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7 Deadly myths of FATCA: Cayman Islands Investment Funds

profileFrom DMS Offshore Investment Services


It is quite a human trait to live in a state of suspended disbelief – when the news is just too bad to absorb, or when the consequences of an action are too much to contemplate.

Response to the Foreign Account Tax Compliance Act (FATCA), it seems, is one of suspended disbelief by some in the Cayman funds industry. Many opinions have been expressed – yet few facts presented – despite the explicit details being freely available in the FATCA regulations and the Cayman Islands Model 1 Intergovernmental Agreement with the U.S. (IGA). There are even those eagerly promoting half-truths and fanciful thinking about the legislation and peddling them to the unsuspecting.

As the rest of the world marches inexorably towards the implementation of FATCA on July 1 this year, these widely circulated myths are interfering with the timely preparation that Cayman Reporting Financial Institutions (CRFIs) should be making on their own behalf, for the benefit of their investors, to avoid the severe penalties for non-compliance that FATCA dictates.

We refer to them as the Seven Deadly Myths and those who subscribe to them could find themselves facing potentially crippling circumstances after July 1. For safety’s sake, we get down to brass tacks and present the facts below – in plain language – to debunk these myths.

Myth 1: No action required now.

This is false. In fact, critical action is required before July 1, when all CRFIs must have implemented a FATCA Compliance Program to comply with Annex I of the IGA. CRFIs must self-certify their FATCA status [Chapter 4 of the U.S. Internal Revenue Code] to their withholding agents by either providing a Global Intermediary Identification Number (GIIN) or new IRS Form W-8BEN-E/W-8IMY prior to this date. This is the commercial reality facing all CRFIs using withholding agents (counterparties) subject to FATCA.

Two types of FATCA status are available to CRFIs when filing new W-8s: (1) registered deemed-compliant or (2) reporting Model 1 FFI. Registered deemed-compliant status is fast, final and foolproof. The other is temporary (for six months) and requires explanation, negotiation and monitoring with counterparties. It will be evident to those experienced in dealing with withholding agents on a daily basis, which FATCA status is most prudent, easier, and in the best interests of the CRFI to mitigate its counterparty and operational risk.

Myth 2: Best to “wait and see” for Cayman Islands enabling legislation.

This is false. Wishing this to be the case does not make this so. To be clear, registration and reporting are distinct functions under FATCA. All FATCA registration is directly with the IRS and is occurring now through the end of 2014. FATCA Reporting will be made to the Cayman Islands Tax Information Authority (TIA) beginning in 2015 and beyond.

Registration with the IRS is free of cost and mandatory for any CRFI to become registered deemed-compliant under the IGA. Only the IRS has the power to register a CRFI and issue a GIIN. Cayman Islands enabling legislation is irrelevant to FATCA registration for CRFIs as no Cayman Islands authority has – or will ever have – the power to register a CRFI and issue a GIIN. Again, we emphasize, this must be done directly with and by the IRS.

There are no credible commercial reasons to delay FATCA preparation and registration as it is never too early for CRFIs to identify any gaps or risks in their ability to comply with the vast requirements of FATCA. Preparing for registration only eliminates risk – without creating any – and brinkmanship with the IRS and U.S. withholding agents is never sound commercial advice.

The truth is, the Cayman Islands enabling legislation is simply intended to provide the legal framework for compliance with, not avoidance of FATCA (and other automatic tax information exchange agreements), and the development of the regulatory framework for operating the TIA. It’s binary legislation for the Cayman Islands. Either the Cayman Islands comply with its obligations under the IGA or not, but Cayman Islands legislation cannot change the IGA or the FATCA regulations. Don’t expect any miracles. High hopes and promises that the Cayman Islands are masters of the FATCA universe and can change the course of U.S. tax legislation are grandiose and unwarranted.

The scope of the Cayman Islands legislation, when passed, is determinable by reference to the IGA. The objects of the Cayman Islands legislation under the IGA are clear and are: “to provide for the implementation of FATCA” and “address legal impediments” to “coordinate the reporting obligations under FATCA with other U.S. tax reporting obligations of Cayman Islands financial institutions to avoid duplicative reporting” i.e. meet existing obligations under the Tax Information Exchange Agreement (TIEA). That’s it.

