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Challenges in Helping U.S. Curb Tax Evasion

Preventing tax evasion is certainly a noble-and potentially profitable cause-for the U.S. government.

The Internal Revenue Service estimates it could bring in an additional $8.5 billion over the next decade if U.S. citizens living abroad and investing in either U.S. mutual funds or overseas funds pay what it says is their fair share of taxes.

But fund managers won't share the same enthusiasm if they have to comply with new legislation requiring them to track down U.S. investors trying to hide from Uncle Sam's reach.

"They will have to change their subscription documentation, recordkeeping procedures and withholding tax platforms," said Jennifer Sponzilli, a principal at KPMG, who spoke at a recent conference in New York hosted by the National Investment Company Service Association (NICSA).

Time is running out on preparing. The new legislation-called the Foreign Account Tax Compliance Act, or FATCA for short-takes effect Jan. 1, 2013. "Fund managers should create a governance committee of operations, legal, tax and compliance executives to evaluate their level of preparedness and just what they have left to do," Sponzilli said. "They may want to provide comments to the government in hopes of making the final regulations more practical to implement."

Although much of the work to comply with FATCA can be outsourced to service providers, fund managers are still on the hook for any missed withholding. Operations executives at two European investment funds contacted by Money Management Executive estimated they could easily spend more than $1 million to change account opening procedures, customer data repositories and tax withholding platforms, if they do the tax work on their own. That could come to an additional $20 to $50 per investor account.

Financial firms-those defined as a bank, custodian or just about any entity in the business of making investments-must sign an agreement with the IRS to be designated as a "participating foreign financial institution" or PFFI. If they don't, their U.S. withholding agent will have to withhold 30% of any U.S. sourced payment of dividends, interest or gross proceeds made to the fund. If the foreign fund is a PFFI, the U.S withholding agent-typically a prime broker or custodian-will not have to withhold the payment but the PFFI would have to apply the withholding to its investors-both U.S. and non U.S. persons-if it does not have the proper documentation.

Prime brokers, U.S. mutual fund families and hedge funds-of-funds that have foreign investors or enter into certain derivative contracts with non-U.S. persons will have to collect an FFI number assigned by the IRS to that foreign investor or derivative counterparty and verify that number on the IRS' database. Without that verification, a withholding tax of 30% of U.S. sourced payments would apply.

Current U.S. tax laws require that U.S. investors disclose any accounts in foreign assets and report any income to the IRS. But the IRS couldn't really enforce the rules because it didn't have the necessary information. Under previous legislation adopted in 2001, investment funds which won the status of qualified intermediary could categorize foreign investors in U.S. assets depending on their country of residence and deduct the appropriate tax. However, they were never required to reveal the names of U.S. investors or corporations. They were also never required to report non U.S. sourced income paid outside the U.S. by foreign based financial institutions to U.S. individuals.

Maintaining PFFI status won't be easy. The fund manager must agree to disclose the identities of direct and indirect US investors in foreign assets, have a compliance officer sign off on its disclosure and agree to external audits. The manager must also comply with the IRS' guidelines for how it will prove it doesn't have any U.S. investors.

Fund managers will likely need to change their prospectuses to explain that under FATCA they are required to obtain information about all investors. "They will also have to review their account opening procedures to determine how they identify U.S account holders," said Roger Wise, a partner in the Washington office of K&L Gates. "They will also need to ensure that they meet the IRS' rules for determining the identities of both existing and new investors."