February 2012

Financial Services

Proposed FATCA regulations affect the asset management industry

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This Alert highlights new rules and key issues affecting the asset management industry arising from the release of the long-anticipated proposed regulations {http://www.irs.gov/ pub/newsroom/reg-121647-10.pdf} on 8 February 2012, under Internal Revenue Code (IRC) Sections 1471 through 1474 (also referred to as the Chapter 4 provisions or Foreign Account Tax Compliance Act (FATCA)), which became part of the IRC under the HIRE Act in 2010. Please see our separate Alert (2012-310 {}) for a more detailed discussion of the regulations.

Background
The FATCA rules, in essence, require that persons making payments after 31 December 2012 of US source fixed, determinable, annual or periodic (FDAP) income, and gross proceeds from the sale of US stocks and debt instruments, to foreign financial institutions (FFIs) must withhold a 30% tax, unless either the FFI enters into an agreement with the IRS (discussed below) to become a participating FFI (PFFI) or the FFI establishes that it is exempt or deemed to be in compliance. These rules can apply to payments by a bank or broker to account holders (and, in certain cases, investors) and payments made by a fund to investors. Any non-US entity that would be called an investment fund, hedge fund, private equity fund, venture capital fund, or the like would most likely be an FFI. The FATCA rules also apply to payments of US-source income to undocumented non-US entities that are not FFIs (non-financial foreign entities, or NFFEs). FATCA rules can affect investment funds in two ways: US investment funds will, as withholding agents, have to either perform FATCA withholding on payments to non-US entities, or document why withholding is not required. Undocumented foreign individuals are subject to withholding as a presumed US person. Non-US investment funds organized to receive withholdable payments will face 30% withholding unless they either become PFFIs (which will require performing due diligence on investors/account holders, reporting to the IRS when required, and performing passthru payment withholding when required) or find other routes to mitigate adverse FATCA compliance issues (e.g., obtaining deemed compliant status).

PFFIs have the following key obligations under the FATCA rules: Perform due diligence on their investors/account holders to determine which of them are US or US-owned. Report to the IRS payments made to certain US or US-owned investors/account holders. Withhold US tax from payments of foreign source income, or, to the extent such payments are allocable to US source income of the PFFI, payments that the PFFI makes to an investor/account holder that either (i) refuses to document its status under these rules or (ii) is an FFI that is not a PFFI and is not otherwise exempt or deemed to be in compliance. This last requirement is known as the passthru payment rule. The Treasury and the IRS issued three prior notices setting forth their current thinking on certain topics. They received very extensive comments, and the proposed regulations provide useful guidance on many but by no means all of the relevant topics to the asset management industry. Ernst & Young observes: The proposed regulations provide some helpful guidance on the definition of deemed compliant FFI, particularly certain qualified collective investment vehicles and restricted funds that may enable certain alternative funds to avoid the need to have to enter into the FFI agreements. The regulations provide for revised future dates on certain withholding obligations and updated information on due diligence requirements. The proposed regulations also address the issue of noncompliant distributors, which is a concern for European funds. When the proposed regulations were released, the United States, France, Germany, Italy, Spain and the United Kingdom issued a joint statement on an intergovernmental approach to improving international tax compliance and implementing FATCA. The joint announcement provides hope that FATCA compliance may be simplified since FFIs established in the above jurisdictions will not be required to enter into a separate FFI agreement with the IRS. However, this agreement raises additional multi-tier compliance issues because local country rather than US reporting and information exchange requirements will be imposed. The new agreement does not absolve non-US funds from FATCA compliance; it just changes the mechanism for reporting the information. I. Classification of alternative investment funds under proposed regulations Consistent with prior guidance, the proposed regulations provide that anything that would be commonly understood to be an investment fund generally will be a financial institution under FATCA because one of the three categories of a financial institution is an entity that is engaged (or holding itself out as being engaged) primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, notional principal contracts, insurance or annuity contracts, or any interest (including a futures or forward

