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September 5, 2013

2013-Issue 36Overview of FATCA

Congress enacted the Foreign Account Tax Compliance Act (FATCA) in March 2010 in an attempt to discourage offshore tax evasion. Specifically, FATCA tries to make it easier for the Internal Revenue Service and the Treasury Department to identify income earned by “U.S. persons” in or through foreign entities. To accomplish this goal, FATCA imposes new due diligence and reporting obligations for foreign financial institutions (FFIs), which include foreign hedge funds, private equity funds, blockers and other foreign entities of such funds. Moreover, to ensure participation in the program, FATCA imposes a 30 percent withholding tax on a wide array of payments and gross proceeds that may be derived by such FFIs from the United States and potentially from abroad.

Reporting Requirements and Penalties

As a result of FATCA’s broadly defined terms, both foreign and domestic entities may be subject to the new due diligence and reporting requirements. Notably, an FFI that does not comply with FATCA, or is not otherwise covered by one of its narrow exceptions, is subject to a stiff 30 percent withholding tax on certain U.S.-based payments (“withholdable payments”) or foreign passthru payments that it receives.

Withholdable payments may include U.S.-sourced income, dividends, interest, rent and any other type of payments. A withholdable payment may be subject to withholding under FATCA even if it is otherwise not taxable under other sections of the Internal Revenue Code. For example, gross proceeds from the sale of investments and other property that generates U.S.-source income (i.e. shares, loans, etc.) are subject to FATCA withholding.

After January 1, 2017, FATCA will also apply to payments that are not purely U.S. sourced (“foreign passthru payments”). In the future, the Treasury is expected to issue more guidance on these types of payments, but for now they may include any payment (other than a withholdable payment) if the payment is otherwise attributable to a withholdable payment and made by a participating FFI. Unless future guidance limits the scope of passthru payments, they may capture transactions that are unconnected to U.S.-sourced income.

For example, if a participating foreign bank invests a small amount in U.S. debt and receives some U.S.-source interest income, then that bank may have FATCA withholding obligations on a portion of any payments it makes to its foreign investors, or its foreign lenders, because such payments may be indirectly (even if minimally) attributed to the U.S.-sourced interest income it receives.

FATCA’s Impact on Private Investment Funds

A foreign private investment fund (PIF) will be subject to FATCA unless it is exempt from FATCA or agrees to participate in FATCA by entering into an FFI agreement. The participating FFI (PFFI) must either execute a direct agreement with the IRS to comply with FATCA, or execute an agreement with the government of its country of residence if such country has a FATCA intergovernmental agreement (IGA) with the United States. Under either agreement, a PFFI must still register with the IRS and follow the applicable procedures for due diligence, reporting and withholding.

There are entities that will be exempt from FATCA altogether and others that will be subject to a more relaxed set of rules within FATCA. The exceptions and limitations are complex and will require a careful analysis of all of the facts and circumstances of the PIFs to ascertain which ones, if any, of these exceptions or limitations may apply. Nevertheless, it is unlikely that these exceptions will be applicable to many PIFs.

In general, intra-group financing entities, treasury centers or holding companies that are not part of a financial group may be exempt from the FFI rules and treated as excepted non-financial foreign entities (NFFEs) under FATCA. NFFEs may not have to enter into an agreement with the IRS and comply with the same due diligence and compliance requirements for FFIs.

The Treasury designated certain FFIs as “deemed-compliant FFIs,” which, among other things, allows them to not enter into an FFI agreement, to have reduced due diligence and reporting requirements and, in some cases, not to register with the IRS. Three general types of deemed-compliant FFIs obtain these benefits: (1) registered deemed-compliant FFIs, (2) certified deemed-compliant FFIs and (3) owner documented FFIs. While it is unlikely that many PIFs would fall within these narrow exceptions, there is one type of FFI that may be treated as a certified deemed-compliant FFI and may be useful for PIF groups, known as a sponsored FFI.

Sponsored FFIs are investment entities that will be treated as certified deemed-compliant FFIs if a sponsoring entity that otherwise complies with FATCA agrees to perform the due diligence, withholding and reporting requirements on their behalf. Managers or trustees of PIF groups may become sponsors for those funds that would otherwise qualify as FFIs and have to comply individually with FATCA.

In the case of U.S. PIFs, they will also need to understand and comply with FATCA because they will be withholding agents subject to liability for failure to withhold on payments to foreign persons. To mitigate their risk, U.S. PIFs must follow rules on gathering the necessary documentation and certifications from their foreign payees before making any payments without withholding. Foreign investors and intermediaries should expect increased scrutiny by U.S. payors in the documentation and support provided to show that the foreign payees are FATCA compliant.

When FATCA is fully implemented, PFFIs will be required to report on their U.S. investors. Following a phased increase in the depth of the disclosures, PFFIs must annually identify all U.S. investors, accounts and account balances, and any amounts paid or credited to the account holder. The IRS began accepting FFI agreements on January 1, 2013. Generally, FFIs will need to:

  • Enter into FFI agreements by June 30, 2014, to avoid the FATCA withholding that begins in 2014; and
  • File their first reports by March 31, 2015.

Due Diligence — Documentation of Account Holders

When a PIF enters into a FATCA agreement, the PIF will be required to identify its U.S. accounts and retain documents that certify the account holder’s status. There are different procedures for old and new accounts. For old accounts, a PFFI will need to review all documentation associated with the opening and maintenance of the account to determine whether there is any indication that the account holder is a U.S. person. For new accounts, a PFFI will need to implement new account opening procedures to determine whether the investor is a U.S. person for FATCA purposes. Procedures will need to be in place to monitor the accounts of existing clients to ensure that there is no change in the status of the account holder.

