Tough new US legislation which imposes stringent compliance requirements on foreign financial service providers is set to have a significant impact on investment funds.
The relevant legislation is the Foreign Account Tax Compliance Act (FATCA) which, principally targets offshore structures being used to avoid US tax.
Werksmans Attorneys director Shayne Krige warns that if, as anticipated, the law is implemented in its current form, it will have far-reaching consequences for South African financial service providers, including investment funds.
Krige, who has represented investment funds, fund managers and investors and has helped various clients to establish international funds, notes that the impact of the Act – certain provisions of which are due to come into force next year – goes well beyond tax issues. In fact, he says that it will affect compliance, internal controls, IT systems, service provider relations and even customer operations.
In general terms, the US cannot enforce its laws in foreign countries. In an attempt to coax information about foreign structures from foreign financial institutions (FFIs), FATCA requires that the FFIs enter into an agreement with the American Internal Revenue Service (IRS) or risk the imposition of a 30% withholding tax. The Act also requires US financial institutions to close the accounts of any uncooperative FFIs. This ultimately means exclusion from the US securities market.
Explains Krige: “The definition of an FFI under the Act is extremely broad and includes banks, trust companies, custodians and any entity involved in investing, re-investing or trading in securities, partnerships or commodities”.
FATCA could therefore impact South African investment funds directly. Investment funds, as FFIs, would be “invited” to enter into an agreement with the IRS, through which they would institute procedures to identify US customers and report their investments to the IRS. The fund would have to identify all interests in the fund held directly or indirectly by US persons.
“Most funds, as a minimum measure, will have to go back to their investors to find out whether any of them are holding as nominees or intermediaries for US persons,” says Krige.
Compounding the issue is that FATCAs record-keeping and reporting requirements are potentially burdensome and costly. Funds are required to supply the IRS with certain information about US investors annually and compliance with the US standards will mean changes to administration and IT systems if not duplicate systems being put in place.
“Many South African businesses are still grappling with multiple corporate record-keeping systems as a result of inconsistencies between the Income Tax Act and new Companies Act. The addition of another record keeping layer will exacerbate the problems affected South African funds and their administrators face,” says Krige.
This is one of a number of challenges facing investment funds. FATCA obliges them to obtain a waiver from each investor so that they can report the required data to the IRS. This applies not only to US persons, but to every investor in the fund. If an investor refuses to allow the fund to report information about it to the IRS – even if the investor is not a US person – the fund must close the account, i.e. forcibly redeem the investor.
Because of confidentiality agreements between South African investment funds and their clients, not to mention compliance obligations placed on institutions and companies by the new Companies Act and Consumer Protection Act (CPA) (with data protection legislation also in the pipeline), the circumstances in which funds will be able to disclose such information to the IRS may be limited, suggests Krige.
The forcible redemption of investors is itself a prickly issue. The CPA, for example, contains a prohibition on “unfair and unjust terms”. Therefore terms that allow the fund to terminate the investment in these circumstances may well breach the CPA, he points out.
Penalties for non-cooperation with FATCA are onerous. Any FFI that does not sign an agreement with the IRS will be subjected to the 30% withholding tax on payments from US payers. This is not limited to US revenue only, but is payable on any payment routed via a US payer – irrespective of the original provenance of the payment. However, if an FFI signs an agreement with the IRS but specific investors refuse to provide information, the withholding will only apply to payments on behalf of non-compliant investors.