Fund managers urged to take more action on tax reporting

Fund managers must adopt a holistic approach towards complying with the multiple tax reporting obligations currently in train, and conduct gap analysis on any potential arbitrages or discrepancies.

Managers have broadly navigated the US Foreign Account Tax Compliance Act (FATCA) successfully. FATCA required foreign financial institutions (FFIs) including fund managers to supply data on US accountholders to the Internal Revenue Service (IRS) directly or indirectly via local tax authorities. FATCA is part of the US Hiring Incentives to Restore Employment Act (HIRE) and is designed to prevent tax avoidance by American citizens.

A failure to comply will result in a 30% withholding tax on all US sourced dividends, payments and interests. As such, any recalcitrant investors could be exited from the fund otherwise the entire fund will be impacted by this withholding tax. The biggest challenge, however, for fund managers was not so much implementing the systems and processes to attain compliance but understanding the myriad of complex rules which FATCA entailed.

However, FATCA is just one piece of the puzzle. The UK government introduced its very own FATCA initiative forcing financial institutions operating in the Crown Dependencies (Guernsey, Jersey, Isle of Man) and Overseas Territories (Anguilla, Bermuda, British Virgin Islands [BVI], Cayman Islands, Gibraltar, Montserrat and the Turks and Caicos Islands) to disclose UK accountholders to Her Majesty’s Revenue and Customs (HMRC).

It also requires UK financial institutions to disclose information on accounts of citizens in the Crown Dependencies and Overseas Territories (CDOT) to their relevant tax authorities. “It is crucial fund managers do not forget to report details of CDOT accountholders. Given the size of these countries relative to the UK, some managers might not have prioritised this obligation,” commented Tim Andrews, director of development at Ipes, a private equity fund administrator.

The most challenging piece of regulation is the Common Reporting Standard (CRS) proposed by the Organisation of Economic Co-operation and Development (OECD) but implemented by signatory countries, of which there are 90 and counting. Dubbed global FATCA or “GATCA”, the CRS obliges signatory countries to exchange information on accountholders in financial institutions. “The operational challenges of the CRS should not be underestimated. It is an enormous undertaking. While there are degrees of overlap between the CRS, US FATCA and UK FATCA, there are subtle differences and nuances which managers need to be aware of,” commented Andrews.

All of these tax rules have different criteria and classifications, which ultimately determines the scope and extent of their reporting. As such, fund managers need to ensure they understand the classifications correctly. “CRS is highly prescriptive and rules-based. This gives firms little flexibility. Meanwhile, FATCA tends to be more principles-based,” said Andrews.

Perhaps the most crucial area for all of these rules is having in place robust client due diligence processes. “Identifying who the clients are and their nationalities is crucial. As we saw with FATCA, the criteria for a US person is quite broad and requires more than just the manager asking to see the investor’s passport. US indicia can include having power of attorney in the US; a US phone number or bank account; a Green Card that has not been fully redacted, and even US parentage. All of this forces fund managers to conduct thorough due diligence. This will be amplified for tax reporting obligations like CRS,” said Mark Stapleton, tax partner at Dechert.

The penalties for non-compliance with GATCA have yet to be finalised. Irrespective, non-compliance with any regulation or tax requirement is nearly always an operational due diligence red flag for institutional investors when analysing prospective fund managers. However, it is crucial that managers carefully assess CRS and how it is implemented in signatory jurisdictions where they have accountholders. There is a huge scope for arbitrage in these rules as different countries adopt multiple approaches towards CRS’ implementation. “Non-compliance is not an option for any financial institution. The reputational and financial consequences of any fall-out from any breach around US and UK FATCA or CRS could be severe,” said Stapleton.

It is important that fund managers adopt a holistic approach towards compliance with all of these three initiatives. Implementing action plans across different business silos could result in error creep and inefficiencies. “Fund managers need to have a coordinated approach to comply with the rules. They need to aggregate the decision making process to ensure that they manage the requirements in a coordinated fashion,” said Stapleton.

Going forward, fund managers will also need to be cognizant of Base Erosion and Profit Shifting (BEPS), another OECD initiative. BEPS comprises of a 15 point action plan. Action 6 is the most concerning for alternative asset managers as it seeks to restrict treaty shopping through its Limitation on Benefits (LOB) provision. This will apply to fund managers which have established treaty eligible business units in tax efficient or offshore jurisdictions.

A number of hedge funds and private equity managers will domicile their funds in tax efficient jurisdictions to attain tax neutrality for clients. If those managers do not have meaningful links, investments or investors in that domicile, they could face accusations of treaty shopping. As such, fund managers have been advised to build up a substantive presence in domiciles to mitigate this risk.

BEPS distinguishes between Collective Investment Vehicles (CIVs) like UCITS and non-CIVs, which are typically offshore hedge funds or private equity funds. There has been no confirmation as to whether AIFMs regulated under the EU’s Alternative Investment Fund Managers Directive (AIFMD) will be deemed non-CIVs or CIVs. CIVs are granted more generous tax terms under BEPs than non-CIVs.