PFFIs will also be required to implement additional procedures depending on the value of the account and depending on whether the investor is an individual or an entity. PFFIs should conduct a complete review of all existing on-boarding, know-your-customer, anti-money-laundering and similar reporting procedures to ascertain their current state of compliance and identify the areas that will need revisions or additions to meet the FATCA regulations. Generally, this will require the participation of a cross-functional team of personnel, including the sales group, legal, tax, information systems and operations.

Update on Countries With Bilateral FATCA Agreements

In February 2012, the Treasury Department and the governments of France, Germany, Italy, Spain and the United Kingdom outlined their intention to explore a reciprocal reporting agreement between themselves and the U.S. to facilitate FATCA compliance. Under an IGA partner agreement, an FFI in a “participating country” would comply with FATCA by reporting to its local government rather than to the IRS. Several countries have signed an IGA with the United States to date, including the U.K., Denmark, Mexico, Switzerland, Ireland, Norway, Germany, Japan, Spain and the Cayman Islands. The U.S. Treasury has announced that it is pursuing agreements with dozens of other countries.

Effective Dates and Deadlines

Although FATCA is generally effective for payments made after December 31, 2012, the IRS issued guidance extending the deadlines of the first requirements to 2014. The following requirements must be done in 2014: FFI agreements must be signed by June 30, 2014, to avoid withholding in 2014. Registration on the FATCA Registration Portal, which has yet to be launched, must occur by April 25, 2014, to be included on the 2014 list of PFFIs.

The following requirements begin on July 1, 2014: new account opening procedures; withholding on U.S.-source FDAP income; and due diligence on certain accounts. The IRS has also extended the first FATCA reporting for FFIs to March 30, 2015, with respect to calendar-year 2014 U.S. accounts.

Following the IRS’s extension of FATCA deadlines, the U.K. similarly delayed reporting requirements under its own information exchange regulations. A six-month extension has been issued on offshore U.K. financial institutions’ duty to disclose information on U.S. investors to the British government.

Practical Example of FATCA

The triggering event for FATCA is the payment of withholdable payments to a foreign entity, regardless of whether such foreign entity has any U.S. investors. Thus, if a foreign fund receives any withholdable payment, it will be required to comply with the requirements described above to avoid the FATCA withholding tax, regardless of whether it has U.S. investors. 

Here, the U.S. investment corporation makes a withholdable payment to a private investment fund (“PIF Cayman”). PIF Cayman may have investors from the U.S. investing through a U.S. feeder, foreign and U.S. tax-exempt investors coming in through a foreign feeder and a group of sponsors or managing partners getting a carried interest through a management vehicle.

What Steps Should the PIF Cayman Fund Managers Take to Prepare For FATCA?

The principal tasks for the managers of PIF Cayman to make a FATCA assessment are:

  1. Determine the category of each entity in the group (i.e. FFIs, NFFEs or exempt entities) and each entity’s obligation to comply with the FATCA due diligence, reporting and withholding rules;
  2. Determine whether the payment from the U.S. investment corporation, or any other payment made by the group, is a withholdable payment under FATCA, including identifying payments that may not be covered by FATCA (i.e. grandfathered or not a withholdable payment);
  3. With respect to those entities that are FFIs, determine the category of FFI (i.e., registered deemed-compliant, certified deemed-compliant, etc.)
  4. Analyze the possibility of qualifying an entity within the group to be a sponsoring FFI on behalf of the FFIs of the group;
  5. Analyze the fund’s current on-boarding processes to determine whether the know-your-customer processes are adequate or if new tasks will be required to comply with FATCA’s due diligence requirements;
  6. The FFIs, or the sponsoring FFI, must enter into an FFI agreement, or if applicable an IGA, to comply with certain requirements, such as:
    a.     Identify its U.S. accounts and comply with verification and due diligence procedures with respect to such accounts;
    b.     Report information on U.S. accounts; and
    c.     Deduct and withhold 30 percent tax on certain payment to account holders or other FFIs that are not in compliance with FATCA.
  7. Register the FFIs by April 25, 2014, and file annual reports identifying U.S. account holders; and
  8. With respect to those entities that are U.S. withholding agents (i.e. the U.S. feeder or the U.S. investment corporation), ensure that procedures are in place to request from the payees the proper certifications and documentation requirements under FATCA to avoid liability for failing to withhold.

Alvarez & Marsal Taxand Says:

Although the FATCA rules have not been finalized and are subject to change as the program evolves, many if not most organizations should act now to assess and plan for what comes next. The following are some of the ways your organization can prepare while regulations are in the works, and ways A&M Taxand can help:

(1) Analyze the fund’s classification under the FATCA rules;

(2) Analyze whether the fund may be deemed to be in receipt of withholdable payments;

(3) Help prepare a valid certification required to be furnished to a withholdable agent;

 (4) Analyze whether a foreign entity may qualify as a withholding agent and assist with compliance requirements;

(5) Review an organization’s IT infrastructure to assess FATCA readiness; and

(6) Assist an organization with overall FATCA compliance.


Juan Carlos Ferrucho
Managing Director, Miami
+1 305 704 6670

Brendan Sinnott, Associate, contributed to this article.

For More Information:

Albert Liguori
Managing Director, New York
+1 212 763 1638


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