Proposed FACTA regulations affect the asset management industry

contract or option) in such an item. The proposed regulations clarify that the term primarily means that the gross income of the entity attributable to these activities equals or exceeds 50% of the gross income of the entity during the shorter of the three-year period ending on December 31 of the year in which the determination is made, or the period during which the entity has existed. This clarification is relevant in some cases where an entity receives both income from securities (FFI income) and income from portfolio management services (active nonFFI income). II. Timing issues impacting alternative funds Effective dates: If an FFI (e.g., an offshore feeder or master fund, non-US alternative investment vehicle or a non-US mutual fund) wishes to become a PFFI to ensure that FATCA withholding will not apply on any payments made to it, the FFI will have to enter into the agreement (the FFI Agreement) with the IRS and the first effective date for FFI Agreements is 1 July 2013. The form of the FFI Agreement has not been published. Although US-based funds are not required to enter into an agreement with the IRS, these funds, acting as withholding agents, must still begin to look at new, foreign entity accounts differently, starting 1 January 2013. Year-end reporting: The proposed regulations did not delay FATCA reporting by US withholding agents; thus, US payors, such as US funds (i.e., funds organized under US law), will be required to report FATCA payments for calendar year 2013. The proposed regulations provide a phase-in of dates for FATCA reporting by FFIs as follows: For reporting in 2014 and 2015 (on calendar years 2013 and 2014), PFFIs need only report the following information for US accounts (investors): name, address, TIN (taxpayer identification number), account number and account balance or value (in local currency or US dollars). Starting with reporting in 2016 (on calendar year 2015), the income associated with US accounts must also be reported. Starting with reporting in 2017 (on calendar year 2016), full reporting will be required, including information on the gross proceeds from broker transactions. Starting with reporting in 2014 (on calendar year 2013), FFIs must also report the aggregate number and aggregate balance or value of: Recalcitrant individual accounts that have US indicia Recalcitrant individual accounts that do not have US indicia Dormant accounts Year-end reporting is generally required by March 31 of the following calendar year. A special reporting rule is given for calendar year 2013, which allows a PFFI to determine its US accounts and recalcitrant individual accounts on 30 June 2014, and to report on such accounts by

30 September 2014. In effect, from a reporting standpoint, a PFFI is given an additional six months to obtain documentation for calendar year 2013, which should reduce the number of investors subject to FATCA reporting. Withholding obligation: withholding agent (US and non-US entities) Generally, FATCA requires a withholding agent to withhold on payments of fixed, determinable, annual, periodical (FDAP) income and gross proceeds on disposition of securities that could produce US source income unless the withholding agent can reliably associate the payment with documentation on which it is permitted to rely to treat the payment as exempt from withholding. The effective dates for FATCA withholding are as follows: 1. US source FDAP income paid after 31 December 2013 to: New accounts held by non-participating and presumed FFIs a. Presumed FFIs include NFFEs that have not provided appropriate FATCA certifications. Pre-existing accounts held by prima facie FFIs, which are defined as: a. Payees that can be identified as a qualified intermediary or nonqualified intermediary in electronically searchable information, if they have failed to furnish required FATCA certifications, or b. For accounts maintained in the United States, a payee that is presumed or documented as a foreign entity for Chapter 3 purposes, and the withholding agents electronically searchable information contains a NAICS or SIC code indicating that payee is a financial institution. For instance, unit investment trusts, end management investment offices and open-end investment funds would fall within prima facie FFI category. 2. US source FDAP income and gross proceeds paid after 31 December 2014, to non-participating and presumed FFIs. Withholding obligation: PFFI (does not apply to US entities) Generally, a PFFI is required to begin withholding on payments of FDAP income paid to the following investor types starting 1 July 2014 (one year after the first effective date for an FFI Agreement): New accounts (e.g., an investor on-boarded after the effective date of the PFFIs FFI Agreement) for recalcitrant individuals Pre-existing accounts for high value recalcitrant individuals Pre-existing accounts for prima facie FFIs Certain types of pre-existing offshore entity accounts 1 July 2015, is the general effective date for withholding on FDAP income and gross proceeds paid to the remaining types of investors. The proposed regulations reserve on the definition of foreign passthru payments and provide that withholding will not be required on such payments before 1 January 2017. Ernst & Young observes: At first blush, it appears an FFIs withholding timeline is clear; however, the proposed regulations require FFIs to determine when withholding begins by reference to the FFIs due

