Small private banks face FATCA challenge

InvestorsLegalOperational RiskRegulation
09 Dec, 2011

Small private banks, particularly in jurisdictions with strict banking secrecy laws, may struggle to become FATCA (Foreign Account Tax Compliance Act)-compliant thereby depriving some hedge funds of much needed assets.

“Compliance with FATCA will be the industry norm but some smaller private banks investing client funds into hedge funds might not participate in the program,” said Anthony Calabrese, senior manager on the US tax desk at Ernst & Young (E&Y) in London, speaking at an AIS Fund Administration event on FATCA.

A few smaller private banks and other investors may be reluctant to share client details with third parties due to concerns over data protection and client confidentiality laws that exist in various jurisdictions. Furthermore, a proposed European Union (EU) data privacy law could lead to tougher fines for banks and institutions which mishandle client data. These fines, according to some, could be up to 5% of global turnover. Such a proposal would certainly raise issues as to how FATCA can be implemented.

Jurisdictions, which have traditionally been criticised for banking secrecy laws, such as Switzerland, have opened up following international pressure. However, this does not mean private banks will automatically hand client data over to the Internal Revenue Service (IRS). Failure to comply with FATCA could spell bad news for return-hungry investors and their clients.

“Such private banks would be treated as non-participating Foreign Financial Institutions (FFI) by the authorities who would therefore subject the bank to a 30% withholding tax on US- sourced income such as dividends and interest as well as on the gross proceeds of US stocks and bonds that the hedge fund generates,” he added.

Managers could be forced to kick these recalcitrant investors out of the hedge fund altogether. “If a small private bank is a non-participating FFI, it might become necessary for the hedge fund manager to cease doing business with them. Managers may also make the strategic decision to not deal with non-participating banks at all. Such measures may deprive managers of assets in this tough capital raising environment,” said Calabrese.

Under FATCA, hedge fund managers must conduct extensive due diligence on their underlying investors worldwide and supply information about US taxpayers to the IRS as part of its attempt to clamp down on wealthy US citizens and residents who are not paying taxes. The IRS believes FATCA, which becomes law on January 1, 2013, could generate $100 billion in taxes although industry experts have disputed this figure.

A survey by RBC Dexia Investor Services in September 2011 revealed 86% of European financial institutions had “strong levels of FATCA awareness.” However, only 26% of respondents worldwide said they had little or no awareness about FATCA. “Large financial institutions with private banking arms are getting prepared. It is the smaller ones that might struggle,” commented Calabrese.

Draft regulation on FATCA is expected to be published by December 31, 2011 with the finalised rules completed by summer 2012. Nevertheless, some experts anticipate there could be delays in implementation.