Much ink has been spilt of late over a United States (“US”) federal law called the Foreign Account Tax Compliance Act (“FATCA”) and hence we thought it fit to spend some time trying to analyse for the readers the aspects which may affect them. FATCA is a part of the US’ Internal Revenue Code, and is aimed at combating tax evasion by comprehensively collecting information about US taxpayers’ offshore interests and assets. Put very simply, FATCA forces non-US entities in which US taxpayers have interests or assets to report details of these interests or assets to the Internal Revenue Service (“IRS”; the US tax department). Here it is pertinent to note that, amongst all developed countries, the US is the only country that levies tax on the entire income of its taxpayers, whether made in the US or overseas; this is known as ‘worldwide’ taxation.

The stick employed by FATCA is a withholding tax regime that, as one commentator puts it is “designed to have such a significant impact on the [non-compliant entity’s] business…that non-compliance would result in its isolation from the global financial markets”. Given FATCA’s enormous extra-territorial reach, the US has been working with countries around the world to help it implement the legislation.

The Central Government and the Central Board of Direct Taxes (“CBDT”) have, vide Notification No.62, dated 7th August, 2015, inserted certain provisions (“FATCA Rules” or “Rules”) into the Income Tax Rules, 1962 (“ITR”). These Rules give effect to FATCA by imposing reporting requirements on certain Indian entities. Towards this end, certain amendments have also been made to the Income Tax Act, 1961.

This article aims to examine the impact of the FATCA Rules on domestic funds, and will proceed in three parts by: (I) describing their background & design, (II) looking into the conditions for its applicability, and (III) providing an overview of the compliances required under it.

I. Background & Design

The US implements FATCA by, inter alia, entering into ‘intergovernmental agreements’ (“IGAs”) with other countries (“Signatory Countries”). Under an IGA, a Signatory Country is required to put in place rules (“Local FATCA Rules”) that make it mandatory for its resident entities to report the details of the US persons who hold interests in such resident entities to the local tax authorities, and the information thus collected needs to be passed on to the IRS by the local tax authorities. If an entity in a Signatory Country complies with the Local FATCA Rules, then it is deemed to be compliant with FATCA itself.

The rationale for entering into IGAs to accomplish FATCA’s aims is two-fold, and turns on the introduction of FATCA reporting obligations into a Signatory Country’s domestic law vide the Local FATCA Rules: First, IGAs obviate the need for entities in a Signatory Country to report directly to the IRS; entities in Signatory Countries need only report to the local tax authorities, thereby reducing the compliance burden on them. Second, by the same token, entities in a Signatory Country can report the details of US persons holding interests in them to the local tax authorities without fear of violating data protection & privacy laws that may have otherwise prevented them from making such reportings to the IRS.

India executed an IGA with the US (“US FATCA”) on 9th July, 2015, pursuant to which the CBDT has inserted the FATCA Rules into the ITR, effectively importing FATCA compliances into Indian law. As indicated above, under the US FATCA, an entity that is in compliance with the FATCA Rules is deemed to be in compliance with FATCA itself.

The cornerstone of the FATCA Rules is the definition of a ‘financial institution’ (“FI”) and the enquiry of whether an Indian entity in question falls within the four walls of the definition. Another important definition to keep in the forefront while studying the FATCA regime is the definition of a ‘financial account’ (“FA“), which is defined as, inter alia, any equity or debt interest in an FI. The FATCA Rules further identify ‘specified US persons’ (“SUSPs”), which essentially means US residents, partnerships, certain trusts and corporations (subject to a long list of exceptions). Non-US entities which are controlled or beneficially owned by SUSPs (“NUSEs”), though not specifically mentioned in the Rules, are also important from a reporting perspective: FAs held by SUSPs and NUSEs are called ‘US Reportable Accounts’ (“USRAs”). ‘Passive non-financial entities’ controlled by persons resident outside India and the US for tax purposes (“PNFEs”), are also relevant in this context.