Proposed FACTA regulations affect the asset management industry

diligence requirements and, in some instances, the definition provision (Prop Reg Section 1.1471-5) alters the withholding timeline (e.g., the definition of a recalcitrant individual for new accounts). Liability for FATCA withholding: As with the Chapter 3 withholding regime, a withholding agent/PFFI who fails to withhold for FATCA purposes, despite knowing or having reason to know that a claim of nonUS status is unreliable or incorrect, will be liable for the tax that should have been withheld, plus interest and penalties. The use of third parties to fulfill FATCA compliance obligations (e.g., transfer agents, fund administrators) will not relieve a withholding agent/PFFI for compliance failures and ultimately under-withheld FATCA taxes. FFI election to be withheld upon: Proposed regulations only allow certain FFIs to use the election to be withheld upon provision: (a) a PFFI who is also a qualified intermediary and (b) a foreign branch of a US financial institution that is a qualified intermediary. Not surprisingly, the proposed regulations provide that a qualified intermediarys election to be withheld on will apply to both FATCA and Chapter 3 withholding and the same rule applies if the qualified intermediary elects to be responsible for withholding. This election may be made to a PFFI or US withholding agent and will be made on Form W-8IMY, Certificate of Foreign Person Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for United States Tax Withholding. Similar to the Chapter 3 rules, the qualified intermediary must attach a withholding statement to Form W-8IMY. The withholding statement provides the information needed to allow the PFFI/US withholding agent to determine the amount to withhold on the qualified intermediarys account holders. III. FFI agreement The FFI Agreement (expected to be released as a model FFI Agreement in an IRS revenue procedure in the summer of 2012) will, among other items, require a PFFI to: 1. Adopt written policies and procedures governing the participating FFIs compliance with its responsibilities under the FFI Agreement. 2. Conduct periodic internal reviews of its compliance (rather than periodic external audits). 3. Periodically provide the IRS with a certification and certain other information that will allow the IRS to determine whether the participating FFI has met its obligations under the FFI Agreement. 4. Obtain waivers when investors local laws would prevent a PFFI from reporting US account holder information as required under the FFI Agreement, or redeem the investors interest. In addition, the FFI Agreement will provide guidelines as to situations where the IRS may enter into a transitional FFI Agreement with an FFI, even if a branch of the FFI or a member of the FFIs expanded affiliated group is unable to comply with terms of the FFI Agreement due to local country laws. Treasury, in conjunction with several foreign governments, has proposed an agreement that would allow an FFI to report US account holder information directly to their home country, thereby no longer requiring these FFIs to enter into an FFI Agreement directly with the IRS. These details have not been finalized.

