA align closely with traditional subscription processing steps that the administrator would perform, such as collecting required documentation and anti-money laundering checks. Similarly, the reporting aspects will be driven by information collected, calculated and stored electronically by the administrator.  

7.  Believing "everything is outsourced"

Although service providers can assist a fund with FATCA compliance, not everything may be outsourced – including the ultimate responsibility for FATCA reporting. Additionally, even though the administrator may receive subscription documents directly from investors, any additional communications between the advisor and investor could contain U.S. indicia, so it’s important for the investment advisor’s employees to be aware of FATCA and the types of indicia to look for.  

8.  Thinking you’re "done"

As if all of this wasn’t complicated enough, it appears as if things will likely become even more complicated with GATCA, or Global FATCA. 

Over 65 countries have publicly committed to this proposed global standard. While the goal of GATCA is to provide for common reporting and due diligence standards with deadlines beginning in 2016, it could, in theory, require a fund to report each and every investor to the investors’ local jurisdiction.  This means that hedge funds will have to continue trying to navigate the complexities of FATCA, all the while keeping an eye on the not so distant horizon where GATCA, aka Global FATCA, is poised to complicate compliance even further. 

Keith Diamond is a director and AML compliance officer at Kaufman Rossin Fund Services. 

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