By Martin Livingston, Jon Fowler, Tim Frawley, Alasdair Robertson

From MAPLES, 29 November 2013

On 18 March 2010, the Hiring Incentives to Restore Employment Act of 2010 added chapter 4 to Subtitle A (“Chapter 4”) of the US Internal Revenue Code (the “Code”).  The provisions in Chapter 4 are commonly referred to as the Foreign Account Tax Compliance Act (“FATCA”).  US Treasury regulations providing guidance on the due diligence, reporting, and withholding obligations under FATCA were passed and came into effect in January 2013 (the “Regulations”).1

In summary, FATCA requires US withholding agents to withhold tax on certain payments to foreign financial institutions (“FFIs”) that do not agree to report certain information to the US Internal Revenue Service (the “IRS”) regarding their US accounts.  A similar withholding requirement applies on certain payments to non-financial foreign entities (“NFFEs”) that do not provide information on their substantial US owners to the relevant withholding agent.  In both cases, the foreign entity would ordinarily be under no legal obligation to do anything – instead the prospect of being subject to a withholding tax creates a powerful compliance incentive.

All Cayman Islands incorporated funds (whether hedge, private equity or other), fund managers/advisors and fund administrators will likely be affected as FFIs.

US Legislation

To understand the approach being followed in the Cayman Islands, it is helpful first to have a broad understanding of the FATCA regime.

What exactly is an FFI?

An FFI is defined in the Code as any financial institution that is a foreign entity (so a US financial institution is not caught).  For this purpose, the Code goes on to provide that a financial institution is, except to the extent provided by the Secretary of the US Treasury (the “Secretary”), any entity that

(a)     accepts deposits in the ordinary course of a banking or similar business;

(b)     as a substantial portion of its business, holds financial assets for the account of others; or

(c)     is engaged (or holding itself out as being engaged) primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, or any interest in such securities, partnership interests, or commodities.

What happens if you are an FFI?

Section 1471(a) of the Code requires any withholding agent to withhold 30 per cent of any withholdable payment to an FFI that does not meet the requirements of section 1471(b).

An FFI meets the requirements of section 1471(b) if it either: (i) enters into an agreement with the IRS to perform certain obligations (an “FFI agreement”) or, (ii) meets requirements prescribed by the US Treasury and the IRS to be deemed to comply with the requirements of section 1471(b) including pursuant to the terms of an intergovernmental agreement (an “IGA”) (see further below).  An FFI that enters into an FFI agreement is required to identify its US accounts and comply with verification and due diligence procedures prescribed by the Secretary.

For the purposes of the foregoing:

(a)       “US account” is defined as any financial account held by one or more specified US persons or US owned foreign entities, subject to certain exceptions.

(b)       “Withholdable payment” is defined to mean, subject to certain exceptions: (i) any payment of interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income, if such payment is from sources within the US; and (ii) any gross proceeds from the sale or other disposition of any property of a type which can produce interest or dividends from sources within the US.

(c)       “Financial account” means, except as otherwise provided by the Secretary, any depository account, any custodial account, and any equity or debt interest in an FFI, other than interests that are regularly traded on an established securities market.

What is the relevance of being an NFFE?

An NFFE is defined as any foreign entity that is not a financial institution.  Section 1472(a) requires a withholding agent to withhold 30 per cent of any withholdable payment to an NFFE if the payment is beneficially owned by the NFFE or another NFFE, unless certain requirements are met, most notably the provision of information regarding substantial US owners.

Timing of US legislation

Originally, under the Regulations the withholding obligation was due to commence on 1 January 2014.  However, this has since been pushed back to 1 July 2014 (see further below).

Intergovernmental Agreements

Framewor

The US Treasury has developed with foreign governments two model IGAs.  The effect of these agreements is that the key provisions of FATCA will be enacted into local law so as to remove any local legal impediments to FATCA compliance and to streamline the obligations of an FFI in a manner consistent with local law.

As an incentive to countries to take up the IGA option, the model IGAs are structured so as to simplify a number of the obligations that would otherwise apply to FFIs pursuant to the Code and the Regulations and, assuming FFIs comply with such obligations, remove the application of withholding tax.

On 29 November 2013, the Cayman Islands Government signed a model 1 non-reciprocal IGA with the US Treasury (the “Cayman IGA”).  The Cayman IGA requires the Cayman Islands Government to enact laws requiring the identification and reporting of information about US accounts to the standards set out therein.  Unless there is an available exemption, Cayman FFIs subject to the Cayman IGA will be required to identify US accounts and report specified information about those US accounts to the Cayman Islands Tax Information Authority (the “Cayman TIA”).  The Cayman TIA would then pass this information on to the IRS on an automatic basis annually.