High and low value accounts: Proposed regulations provide de minimis thresholds for existing individual ($50,000) and entity accounts ($250,000) for which additional diligence and review is not required. The proposed regulations have increased the value of accounts that require a paper- based search from $500,000 to $1 million. However, many alternative investment funds generally require a capital commitment from their investors that is often in excess of $1 million, so this increase will not likely reduce the number of investors requiring a paper-based search. Therefore, in many cases, the enhanced documentation review required for high-value accounts that includes the review of the paper files will still be relevant. Under the proposed regulations, an electronic file search will be required for investors if their net asset value exceeds $1 million at December 31 of the year preceding the effective date of the PFFIs FFI Agreement. The electronic search is limited to the PFFs current master client file as well as other certain specified documents (e.g., limited partnership agreement, AML documents) obtained from investors within the past five years by the PFFI. In addition, if a relationship manager is assigned to an investors account, the PFFI must make an inquiry as to whether the relationship manager has actual knowledge that an investor is a US person. Ernst & Young observes: Further consideration should be given to the application of the concept of the relationship fund manager (originally, this concept was generally aimed to apply to an investment bank relationship) to the activities conducted in a typical alternative investment fund complex. If any of the following information on a high-value individual investor cannot be found through searching electronic files, then a paper search will be required for the missing item(s): (1) the investors nationality, (2) the investors current residence address and mailing address, (3) the investors current telephone number, (4) whether there are any standing instructions to transfer funds in the account to an account at another branch of the PFFI or another financial institution, (5) whether there is a current in care of address or hold mail address, or (6) whether there is a power of attorney or other signatory on the investor account. Some relief is afforded because the proposed regulations reflect a greater reliance on documentation gathered for other purposes. These rules reflect an intention to minimize the circumstances in which PFFIs would need to go back to investors for additional documentation or modify onboarding procedures on a going-forward basis. Ernst & Young observes: Review of the investment fund data should be conducted so that the information is updated for the items indicated above in order to avoid the need for the paper-file searches. Responsible officer due diligence review certification: The FFI Agreement will require the PFFIs responsible officer to make two certifications with respect to their identification procedures for preexisting obligations (e.g., a fund agreement executed prior to the FFI Agreements effective date). If both certifications are not made, then a funds PFFI status will terminate. The first certification needs to be made within one year of the effective date of the FFI Agreement. Under this certification, the responsible officer must certify that the PFFI completed the required due diligence review of the funds pre-existing individual investors that are high-value accounts and to the best of the responsible officers knowledge, the PFFI did not have any formal or informal practices or procedures in place at any time from

Proposed FACTA regulations affect the asset management industry

6 August 2011 (120 days from official publication date of Notice 2011-34) through the date of such certification to assist investors in the avoidance of FATCA. The second certification requires the responsible officer to certify that within two years of the effective date of its FFI Agreement, that the PFFI has completed the account identification procedures and documentation requirements for all pre-existing obligations (entities are included) or, if it has not obtained the documentation required to be obtained from an investor, that the PFFI treats such investor in accordance with the requirements of the FFI Agreement. Note, with respect to the first certification, the IRS has requested comments regarding alternative due diligence or other procedures that should be required for PFFIs that are unable to make the first certification (e.g., the fund did not have any formal or informal policies or procedures that would assist investors in avoiding FATCA). Responsible officer FFI Agreement compliance certification: In lieu of requiring a third party to perform an agreed-upon procedure review as set forth in Chapter 3 for qualified intermediaries, the FFI Agreement will require, among other items, that the PFFI: (i) adopt written policies and procedures governing the PFFIs compliance with its responsibilities under the FFI Agreement; (ii) conduct periodic internal reviews of its compliance; and (iii) periodically provide the IRS with a certification and certain other information that will allow the IRS to determine whether the PFFI has met its obligations under the FFI Agreement. Based on the results of such reviews, a responsible officer of the PFFI will periodically certify to the IRS the PFFIs compliance with its obligations under the FFI Agreement, and may be required to provide certain factual information and to disclose material failures with respect to the PFFIs compliance with any of the requirements of the FFI Agreement. The Treasury Department and the IRS request comments regarding the scope and content of such reviews and the factual information and representations FFIs should be required to include as part of such certifications. The preamble to the proposed regulations states that the IRS intends to set forth the requirements to conduct the periodic reviews and to provide the certifications in the FFI Agreement or in other guidance.

Treatment of affiliated groups: The proposed regulations clarified the affiliated group rules to require that members of the affiliated group are connected through common ownership. Common ownership means more than 50%. These requirements may be satisfied in certain structures (e.g., in a typical master-feeder structure, the offshore corporate fund owns more than 50% of the offshore investment fund that is treated as a partnership for US tax purposes). The testing should be done on a case-by-case basis. However, since the general partner (GP) entity normally owns 1% or less of the various fund vehicles and the management company normally does not hold any equity interest, the GP and management company entities should not be viewed as being part of the affiliated group. Therefore, it may be more challenging to administer FATCA requirements for a group of connected funds because the concept of lead FFI (discussed in the preamble as a point of future guidance), which would serve as the lead contact for FATCA compliance, is not expected to apply in most alternative fund structures. For tiered structures, no guidance was provided on whether the common ownership calculation should be performed from the bottom up or top down, as different results could apply. IV. US funds as withholding agents investor diligence and documentation For purposes of FATCA, generally the payee is the person to whom a payment is made (e.g., the investor who signed the fund agreement), regardless of whether the person receiving the payments is the beneficial owner. However, if the person signing the fund document is an agent or intermediary (other than a qualified intermediary who has assumed withholding responsibility), then the payee is the investor for whom the agent or intermediary collects the payments. A special rule is provided in case a fund, which is a participating FFI (other than a QI that assumed withholding responsibility), receives US source FDAP income as an agent or intermediary. In that case, the payee is the person for whose benefit the payment is collected by the NFFE or participating FFI.

