Anti-base erosion and profit-shifting regulations could have a significant impact on tax reporting for private equity and venture capital firms. In the U.S., the sector will have to contend with the requirements of the Foreign Account Tax Compliance Act (FATCA). Overseas investments in jurisdictions including China, the Cayman Islands, and the United Kingdom use the Common Reporting Standard (CRS) to provide transparency around foreign financial holdings.
Due to the nature of their business, private equity and venture capital firms may have significant FATCA and CRS reporting requirements. Although the FATCA and the CRS are similar (and in fact, the CRS is based on the FATCA), compliance with one does not equate to compliance with the other. Failure to meet reporting requirements with either the FATCA or the CRS could trigger significant fines, so organizations will want to spend some time with the regulations before filing deadlines to ensure regulators have the information they need. A big update is also coming to FATCA in 2019, so companies will also want to prepare for how those changes could affect their reporting responsibilities.
What is FATCA?
The U.S. uses the FATCA to monitor the financial assets of a U.S. taxpayer held in qualifying Foreign Financial Institutions (FFIs). Both U.S. taxpayers and the qualifying FFIs have FATCA reporting requirements. U.S. taxpayers with a certain threshold of foreign holdings report their foreign-held assets using the FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR). FFIs provide information to the IRS about their U.S. taxpayer accounts and foreign entities with substantial U.S. ownership interest.
An FFI is any foreign entity that accepts deposits in the ordinary course of banking, holds financial assets for the account of others as a substantial portion of its business (such as brokers or custodians), or is engaged primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, or any interest. Holding companies set up to manage investment funds are frequently subject to FATCA, leaving private equity and venture capital firms with the potential for extensive FATCA reporting obligations.
How Does FATCA Work to Prevent Profit Shifting?
FATCA helps eliminate tax evasion by issuing withholding taxes. A U.S. withholding agent will generally withhold 30 percent of a qualifying payment made to an FFI unless the withholding agent is able to treat the FFI as a participating FFI, deemed-compliant FFI, or exempt beneficial owner. Withholding would also apply to a qualifying payment made to a passive non-financial foreign entity (NFFE) that fails to identify its substantial U.S. owners (or certifying that it does not have any substantial U.S. ownership). This withholding tax applies to payments of certain U.S. source income (e.g. dividends, interest, insurance premiums).
How is FATCA Changing?
Starting Jan. 1, 2019, the 30 percent U.S. withholding tax will apply to the gross proceeds from the sale or other disposition of property that can produce the U.S. source income previously described. In the future, this U.S. withholding tax will apply to a foreign pass-through payment made to a recalcitrant account holder or a nonparticipating FFI. As of the date of this publication, the effective date of this withholding tax is uncertain. The FATCA regulations state the withholding tax applies to the later of Dec. 31, 2018, or the date of the Treasury Regulations publishes the definition of foreign pass-through payment.
There is an exception built into the rule change that would exempt certain smaller FFIs and exempt beneficial owners (e.g., government-owned entities, and international organizations) from the withholding tax if they can demonstrate they qualify for the exemption.
How to Prepare for FATCA Changes
FATCA registration will look a little different than years past. In July, the IRS upgraded its FATCA Registration System to include more options for FATCA registration, and assist with some of the periodic certification requirements. Entities will now be able to select from statuses that include:
- Direct reporting non-financial foreign entity
- Participating FFI, including a reporting financial institution under a Model 2 IGA
- Registered deemed-compliant FFI that is a local FFI
- Registered deemed-compliant FFI that is a non-reporting member of a participating FFI group
- Registered deemed-compliant FFI that is a qualified collective investment vehicle
- Registered deemed-compliant FFI that is a qualified credit card issuer or servicer
- Registered deemed-compliant FFI that is a restricted fund
- Reporting financial institution under a Model 1 IGA
- Sponsoring entity of sponsored direct reporting non-financial foreign entity
- Sponsoring entity of sponsored FFIs
- Sponsoring entity of sponsored FFIs, and sponsored direct reporting non-financial foreign entities
- Trustee of trustee-document trust
- U.S. financial institution
Please note, FFIs are required to log on and update their FATCA classification by Dec. 15, 2018.
What Is the CRS and How Is It Different From FATCA?
Developed by the Organisation for Economic Co-Operation and Development (OECD), the CRS creates an exchange for reporting financial information with over 96 participating countries. The CRS has different types of account holder classifications than the FATCA, including individuals, financial institutions, active non-financial entity, and passive nonfinancial entity with controlling persons. Investment funds that primarily invest or manage funds and are located in a CRS participating jurisdiction typically are classified as a financial institution for CRS. However, if the investment fund is located in the U.S., it would be classified either as a passive nonfinancial entity or an investment entity in a jurisdiction that is not a participating jurisdiction and is managed by another financial institution. In this case, information on controlling persons would be required.
How to Comply with the CRS
Private equity and venture capital firms should evaluate the OECD’s website to determine whether they have funds or holding companies in CRS jurisdictions. Any entity in an applicable jurisdiction must self-report information about its accounts, which will then be used to determine whether the account holder is subject to the CRS.
Evaluate Overseas Holdings Carefully
Both the FATCA and the CRS require a significant volume of information gathering and reporting. It is important to perform a legal entity analysis in order to classify all entities in the organization for FATCA and CRS purposes. This analysis will ensure compliance with reporting requirements. A failure to do so may result in potential withholding, interest, and penalties. If your entity determines it has a significant number of funds subject to anti-base erosion regulations, it may want to consider enlisting the help of an experienced tax provider.
For more information about how FATCA and the CRS could affect you, please contact us.
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