Cayman FFIs that comply with the laws implemented pursuant to the Cayman IGA will be treated as satisfying the due diligence and reporting requirements of FATCA.  As such, those FFIs will not need to comply with the Regulations and will instead be ‘deemed compliant’ with the requirements of FATCA as outlined above.  As noted above in “What happens if you are an FFI?”, a deemed compliant FFI will not be subject to withholding tax.

Financial Institutions and Investment Entities

Although the Cayman IGA uses the term ‘Financial Institution’, this is equivalent to the concept of an FFI in the Regulations.  Financial Institution (“FI”) is defined in the Cayman IGA to mean a Custodial Institution, a Depository Institution, an Investment Entity, or a Specified Insurance Company.  In the context of investment funds, it is the Investment Entity that is of specific relevance.

“Investment Entity” is defined in the Cayman IGA as any entity that conducts as a business (or is managed by an entity that conducts as a business) one or more of the following activities or operations for or on behalf of a customer:

(a)       trading in money market instruments (cheques, bills, certificates of deposit, derivatives, etc.); foreign exchange; exchange, interest rate and index instruments; transferable securities; or commodity futures trading;

(b)       individual and collective portfolio management; or

(c)       otherwise investing, administering, or managing funds or money on behalf of other persons.

The definition is intentionally broad2 and catches not only investment funds (whether they may be closed or open ended, hedge or private equity, retail or institutional, or other) but also managers/advisors of funds and administrators of funds.

Types of Financial Institutions

The Cayman IGA categorises FIs as either “Reporting FIs” or “Non-Reporting FIs”.  By default, all FIs are Reporting FIs unless they qualify as Non-Reporting FIs.  The categories of Non-Reporting FI are specified in Annex II to the Cayman IGA.

Non-Reporting FIs

Section IV of Annex II lists those types of Investment Entity that are regarded as Non-Reporting FIs.  The types that are most likely to be relevant are:

(a)       Trusts – a trust established under Cayman law provided the trustee of the trust is, amongst other things, a Reporting FI.  Assuming the trustee is a Cayman based trustee (which will, by default, be a Reporting FI), this category would include all unit trusts formed in Cayman and all trusts where the voting shares of an investment fund are held for charitable purposes.

(b)       Sponsored Investment Entity – an FI that is an Investment Entity formed in Cayman that is not a qualified intermediary, withholding foreign partnership, or withholding foreign trust pursuant to relevant US Treasury Regulations, and where another entity has agreed with the FI to act as a sponsoring entity for it.  The sponsor itself is subject to certain registration, reporting and due diligence requirements in relation to its role as sponsor.  There is a similar category of exemption relating to Sponsored Closely Held Investment Entities.  (There is also a category of sponsored controlled foreign corporation but that is not examined in this article.)

(c)       Investment Advisors and Investment Managers – an Investment Entity established in Cayman that is an FI solely because it (1) renders investment advice to, and acts on behalf of, or (2) manages portfolios for, and acts on behalf of, a customer for the purposes of investing, managing, or administering funds deposited in the name of the customer with an FI other than a Non-Participating FI (as to which see further below).

(d)       Collective Investment Vehicles – certain types of Investment Entity established in Cayman and which are regulated as collective investment vehicles, provided that all of the interests in the collective investment vehicle (including debt interests in excess of $50,000) are held by or through certain categories of person such as other FIs (that have not been designated as Non-Participating FIs).  Investment Entities seeking to take advantage of this category need to follow certain other special rules set out in Annex II.

There are three important consequences of being a Non-Reporting FI.  First, a Non-Reporting FI is not required to identify and gather information on its US Reportable Accounts.  Second, a Non-Reporting FI is a deemed compliant entity and as such not subject to withholding under the Code just like a Reporting FI.  Third, a Non-Reporting FI does not need to register on the IRS FATCA registration website, save for certain Sponsored Investment Entities that may have US Reportable Accounts.  A Non-Reporting FI will however need to provide certification to the relevant withholding agent as to its deemed-compliant status.  It is expected that this will be done using a modified form of the W8 certification.

Reporting FIs

Each Reporting FI is to be regarded as complying with, and not subject to withholding under, the Code if the Cayman TIA complies with its information gathering and reporting obligations under the Cayman IGA, and the relevant Reporting FI satisfies a number of obligations, the most notable of which are:

(a)     Identifying US Reportable Accounts and reporting annually to the Cayman TIA specified information in relation to those US Reportable Accounts; and

(b)     Complying with the applicable registration requirements on the IRS FATCA registration website.