Proposed FACTA regulations affect the asset management industry

Similar to the withholding rules under Chapter 3, a single owner of a disregarded entity is the payee (there are exceptions for payments to non-US branches that have FATCA compliance restrictions, but such exceptions are generally not relevant for alternative investment funds). Many alternative investment funds are structured as partnerships for US tax purposes. As a general rule, the partners, beneficiaries or owners of a flow-through entity are the payees. The proposed regulations, however, provide that the following types of flow-through entities will be treated as the payee for FATCA: (1) an FFI (other than a PFFI receiving US source FDAP income), (2) an active NFFE, (3) an excepted FFI, (4) a withholding foreign partnership or a withholding foreign trust when not acting as intermediary with respect to a payment, and (5) an entity receiving or deemed to receive effectively connected income or receiving gross proceeds from the sale of property that can produce income not treated as a withholdable payment under FATCA. For payments of US source FDAP income made to alternative investment funds structured as partnerships after 31 December 2013 (subject to a transition exception), a US fund (withholding agent) is required to withhold 30% on the entire payment unless the US fund receives a valid withholding certificate (e.g., Form W-8 or W-9). In certain instances, documentary evidence (e.g., organizational document) may be obtained instead of a withholding certificate. Categories of payees To prevent FATCA withholding, the proposed regulation sets forth the various types of documentation a withholding agent may rely on for the following payees:
1. US persons 3. Participating FFIs 5. Registered deemed-compliant FFIs 7. Exempt beneficial owners 9. Excepted FFIs 11. NFFEs 2. Non-US individuals 4. Non-participating FFIs 6. Certified deemed compliant FFIs 8. Owner-documented FFIs 10. Territory financial institutions

V. Payee classifications useful for alternative investment industry Treating funds as deemed-compliant FFIs or as exempt beneficial owners and therefore exempt from FATCA withholding. Both FFIs treated as exempt beneficial owners and as deemed- compliant FFIs are exempt from FATCA withholding.

Proposed FACTA regulations affect the asset management industry

The deemed-compliant FFI categories are: (1) registered deemedcompliant FFIs, (2) certified deemed-compliant FFIs, or (3) ownerdocumented FFIs. Registered deemed-compliant FFI funds need to register with the IRS, but do not need to enter into an FFI agreement. Certified deemed-compliant FFIs do not need to register with the IRS but must provide a withholding agent with specific documentation. Owner-documented FFIs are required to document their status with a designated withholding agent that is either a US financial institution or a participating FFI that agrees to report to the IRS as to any of its direct or indirect owners that are specified US persons. Although there are various types of deemed-compliant FFIs, the types that are particularly relevant to funds are the following: Registered deemed-compliant FFIs Restricted funds: Restricted funds are a type of registered deemed-compliant FFI. A restricted fund must be a regulated investment fund under the law of its country, which must be a Financial Action Task Force (FATF)-compliant country.* The FFI must meet certain requirements, i.e., that fund interests may be sold only by participating FFIs, registered deemed-compliant FFIs, non-registering local banks or restricted distributors. Also, distribution of these interests must take place under distribution agreements that incorporate restrictions ensuring that fund interests cannot be held by US persons, non-participating FFIs or US-owned passive NFFEs with one or more substantial US owners (unless the interests are both distributed by and held through a participating FFI.). Further, the FFI must ensure that each distribution agreement requires the distributor to notify the FFI of a change in the distributors FATCA status within 90 days of the change; and the FFI must certify to the IRS that, as to any distributor that ceases to qualify as a permitted distributor, the FFI will terminate its distribution agreement within 90 days of being notified of the distributors change in status, and will acquire or redeem all debt and equity interests of the FFI issued through that distributor within six months of the distributors change in status. In addition, if the fund was not subject to sufficient restrictions prior to registration, it must identify accounts held by US persons and non-participating FFIs and redeem these accounts or withhold and report. A restricted distributor must, inter alia, be organized and operated in a FATF-compliant country and meet local AML due diligence requirements. It must have a purely local business and have at least 30 unrelated customers which make up at least 50% of its customer base. Its gross revenue and assets under management are subject to size restrictions. Ernst & Young observes: The addition of the restricted funds is responsive to industry comments related to reducing the

