Dermot Butler, chairman, Custom House Global Fund Services Ltd and Custom House Group

Comment: FATCA could well cause managers to turn their backs on the US

Another draconian measure is set to grace the industry – FATCA (Foreign Account Tax Compliance Act), says Dermot Butler (pictured) chairman of Custom House Global Fund Services Ltd and Custom House Group.

I have to say, as far as regulation goes, this worries me in terms of its pervasive nature and the number of foreign financial institutions (FFIs) it’ll affect.

Compliance on this is going to be a major headache. As I understand it, any FFI involved will be responsible for reporting the activities of American investors to the IRS. If investors are holding assets in an offshore fund and not disclosing them properly then the IRS, under FATCA, will penalise them by taking 30% of the proceeds of the sale including their original investment. And if FFIs, who will have to foot the bill to get their reporting systems FATCA compliant by 1 January 2013 – something that I find highly improbable – don’t accurately share information on their US investors with the IRS, the relevant fund will be hit with a 30 per cent withholding tax on the gross value of US investments.

You have this potential, if I understand so correctly, for a US investor to invest USD1million in a fund. If that fund falls, they lose USD200,000 and decide to liquidate their investment, but don’t bother to send a report highlighting this loss, they’ll still get charged 30% of the proceeds (USD800,000), which is basically a tax of USD40,000,on a losing position.

I would be very surprised if somebody didn’t mount a legal action on the basis that to take 30% of everything is wrong. It should only be for capital gains. But that isn’t what FATCA is. It’s a penal instrument. If you haven’t made the proper disclosure they’ll do it, period.

What’s more, it has the potential to affect non-US investors as well. You might be invested with a UK fund manager, but any institutions the fund invests in which derive part of their income (e.g. banks) from the US could be subject to 30% withholding tax on the gross value of that income in what is referred to as a ‘pass-thru payment’.

I have to say I find FATCA very unfair.

A lot of people are talking about the implications of it and trying to understand the details but it’s very unclear. Like the AIFMD I think FATCA has been badly written. When you rush something out, people don’t think about the knock-on effect it’s going to have further down the road.

Different interpretations are floating around the industry. One obvious consequence will be that some managers will stop investing in the US altogether and close off their funds to US investors. For years, GLG Partners didn’t have one investor stateside.

It happened before when the US brought in withholding tax on US government bonds. People just sold all their treasuries and suddenly there was no money coming in so they had to change the law back. One of the indirect consequences of FATCA, will, in my opinion, be this appetite for disinvestment, although the recent KPMG report of FATCA showed that 42% of fund managers would not take this course of action with respect to US equities.

Five or 10 years ago, missing the largesse of investing in the US markets would have been deemed financial suicide. Nowadays I’m not so sure. The global market is bigger than the US market.

Of course there’s nothing to stop the EU bringing in its own type of legislation but rather than this tit-for-tat, I think managers and investors will decide they don’t want to be exposed to the US anymore. Why face the risk?

The real challenge for FFIs will be determining who their US investors are. Under the EU Savings Directive, we as administrators have to go through all the funds that make up distribution and check whether a distributor is a resident of an EU Member State. If he is, then any distribution he’s made we have to report to the Irish Revenue who then report to the relevant EU revenue departments. We have to identify this at the time of subscription, and our systems are going to need to do this for US investors, regardless of where they live.

We’re checking to see what technology we’ve got to produce these reports for FATCA automatically. That shouldn’t be difficult as I believe on the whole we know who our US investors are. The problem is going to be knowing if someone is trying to evade tax and hasn’t told us they’re a US investor. Certainly, the gut feeling amongst myself and my senior colleagues is that FATCA is a complete mess.

What also concerns me, in the other pillar of regulation facing Europe – AIFMD – is that an external valuer is not necessary if the manager is prepared to value the assets. That’s how it reads. One of the main purposes of having an administrator is to provide independence, but this seems to say that’s not necessary. How’s that protecting anybody?

Moreover, AIFMD says that if there’s any decision to be made it’s the manager who has to make it, not the administrator. Well the whole of the post-2008 movement by investors has been to try and make sure the investor was protected from the manager going AWOL.

Unfortunately, you can’t defeat political dogma with logic. In a certain way the manager is the be-all and end-all because without him there wouldn’t be a fund, but as far as investor protection goes, the governing body of the fund should not be the manager.

Personally, I think managers will shy away from setting up AIFM funds for the foreseeable future. Why go through the hassle when they can continue selling their fund under private placement until 2018? Not to be cynical, but the average lifespan of a hedge fund is only five years anyway.

Going back to FATCA, I’m inclined to share Peter de Proft’s scepticism on the revenues this Act will generate. The Savings Directive I referred to above raised a derisory amount of money. I don’t know if FATCA will generate meaningful revenues for the IRS. Offshore tax avoidance is achieved by corporations through perfectly legal structures but the average American is terrified of the IRS. I’m quite sure most pay their taxes, so I personally have my doubts that it’s going to raise much revenue.

FATCA, AIFMD, Dodd-Frank, the UK Bribery Act: All this regulation is either going to drive smaller hedge funds out of business or it’s going to make the cost of running a fund more expensive by using outside compliance sources.

It is possible that FATCA could induce isolationism. It’s a worry. Wedging these two blocks - AIFMD and FATCA – between Europe and the US to prevent the two countries working together is, in my opinion, disastrous.

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