A Reporting FI which fails to comply with paragraph (a) above is not subject to withholding under the relevant provision of the Code unless it is regarded by the IRS as a Non-Participating FI pursuant to the terms of the Cayman IGA.

For each US Reportable Account that it maintains, a Reporting FI which is an Investment Entity is required, amongst other things, to obtain the name, address, and TIN of each Specified US Person that is a holder of such account (subject to the application of look-through provisions), the account number  and certain financial information in relation to the account.

A “US Reportable Account” is any Financial Account maintained by a Reporting FI and held by one or more Specified US Persons or by a non-US entity with one or more “controlling persons” that is a Specified US Person.

For Investment Entities, a “Financial Account” includes any equity or debt interest in the Investment Entity, other than interests that are regularly traded on an established securities market.

A “Specified US Person” is generally defined as a US Person that is not otherwise;

(a)     a corporation listed on an established stock exchange;

(b)     a member of an expanded affiliated group (of the FI);

(c)     a US federal or state agency;

(d)     any tax exempt organisation (entity or other arrangement) under the Code; and

(e)     an entity registered with the Securities and Exchange Commission.

A “US Person” is defined as including;

(a)     A US citizen or resident individual;

(b)     A US partnership or corporation;

(c)     A trust if ;

i.        a US court has jurisdiction over the administration of the trust, and

ii.       one or more US Persons have the authority to control all substantial decisions of the trust.

Finally, the term “controlling person” is to be interpreted in a manner consistent with the Financial Action Task Force Recommendations, which essentially provide that;

(a)     for “legal persons” such as a company, control depends on the ownership structure of the company and may be based on a threshold, e.g. any person owning more than a certain percentage of the company (e.g. 25%); or

(b)     for “legal arrangements” persons exercising ultimate effective control over the trust may include the settlor, the trustee(s), the protector (if any), the beneficiaries or class of beneficiaries, without reference to thresholds.

Annex I of the Cayman IGA also includes certain categories of account that are not treated as US Reportable Accounts, i.e. such accounts do not need to be reviewed, identified or reported.

For Investment Entity purposes they include:

(a)     A pre-existing individual account with less than US$50,000 as of 30 June 2014; and

(b)     A pre-existing entity account with less than US$250,000 as of 30 June 2014.  Further, such pre-existing entity account does not need to be reviewed, identified, or reported as a US Reportable Account until the account balance or value exceeds US$1,000,000.

Non-Participating FIs subject to withholding

Reporting FIs are not subject to withholding tax unless they are designated as Non-Participating FIs.  Under the Cayman IGA, the Secretary can notify the Cayman TIA when it has determined that there is “significant non-compliance”3 with the obligations under the Cayman IGA with respect to a Reporting FI.

The Cayman TIA is then required to take enforcement action under Cayman law to address the non-compliance.  If such enforcement action does not resolve the non-compliance within 18 months then the US Treasury can treat the Reporting FI as a Non-Participating FI.  Non-Participating FIs are subject to withholding tax on relevant payments under the Code.

Delegation and sponsored entities

The Cayman IGA expressly notes that Reporting FIs may use third party service providers (such as the fund administrator or the investment manager) to fulfil their obligations under Cayman law.  Not surprisingly, the obligations remain the responsibility of the Reporting FI notwithstanding the ability to delegate certain functions.

A Reporting FI that is an Investment Entity can also take advantage of the Sponsored Investment Entity regime set out in Annex II.

What if my entity is an NFFE?

For an NFFE to avoid the withholding, it must provide to the withholding agent certain information about any substantial US owners.  As with Non-Reporting FIs, it is understood this will be done via a modified W8 certification.  Compliance with this requirement should not be particularly difficult if the NFFE’s parent entity is an Investment Entity which is a Reporting FI since account due diligence procedures should already have been carried out at that level.  If the parent entity is an Investment Entity which is a Non-Reporting FI then this may necessitate additional due diligence at the parent entity level.

For an entity that is not an Investment Entity nor otherwise an FI, by default it will be an NFFE.  As noted above, most investment funds, investment managers/advisors and administrators will be regarded as FIs but that is not necessarily going to be the case with subsidiary entities of investment funds used, for example, to hold assets for liability management purposes.

Are there any exceptions to withholding on payments to NFFEs?

The Regulations state that, unless subject to an exception, a withholding agent must withhold 30 per cent of any withholdable payment to a payee that is an NFFE unless it has obtained, amongst other things, certification from the NFFE as to its substantial US owners.