compliance burden for retail funds. In particular, the IRS appears to have responded to comments received on the original proposals in Notice 2011-34 and removed the requirement that a restricted fund could not have direct individual investors. Moreover, while the conditions for qualifying as a restricted distributor are narrow and focused on truly local and small operations, the fact that such entities need not register or have a relationship is a welcome development. Nevertheless, there will still be a significant operational burden on funds to ensure that, for example, their distributors meet the conditions to be considered a restricted distributor and to ensure all distribution agreements are appropriately updated. Qualified collective investment vehicles (QCIV): A QCIV is another type of registered deemed- compliant FFI. An entity is a QCIV if all of the following apply: (1) it is an FFI solely because it invests, reinvests and trades in stocks, securities, etc., and is regulated as an investment fund in its country of incorporation or organization; (2) each record holder of direct debt interests over $50,000 or equity interests in the FFI or any other holder of a financial account with the FFI is one of the following: a participating FFI, a registered deemed-compliant FFI, a nonreportable US person or an exempt beneficial owner; and (3) all other FFIs in the expanded affiliated group are either participating FFIs or registered deemed-compliant FFIs. Ernst & Young observes: This may be a very significant exception for alternative funds that are considered to be regulated within the meaning of the proposed regulations. Cayman, Luxembourg and Irish funds are subject to a certain degree of regulation and it will need to be further confirmed whether this regulatory oversight is sufficient for purposes of meeting the definition of the QCIV. If that degree of regulation is sufficient, a typical offshore fund structure that only has US tax exempt and participating FFI institutional investors could qualify for the QCIV status. Chief compliance officer certification for registered deemedcompliant FFIs: A registered deemed-compliant FFI must have its chief compliance officer or an individual of equivalent standing with the FFI certify to the IRS in such a manner as the IRS specifies that all of the requirements for the deemed-compliant category claimed by the FFI have been satisfied as of the date the FFI registers as a deemed-compliant FFI. 2. Certified deemed-compliant FFIs Nonprofit organizations: This category of deemed-compliant FFI is not required to register with the IRS and is referred to as a certified deemed-compliant FFI because it must provide the withholding

* For further information, please visit: http://www.fatf-gafi.org/pages/0,3417,en_32250379_32236992_1_1_1_1_1,00.html

Proposed FACTA regulations affect the asset management industry

agent with specific documentation. This category covers charitable and other similar organizations that are exempt from income tax in their home country, provided that no one has a proprietary interest in the assets of the entity. The exact details of how this provision will apply to some of the larger charity group structures remains to be seen. Retirement funds: This category of deemed-compliant FFI also is not required to register with the IRS and is referred to as a certified deemed-compliant FFI because it must provide the withholding agent with specific documentation. A retirement fund can be within this category if it meets either of two sets of conditions. The first set of conditions requires that the fund must be an FFI that is organized to provide retirement or pension benefits under the law of the country in which it is established and meets certain other requirements, including that: (1) all contributions are from the employer, government or employee and are limited by reference to earned income, (2) no single beneficiary has a right to more than 5% of the FFIs assets and (3) either contributions are deductible or excluded from the beneficiarys gross income or 50% or more of the total contributions to the FFI are from the government or the employer. The second set of conditions requires that the fund: (1) must have fewer than 20 participants, (2) must be sponsored by an employer that is not an FFI or passive NFFE, (3) that the contributions to the FFI be limited by reference to earned income, (4) that non-residents of the FFIs country of organization be entitled to more than 20% of the funds assets and (5) that no nonresident participant in the fund be entitled to receive more than $250,000 of the funds assets. 3. Owner-documented FFIs These FFIs must be categorized as FFIs solely because they are primarily engaged in the business of investing. An ownerdocumented FFI will only be treated as deemed-compliant with respect to payments for which it is not acting as an intermediary

