FATCA - An uneven playing field

Some say FATCA is a sledgehammer-to-cut-a-nut response to US tax evasion. Many non-US funds will have to comply with it when it comes into force on 1 January 2013, and that includes any European private equity firm that owns businesses with a US presence.. However, the reach of the law ignores the fact that only a minority of investors ever seek to evade tax - and that those that do rarely use foreign private equity as an instrument for doing so.

"One of the big problems for the industry is the fact that FATCA creates different parameters for US funds versus non-US funds. US funds are not subject to the Act, so it therefore creates a bit of unfair competition," points out Sara Clarke, director of UK private equity fund tax services at PricewaterhouseCoopers. "There's been a fair degree of concern in the industry, which is why some people are talking about lobbying the European Commission."

Another major issue for private equity is the way the law requires foreign financial institutions (FFIs) to declare all US investors in their funds to the US Inland Revenue Service (IRS). Should it fail to do so, this individual will be labelled a "recalcitrant account holder" and the IRS will withhold 30% (gross) of any payment travelling to the fund outside the US.

The issues doesn't just become a problem in 2013; the 10 + 1 + 1 lifespan of the majority of GPs, coupled with the effect of the credit crunch, means that many are still nurturing assets within vehicles they launched in the late 1990s. "Some of the guidance information that's been sent out suggests that we should kick out those recalcitrant investors from our funds, but how can you do that?" asks Clarke. "First of all, your partnership agreement doesn't allow you to, so you would be in breach of your own legal parameters, and secondly, how on earth do you get the liquidity to be able to throw them out?"

The impact on US subsidiaries of European portfolio companies has sparked much debate of late. One question to arise is whether FATCA will consider a private equity-backed holding company which owns a US subsidiary as a genuine holdco or as an FFI. "At the moment I don't think we know," admits Clarke, "but in theory it could be classified as an FFI because it's just there to access the capital structure and enable you to do more efficient investment."

Furthermore, unlike with the AIFM Directive, which may offer a lighter touch for venture capital firms, FATCA looks set to affect all VCs to the extent they have US investors in their funds. "If you don't ever invest in the US, then you don't have to pay," adds Clarke. "But there is a feeling that although you may not hold US assets now, if you buy one at some point in the future, it's too late then to try and comply." There are minimal exceptions however - funds do not have to comply for any account holders holding investments of less than $50,000, but this rule is clearly more applicable to insurance companies and banks than PE firms.

The cost of compliance
While the precise nature of the Act is still unknown, complying with FATCA is likely to place a huge administrative burden on GPs. Some believe it will affect the way European outfits structure funds, as they attempt to find a way to segregate their US LPs to avoid reporting on the entire investor population. The process will involve applying to the IRS for a participation number and supplying quarterly reports detailing the name, address and identification number of any US LPs, alongside the value of their interest in one's fund.

In the case of the likes of CVC and Apax Partners, for example, there will be literally hundreds of FFIs which must be identified in this way, which means that preparations are best made as soon as possible. "If you wait until we get the final information to begin putting the systems into place to deal with this, you'll be playing catch-up and you'll drive yourselves mad," warns Clarke. "Our advice for the larger houses is to start looking at the structures you have and identify where your FFIs are. We are hoping to get greater clarity in the autumn so the smaller, mid-market houses should perhaps wait until then."

Amidst all this imminent doom and gloom, it appears time to consider what the best-case scenario would be. For Clarke, the following is imperative: "Absolute clarity as soon as possible, some sensible grandfathering rules, and an acceptance that European PE funds are probably not the target of US tax evaders at all."

As the FATCA ball is already rolling, this could be the best that any of us can hope for.

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