FIs are required to comply with Rules 114G & 114H of the FATCA Rules, under which an FI must conduct a due diligence and maintain information regarding FAs held in them by SUSPs, NUSEs, & PNFEs and then report this information electronically in Form No.61B. A failure to file Form 61B will carry an INR 100 fine for every day on which the failure continues, with this fine going up to INR 500 in case the FI does not file Form 61B even after a notice has been given to it by the Revenue. Inaccurate reporting will, under certain circumstances, result in an INR 50,000 fine for the FI. An FI is also required to register with the IRS and obtain a Global Intermediary Identification Number.

II. Applicability

The applicability of the FATCA Rules to a domestic fund can be ascertained via two litmus tests: (I) analysing whether the fund falls under the definition of an FI, and (II) determining whether the Limited Partners (“LPs”) in the fund fall under the definition of SUSPs, NUSEs, or PNFEs who hold FAs in the fund.

Coming to the first test, an FI is defined as any one of a ‘custodial institution’, a ‘depository institution’, an ‘investment entity’ (“IE”), or a ‘specified insurance company’. An IE is defined as an entity that primarily conducts businesses such as trading in money market instruments, transferable securities, commodity futures, etc., or individual and collective portfolio management, or otherwise investing, administering, or managing financial assets or money on behalf of other persons. In addition, any entity whose gross income is primarily attributable to investing in securities, and is managed by another entity that is itself an IE, is also regarded as an IE. As can be seen, the definition of FI is very wide, and aims to capture not only domestic funds, but also domestic fund managers, and possibly even trustee companies.

While we are discussing the applicability of the FATCA Rules, we would like to point out the exemptions provided therein as well. Entities that qualify as non-reporting financial institutions (“NRFIs”) under the FATCA Rules, such as qualified credit card issuers, or the Employees’ State Insurance Fund or a pension fund, are exempted from the reporting requirements. However, the NRFI exemptions are not likely to be very useful to domestic funds since they come with numerous strings attached. For example, to be regarded as a ‘sponsored closely held investment vehicle’, which is one kind of NRFI, the fund cannot act as an investment vehicle for unrelated parties, and at the most, can have twenty or less LPs, amongst other conditions. Another possibility which may be explored is an NRFI exemption called a ‘sponsored investment entity’, wherein one entity may register with the US as a ‘sponsor’ of the IE and perform FATCA compliances on the IE’s behalf.

Moving on to the second test, the definition of FA encompasses partnership interests as well as interests held by settlors and beneficiaries in trusts, either directly or indirectly. An LP may be regarded as an NUSE if it is beneficially owned by US-based persons. Further, the beneficial ownership in such is cases to be determined by the application of anti-money laundering/KYC circulars issued by the Securities & Exchange Board of India and the Reserve Bank of India. Consequently, the second test may be satisfied if an LP in a domestic fund is a US taxpayer. Given the expansive nature of the definitions involved, and the assertion made in a guidance note released by the CBDT (“CBDT Guidance”), that an FA may need to be reported because of the controlling person behind the FA holder, it is also possible that a vehicle set up by a US-based investor in an intermediate jurisdiction to invest in a domestic fund maybe caught in the net cast by the FATCA Rules. The definition of PNFE is both wide and elaborate, and may capture LPs who are neither SUSPs nor NUSEs; determining whether an LP is a PNFE or not should be done on a case-by-case basis based on the facts.

To sum up, domestic funds will now have to closely examine the FATCA Rules to determine their status, and the status of their LPs, to ascertain the applicability of the FATCA Rules to them. These are largely fact driven enquiries, but at first blush, it seems as though a domestic fund that has US-based investors may have to make reportings under the FATCA Rules. It is also worth noting that even if a domestic fund does not have any FAs that are held by SUSPs, NUSEs, or PNFEs, it is still required to furnish a nil reporting statement to the Director of Income Tax (Intelligence and Criminal Investigation) or the Joint Director of Income Tax (Intelligence and Criminal Investigation). The CBDT Guidance suggests that if a domestic fund is structured as a trust, the reporting requirement will lie on the trustee.

Lastly, even though fund managers fall under the definition of FI, they seem to have been provided with an exemption, such that the fund managing entity will not have to report equity or debt interests held in it by SUSPs, NUSEs or PNFEs.