and which are received from withholding agents (designated withholding agents) that have agreed to treat the fund as an owner-documented FFI and to whom the FFI has provided required documentation. Also, the withholding agent must agree to report to the IRS all of the information required with respect to the FFIs direct or indirect owners that are specified US persons. Exempt beneficial owners: FATCA withholding does not apply to withholdable payments (or portions of withholdable payments) made directly, or through intermediaries, to exempt beneficial owners based on valid documentation. No IRS agreement or registration is required. The entity categories that can be exempt beneficial owners are the following: (1) foreign governments, political subdivisions of a foreign government, and wholly owned instrumentalities and agencies of a foreign government; (2) international organizations and wholly owned agencies of an international organization; (3) foreign central banks of issue; (4) governments of US possessions; (5) certain non-US retirement plans; and (6) certain FFIs, e.g., entities primarily engaged in the business of investing, reinvesting, or trading in securities, and wholly owned by one or more of the entities described above. To be treated as exempt, a retirement fund entity must, broadly, be the beneficial owner of payments made to it, established in a country with which the United States has an income tax treaty in force, generally exempt from income taxation in its country of establishment and entitled to treaty benefits under the applicable US treaty. Alternatively, the retirement fund must: (1) be formed for the provision of retirement or pension benefits under the laws of the country in which it is established, (2) receive all of its contributions from government, employer, or employee contributions that are limited by reference to earned income, (3) not have a single beneficiary with a right to more than 5% of the funds assets and (4) be exempt from tax on investment income under the laws of the country in which it is established or in which

Proposed FACTA regulations affect the asset management industry

it operates due to its retirement or pension fund status. Subject to conditions, sovereign wealth funds could qualify as a controlled entity of a foreign government and, therefore, as an exempt beneficial owner under the proposed regulations. Excepted NFFEs include: (1) corporations, the stock of which is regularly traded on one or more established securities markets, (2) corporations that are members of the same expanded affiliated group of regularly traded corporations, (3) entities that are organized or incorporated under the laws of a US possession and are directly or indirectly wholly owned by one or more bona fide residents of the same US possession, (4) foreign governments, international organizations, foreign central banks, governments of US possessions, certain retirement funds and entities wholly owned by exempt beneficial owners (as discussed above), (5) NFFEs if less than 50% of the NFFEs gross income for the preceding calendar year is passive income, or less than 50% of the assets held at any time during the preceding calendar year are assets that produce or are held for the production of passive income (active NFFEs), and (6) excepted FFIs as described above. VI. The effect of the intergovernmental agreement on the fund industry Many alternative investment funds are set up outside of the United States, including various European jurisdictions. As noted above, at the same time the proposed regulations were released, Treasury also released a joint statement {http://www.treasury.gov/press-center/ press-releases/Documents/020712%20Treasury%20IRS%20FATCA%20 Joint%20Statement.pdf } from the US, France, Germany, Italy, Spain and the UK announcing an agreement to explore an intergovernmental approach to FATCA implementation that would allow FFIs in each country to provide the information required under FATCA to that countrys tax authorities rather than to the IRS. Luxembourg and Ireland, which are major centers for the alternative investment industry, are currently not part of this intergovernmental approach, but it is expected that additional countries will join this approach, which may simplify the reporting of customer data under FATCA. Note that the goal of the approach is to simply facilitate the reporting. It will not exempt offshore funds from FATCA compliance. VII. Timing and recommended approaches Although the proposed regulations provide a lot of helpful guidance, many questions still remain unanswered and interpretation and implementation of the FATCA rules will pose significant challenges for the alternative investment industry. Overcoming these challenges requires significant planning. We believe the following are critical steps as part of the initial FATCA assessment process, or to refresh the assessment if one has already been performed, in order to create a target operating model that can be implemented in a staged fashion over the next five years to allow a fund to achieve compliance: 1. Organizational awareness/education: FATCAs enterprise-wide reach requires an assignment of project ownership, people and budgets across business units (technology, operations, tax, legal/compliance, etc.) It is particularly important to increase FATCA awareness throughout the organization and across service lines.

