US ‘FAT CAT’ tax may hit foreign funds

The US House of Representatives has passed a bill – which is now being debated in the Senate – that would have a significant impact on non-US private equity funds that have income from US investments.

If it is passed by the Senate and signed into law, The Foreign Account Tax Compliance Act of 2009, already nicknamed the “FAT CAT” bill, would impose on non-US fund managers a 30 percent withholding tax on all US-source income and any gross proceeds from the sale of assets that would produce US interest or dividends – unless fund managers sign on to an agreement to report such information as the Treasury might require about US account holders.

The act is part of the US government’s ongoing efforts to reduce tax evasion. President Obama and Treasury Secretary Timothy Geithner both spoke on the record in support of the bill the day it was introduced, which seems to indicate it has a high likelihood of passing into law in close to its current form, law firm King & Spalding noted in a recent client memo. 

The withholding tax would apply to all foreign investment entities, which are defined as any entity not formed under the laws of the US that is “engaged primarily in investing or trading in securities, partnership interests, or commodities”. Most private equity, venture capital, and hedge funds would fall into this category, according to the King & Spalding memo. Government entities such as sovereign wealth funds, however, would be excluded.

Those entities would have to pay a 30 percent tax on US source fixed, determinable, annual or periodic income, as well as any gross proceeds from the sale of property that can produce US source interest or dividends. 

The bill changes several parts of US tax law in order to make sure that fund managers can’t avoid this tax. Previously, fund managers could have relied on “portfolio interest” withholding exemptions, but this is no longer the case under the new bill. Fund managers also would have paid tax on net gain rather than gross proceeds from the sale of property, but this too would change under the bill.

To avoid the tax, foreign fund managers must sign on to an agreement with the Treasury to report the identities, account balances and account transaction activity of account holders that are US persons or have US persons as substantial owners. Whereas for banks and financial institutions, the substantial owner threshold has been set at 10 percent, there is no threshold for investment fund managers – any direct or indirect ownership by a US person to quality a fund as “US owned”. 

Given this expansive definition, foreign managers could find themselves bound to report information on many of their LPs and lenders. For instance, King & Spalding points out in its memo, a feeder fund or blocker corporation investing in a foreign investment fund could itself have substantial US owners, and that ownership would then be attributed through to the foreign fund.

Though private equity and hedge funds aren’t often vehicles for tax evasion, some LPs may not like their information being reported to the US government. For foreign managers with LPs who value their privacy, the best solution may be to avoid making US investments.