A withholding agent is not required to withhold if satisfied the payment is beneficially owned by an ‘excepted NFFE’.  While there are a number of limbs to the definition of excepted NFFE, none are likely to assist where the entity is a subsidiary of an investment fund established for holding an investment asset.

Related Administrative Issues

The register of members of Cayman companies is not a public document nor is the register of limited partnership interests of a Cayman limited partnership.  In addition, it would be unusual for a Cayman company or partnership to include in its articles of association or partnership agreement a power to be able to disclose the identity of shareholders/limited partners to withholding agents (especially unaffiliated third party withholding agents).  In some instances, the investors in a high profile fund might be well known publicly, so disclosure will be less of an issue.  However, in most instances disclosure could well be problematic and at variance with constitutional powers.  While it is expected that breach of confidentiality issues will be addressed through the Cayman enabling legislation, investment funds may need to consider also amendments to their constitutional documents to introduce additional disclosure powers.

For an investment fund that is ultimately designated as a Non-Participating FI there may well be withholding tax consequences.  If this has occurred because of investors refusing to provide the requisite information, the fund may wish to redeem compulsorily that investor or segregate that investor into a “side pocket” while allocating the withholding tax liability to that side pocket.  Investment funds should review their constitutional and other related documents to ensure they reserve this ability.  Equally, investment funds should ensure their constitutional documents allow them the ability to withhold tax on payments made to investors should that become a feature of the local enabling legislation.

Looking Forward

Now that the Cayman IGA has been signed, it will need to be brought into force by both jurisdictions.  In the Cayman Islands, the necessary legislation and related guidance will need to be enacted to hardwire the Cayman IGA regime into local Cayman law.

In July 2013, the IRS published Notice 2013-43 entitled, “Revised Timeline and Other Guidance Regarding the Implementation of FATCA” (the “Notice”).  While previously the withholding obligation would have applied to payments made after 31 December 2013, withholding agents generally now will only be required to begin withholding on withholdable payments made after 30 June 2014.

For Reporting FIs, including sponsors of Cayman based Investment Entities, the next step is to register with the IRS through the FATCA registration website to obtain a global intermediary identification number (“GIIN”).

The portal has been made available for FIs to acquaint themselves with its content, but registrations will not be formally accepted until after 1 January 2014.  Per the Notice, the first IRS FFI list will be published on 2 June 2014 and for Reporting FIs to be on that list they should submit their registration applications by 25 April 2014.  It should also be noted that withholding agents are not required to verify GIINs on payments made prior to 1 January 2015 where the payee is a Model 1 Reporting FI (although a form of W8 certification will still be required).  Consequently, while Reporting FIs can lodge registration applications after 1 January 2014, they also have time beyond 25 April 2014 to do so.

As the Cayman Islands is listed on the US Treasury website it is now treated as a jurisdiction having an IGA in effect.  Notably, an FI resident in a jurisdiction that is treated as having an IGA in effect will be permitted to register on the FATCA registration website as a registered deemed-compliant FFI.

FIs should begin determining whether they have any US Reportable Accounts.  The criteria and exceptions applicable under Annexes I and II of the Cayman IGA should be reviewed closely in relation to both pre-existing and new accounts, i.e. those opened after 1 July 2014.  Annex I also contains a description of the US indicia that would be applied in determining whether a person was a US Person for the purposes of FATCA.

Different approaches are permitted in the review process under Annex I, from using KYC data and electronic searches for pre-existing accounts for lower value accounts (e.g. under US$1,000,000 for pre-existing individual accounts), through to hard copy record searches, in addition to electronic searches for higher value accounts.

MaplesFS

In early 2011, MaplesFS, which provides administration services to a large portfolio of investment funds and structured finance vehicles, commenced an evaluation of the impact of FATCA on its business and its clients.  Systems and processes across all business units and client profiles were reviewed to ensure the requirements of FATCA can be met and continue to be met.

The MaplesFS FATCA team has developed a suite of products over the last two years to assist clients with their FATCA obligations.  Those services include assisting with registrations to obtain GIINs, classification of accountholders and accounts, remediation and validation of Reportable Accounts, implementation of new on-boarding procedures and reporting.

1 The Cayman Islands have signed an inter-governmental agreement with the United Kingdom to implement a UK FATCA style regime and it is expected in due course further FATCA style IGAs will be signed with other countries.  This update focuses only on the FATCA arrangements with the US.

2 The definition states that it shall be interpreted in a manner consistent with the definition of “financial institution” in the Financial Action Task Force Recommendations.  It is not understood how this will be applied in practice.

3 This is not defined in the IGA