2.

Investor analysis: Review quality and completeness of investorlevel data and categorize investors into appropriate FATCA classifications, which will lead to an additional set of tasks depending on the classification. Legal entity analysis: Assess current and potential legal entity structure and classification (e.g., deemed compliant) of fund entities based on the FATCA categories of payees identified by the proposed regulations. Investment analysis: Identify which investments generate USsourced income, the payor/payee of those investments and the domicile and FATCA status of the payor/payee. On-boarding process review: Review current on-boarding process, including well-controlled Form W-8/W-9 collection and validation procedures, and integration with KYC and AML processes. Although the IRS has indicated that they will rely on a firms existing KYC/AML process for the purposes of investor identification and classification in order to reduce the need to re-engineer processes and systems, there is the expectation that those firms that do rely on existing processes currently have robust controls in place. Meeting these standards could pose a challenge to many firms. The goal should be to have a repeatable process to satisfy internal and IRS review/certification on investors that will be required to begin as early as 1 January 2013. Coordination with administrators and other market participants: Assess the breadth and depth of potential amendments to legal agreements and third-party contracts. Existing contractual relationships are likely to be impacted by FATCA, particularly those that will exist over the implementation dates. Financial institutions should begin to inventory their vendors and vendor contracts and understand the extent FFIs will be able to rely on third-party providers to perform FATCA activities on their behalf.

3.

4.

5.

6.

Asset managers should continue to monitor FATCA and develop a program that includes all impacted areas in the discussion and planning phase. The program should also be flexible enough to meet the due diligence requirements proposed by the regulations. The scope and priorities of asset managers program plans should be adjusted as further guidance is released (e.g., guidance related to passthru payments and the intergovernmental framework).

Proposed FACTA regulations affect the asset management industry

For additional information concerning this Alert, please contact: Ernst & Young LLP, Financial Services Asset Management

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Michael Serota +1 212 773 0378 Jun Li +1 212 773 6522 Maria Murphy +1 202 327 6059 Jim Kickham +1 212 773 7032 Jeffrey Hecht +1 212 773 2339 Dmitri Semenov +1 212 773 2552 Matthew Blum +1 617 585 0340 Ann Fisher +1 617 585 0396

Ernst & Young Assurance | Tax | Transactions | Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 152,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit www.ey.com. Ernst & Young is a leader in serving the global financial services marketplace Nearly 35,000 Ernst & Young financial services professionals around the world provide integrated assurance, tax, transaction and advisory services to our asset management, banking, capital markets and insurance clients. In the Americas, Ernst & Young is the only public accounting organization with a separate business unit dedicated to the financial services marketplace. Created in 2000, the Americas Financial Services Office today includes more than 4,000 professionals at member firms in over 50 locations throughout the US, the Caribbean and Latin America. Ernst & Young professionals in our financial services practices worldwide align with key global industry groups, including Ernst & Youngs Global Asset Management Center, Global Banking & Capital Markets Center, Global Insurance Center and Global Private Equity Center, which act as hubs for sharing industry-focused knowledge on current and emerging trends and regulations in order to help our clients address key issues. Our practitioners span many disciplines and provide a well-rounded understanding of business issues and challenges, as well as integrated services to our clients. With a global presence and industry-focused advice, Ernst & Youngs financial services professionals provide high-quality assurance, tax, transaction and advisory services, including operations, process improvement, risk and technology, to financial services companies worldwide. Its how Ernst & Young makes a difference. 2012 EYGM Limited. All Rights Reserved. EYG No. CK0509
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