FATCA compliance for Chinese offshore investment funds

Since the US Foreign Account Tax Compliance Act (FATCA) took effect on 1 January 2015, the full extent of global compliance with the legislation that is designed to combat offshore tax evasion is becoming clear from some staggering numbers.

A total of 147,044 foreign financial institutions (FFIs) from 225 jurisdictions took the first steps towards FATCA compliance and registered with the US Internal Revenue Service’s (IRS) FATCA FFI registration system by January 1, 2015.

This long list of “deemed compliant” FFIs no doubt includes hundreds of Chinese offshore investment entities operating in jurisdictions such as British Virgin Islands and the Cayman Islands, who have been galvanised to fall in line due to FATCA’s far-reaching nature and the huge risks of non-compliance.

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Rise of global tax compliance

China has agreed in substance to a Model 1 intergovernmental agreement (IGA) with the US regarding FATCA. This IGA means that Chinese financial institutions must report on reportable accounts to the Chinese competent authority annually for exchange of tax information with the IRS every September. Ninety-seven other countries also have either signed a Model 1 IGA or agreed to it in substance. Hong Kong’s Model 2 IGA with the US requires Hong Kong financial institutions to report on reportable accounts directly to the IRS by 31 March each year. China and Hong Kong will continue to be treated as having an IGA in effect, provided they each continue to demonstrate firm resolve to sign the IGA that was agreed in substance.

FATCA has helped to usher in a whole new era of international tax information exchange and has emerged as a catalyst for the G20 and the Organisation for Economic Co-operation and Development (OECD) to develop a new global standard for automatic exchange of financial information in tax matters, commonly referred to as GATCA, or “global FATCA”. Following on just a year from FATCA, GATCA will begin a phased implementation, starting on 1 January 2016.

Notwithstanding lagging behind on FATCA, China is firmly committed to GATCA. China signed the OECD’s multilateral convention on mutual administrative assistance in tax matters on 27 August 2013, and plays a leading role in the Global Forum on Transparency and Exchange of Information.

Offshore investment entities

FATCA and the IGAs classify all non-US investment entities as FFIs. Subject to certain specific exemptions, all FFIs have new international tax compliance obligations regarding their account holders, beneficial owners and controlling persons.

An investment entity is defined very broadly to include any entity – e.g. company, trust or partnership – that is an investment manager and any entity that is professionally managed by an investment manager. Managed investment entities generally have international tax compliance obligations under the IGAs, including registration with the IRS and any local competent authority, customer due diligence, record keeping, reporting and, except in the case of a Model 1 IGA, withholding on US source withholdable payments.

Some familiar examples include British Virgin Islands private equity funds and structured finance special purpose vehicles, Cayman Islands hedge funds, mutual funds and securitisation special purpose vehicles, Irish undertakings for collective investment in transferable securities, and Luxembourg open-ended collective investment schemes known as SICAVs. Less obvious examples would include those investment entities’ holding, trading or portfolio entities that are also professionally managed by the same or different investment managers.

FATCA risks

Investment entities and other FFIs that fail to comply with FATCA and the IGAs face an array of unpleasant consequences. In the short term, these include 30% FATCA withholding on any US source withholdable payment, account closure by US withholding agents or by US and non-US financial institutions such as banks, brokers, custodians, insurance companies, and investment entities. In the medium to longer term, these include regulatory investigation and enforcement action and loss of capital as investors decide to move where their assets and business are safer.

FATCA and/or IGA-enabling regulations may impose criminal sanctions against the investment entity and its directors, general partner or trustee for any non-compliance by the investment entity or its agents such as its responsible officer or administrator.

The IRS issues a unique Global Intermediary Identification Number (GIIN) to each investment entity upon registration. The GIIN must be included on the withholding certificate or self-certification that the investment entity will be required to provide to the US withholding agents and financial institutions with which it transacts business together with supporting due diligence documentation. In addition, these investment entities must establish written international tax compliance arrangements (compliance programmes) setting out the policies, procedures and processes they will follow to satisfy customer due diligence, record keeping, withholding (if any), and reporting obligations.

FATCA responsible officer

The directors or other governing body of the investment entity, or of its general partner or trustee, must appoint a FATCA responsible officer (FRO) whose responsibilities include registering the investment entity with the IRS and controlling its FATCA registration account.

They often delegate primary responsibility for overseeing regulatory compliance to an FRO with relevant specialist knowledge. This may be desirable for risk mitigation, efficiency and containing costs, particularly where the directors personally do not have the interest, capacity or expertise to monitor the administrator’s work and approve or prepare and transmit FATCA-related reports to the relevant competent tax authority. The FRO of an investment entity that has entered into an FFI agreement with the IRS will always have these responsibilities.

And there is more to come. While 2015 may be seen as the year that FATCA well and truly takes root across the globe, FFIs will very soon need to prepare themselves for further compliance requirements when GATCA rolls around in 2016.

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Peter Stafford is a director and technical lead of the tax information services team of DMS Offshore Investment Services. Niaz Khan is an executive director of DMS Offshore Investment Services in Hong Kong