III. Compliances

The primary compliance to be undertaken under the Rules is the collection, maintenance and reporting of the names, addresses, taxpayer identification numbers, and certain other particulars of SUSPs, NUSEs and PNFEs that hold FAs in the fund; in certain cases, similar particulars of the controlling person behind an FA holder will also have to be reported. The fund will have to report any distributions made to SUSPs, NUSEs and PNFEs during a relevant calendar year. The Rules also require a fund to name a person as a ‘Designated Director’, who must verify and furnish reportings. The Designated Director must obtain a registration with the Principal Director General of Income Tax (Systems).

It should be noted here that the reporting requirement is not merely prospective: FIs are also required to make certain reportings pertaining to 2014 and 2015; importantly, the deadline to make the reportings for 2014 is 10th September, 2015.

Another major compliance required to be undertaken under the FATCA Rules is the due diligence requirement found in Rule 114H. Rule 114H delineates FAs into six categories: (i) ‘individual’ FAs and (ii) ‘entity’ FAs, with the distinction between the two being self- explanatory, (iii) ‘pre-existing’ FAs (FAs maintained on 30th June, 2014), and (iv) ‘new’ FAs, (FAs opened on or after 1st July, 2014) (these are the dates applicable for USRAs), (v) ‘high value’ FAs (pre-existing individual FAs having a value of more than USD 1 million), and (vi) ‘lower value’ FAs (pre-existing individual FAs having less than USD 1 million).

Rule 114H prescribes due diligence procedures for the different kinds of FAs, and this is another characterization that a domestic fund will have to make while profiling its LPs for FATCA purposes.

By way of a brief illustration, the due diligence procedure specified for ‘pre-existing entity’ FAs involves a review of information about the FAs held by the fund for regulatory or customer relationship purposes (including information maintained under anti-money laundering rules) to determine whether the FAs are held by SUSPs or NUSEs, and further review of the entities that hold FAs to determine whether they are ‘non-participating financial institutions’ or ‘passive non-financial entities’, as defined under the Rules. The due diligence procedures laid down in Rule 114H seem to be ‘two-way’ i.e., the fund cannot perform them single-handedly, but will require the cooperation of its LPs to complete them effectively.

One point to highlight here is that it is understood that the US FATCA has come into force on the 3rd August, 2015. The date of the US FATCA’s entering into force is relevant because Rule 114H offers an alternate procedure for performing the prescribed due diligence on USRAs opened between 1st July, 2014 and the date of entry of the US FATCA. Under the alternate procedure, an FI has one year from the date of entry into force of the US FATCA to complete the prescribed due diligence and information requests, with the reporting to be made within a prescribed time period of the identification of an FA as one which requires reporting. A further alternate procedure exists for entity FAs opened by SUSPs and NUSEs between 1st July 2014 and 1st January 2015. If the prescribed due diligence on these FAs cannot be completed within a year of the entry into force of the US FATCA, the fund may be forced to ‘close’ these FAs. However, this appears to be an unlikely situation, since both the countries are working in tandem to ensure the effective implementation of FATCA without undue distress to stakeholders.

Going forward, while certain reporting deadlines seem to be some way off, others are close at hand, and it would be prudent, and in tune with best practices and good corporate governance, to begin the process of ascertaining FATCA applicability and due diligence, if necessary. Further, domestic funds may capture the data necessary to comply with the FATCA Rules from LPs during the fundraising process itself to avoid later scramble for such information prior to the requisite filings. As mentioned above, the CBDT has tried to bring clarity to what is viewed as a complex law by releasing the CBDT Guidance, but this is simply a work-in-progress, and the CBDT has said that it will be taking feedback from stakeholders to update the CBDT Guidance.

For the US, FATCA represents a positive step towards collecting the information necessary to effectively combat tax evasion. Co-operation with the US in this regard is a good idea for India too: the US FATCA’s emphasis on reciprocity will allow India to get a clearer picture of assets held abroad by Indians, thereby lending impetus to the current Government’s “bring home the black money” campaign. While it does impose another compliance burden on certain Indian entities, this will hopefully lead to better KYC and information collection practices.

As published on https://www.vccircle.com/fatca-impact-domestic-funds.