Bill Would Have Significant Impact on Private Funds
On July 12, 2011, United States Senator Carl Levin (D – Michigan) introduced the Stop Tax Haven Abuse Act of 2011 (the “Bill”). A prior version of the Bill was introduced in 2009. The Bill contains several provisions of interest to private fund managers, including provisions that:
- Treat foreign corporations whose management and control occur primarily in the United States as U.S. domestic corporations for income tax purposes;
- Clarify under the Foreign Account Tax Compliance Act (“FATCA”) when foreign financial institutions and U.S. persons must report foreign financial accounts to the IRS;
- Treat Credit Default Swap (“CDS”) payments sent offshore from the United States as taxable U.S. source income; and
- Require Anti-Money Laundering (“AML”) programs for hedge funds, private equity funds, and formation agents to ensure screening of offshore clients.
The Bill also authorizes the Treasury Secretary to take special measures against foreign jurisdictions or financial institutions that impeded U.S. tax enforcement as well as imposes additional disclosure requirements on multinational corporations by requiring them to include basic information on a country-by-country basis in their filings with the SEC. Notably, the Bill does not include a controversial proposal in the 2009 bill that specifically identified 34 “Offshore Secrecy Jurisdictions,” including the Cayman Islands and British Virgin Islands.
Foreign Corporations Treated as Domestic Corporations
Section 103 of the Bill prevents companies that are run from the United States from claiming foreign tax status if those foreign corporations
have gross assets of $50 million or more. The provisions indicate that gross assets includes “assets under management for investors, whether held directly or indirectly.” For corporations primarily holding investment assets, the management and control is treated as occurring primarily in the United States if “decisions about how to invest the assets are made in the United States.” These provisions if enacted could potentially eliminate any benefits of establishing offshore funds, which are primarily established for offshore and U.S. tax-exempt investors.
Strengthening FATCA Provisions
The U.S. Foreign Account Tax Compliance Act (“FATCA”) imposes a 30% withholding tax on U.S. persons holding offshore accounts on certain “withholdable payments” to “foreign financial institutions” which do not provide information about their U.S. accounts to the Internal Revenue Service. A “withholdable payment” is generally any U.S. source income, such as interest, dividends, rents, royalties and other fixed or determinable income (“FDAP”). Non-U.S. private funds will generally qualify as foreign financial institutions (“FFI”). In order for an offshore fund to avoid withholding, it must enter into an agreement with the U.S. Treasury to identify its U.S. investors, if there are any.
Section 102 of the Bill would expand the definition of a foreign financial institution to include entities that engage in derivative transactions. Section 102 also creates presumptions of U.S. control for purposes of certain legal proceedings for entities with accounts opened at non-FATCA institutions when those entities are established by or receive assets from U.S. persons.
Treatment of Credit Default Swaps
Existing tax laws allow CDS payments to avoid taxation if sent from the United States to persons offshore, such as an offshore hedge fund or foreign bank. Section 104 of the Bill would treat CDS payments sent offshore from the United States as taxable U.S. source income.
Anti-Money Laundering Programs for Hedge Funds
Sections 203 and 204 of the Bill would impose anti-money laundering requirements on unregistered investment companies, including hedge funds and private equity funds, and formation agents. Hedge funds would be required to establish AML programs; ascertain the identity of investors, including beneficial owners of foreign entities; and submit suspicious activity reports. Agents engaged in the business of forming corporations or other legal entities would also be required to establish AML programs.
The Bill will still need to survive a vote by both the Senate and the House and ultimately be signed by the President before becoming law. There is likely to be some time before this Bill moves forward (especially considering the current focus on the debt ceiling) which means plenty of time for the industry to lobby against this effort. However, the bill highlights the unpopularity of the investment management industry with certain members of Congress and it is no surprise we see proposed taxing provisions- the U.S. needs more tax revenue and investment managers are an easy group to target. We see this every couple of years when various members of Congress propose to increase the carried interest for fund managers. It will be interesting to see how this plays out and we will provide periodic updates on the situation.
Cole-Frieman & Mallon LLP is a law firm which provides advice with respect to domestic and offshore hedge fund operations. Bart Mallon can be reached directly at 415-868-5345; Karl Cole-Frieman can be reached at 415-352-2300.