Cayman Islands enabling legislation is also required “to implement as necessary requirements to prevent Financial Institutions from adopting practices intended to circumvent the reporting required under this Agreement.” [Article 5.4, IGA]

Myth 3: IRS registration may breach confidentiality.

This is false. Withholding agents already require W-8s from all CRFIs to avoid withholding liability. This is a long-established practice and the Form W-8 has simply now been revised to include FATCA status. A CRFI must self-certify, under penalty of perjury, its FATCA status to withholding agents using the new W-8 before July 1. To obtain a GIIN, a CRFI must file Form 8957 via the IRS Foreign Financial Institution Registration System (FRS) (or manually). Once the GIIN is obtained, it can be verified by withholding agents via FRS or submitted via Form W-8. There are no material differences between the information disclosed, or commitments made, under Form W-8 and Form 8957. Both forms are complementary and require basic identifying information about the CRFI. Specific investor information is never disclosed.

Myth 4: Cayman Islands funds may be exempted.

There is speculation that typical Cayman Islands investment funds can claim exemptions under Annex II of the IGA as sponsored entities or collective investment vehicles.

Sponsored entity exemption.

This is false for typical CRFIs. Sponsored entity exemption would require all the sponsored CRFIs of the sponsor to use a single GIIN. If any CRFI using the sponsored GIIN becomes FATCA non-compliant – for any reason – all CRFIs using the same GIIN would also become non-compliant. This is impractical for most sponsors, because it exposes their investors to significant cross-liability (withholding) risks. The sponsored entity exemption is also temporary, expiring after 2015 for all entities, and was intended for narrow, brief application for certain other entities, not CRFIs. Additionally, the sponsored entity exemption is impractical for complying with the U.K. IGA because that agreement requires the sponsor to be based in the Cayman Islands.

Collective Investment Vehicle.

This is false for typical CRFIs. Collective Investment Vehicles (CIV) would generally not meet the definition of “regulated” under the U.S. Treasury regulations and Internal Revenue Bulletin 2013-15, that requires either the CIV, or its manager, to be regulated in every country wherever the CIV is registered and operating.

Myth 5: Model 1 IGA displaces U.S. Treasury Regulations.

This is false. They both work in tandem. A CRFI is treated as FATCA-compliant, and not subject to FATCA withholding tax, to the extent it complies with its obligations under the IGA. The U.S. Treasury regulations are incorporated by reference into the IGA. Under Article 4(7) of the IGA, the Cayman Islands are bound to use U.S. Treasury definitions to the extent those definitions are not defined by the IGA, and importantly, the Cayman Islands are not permitted to use any other definition in local legislation that would “frustrate the purposes” of the IGA. As mentioned above, it is noteworthy to reiterate that the Cayman Islands has agreed in the IGA to prevent CRFIs from adopting practices intended to circumvent their reporting obligations.

Myth 6: FRO is not required by a Model 1 IGA.

This is false. The key points to know about the role and responsibilities of the FATCA Responsible Officer (FRO) under the IGA are:

U.S. Treasury Regulations define the FRO as an “officer” of the registered deemed-compliant FFI with “sufficient authority to ensure that the FFI meets the applicable [registration] requirements of §1.1471-5(f)”. [§1.1471-5(f)” [§1.1471-1(b)(108)]

The IGA binds the U.S. Treasury Regulations. [IGA, Article 4, 7.]

The IGA requires that CRFIs must “comply with the applicable registration requirements on the IRS FATCA registration website.” [IGA, Article 4, 1(c)]

IRS requires the appointment of an FRO who certifies that the CRFI will comply with its FATCA obligations in accordance with the regulations and IGA.

Myth 7: FRO’s obligations under the Model 1 IGA are “lite”.

This is false. FROs have serious compliance responsibilities under FATCA. In fact, FATCA compliance revolves around the FRO, like Sarbanes Oxley compliance revolves around the CFO. Especially in the context of a CRFI that does not typically have any staff, the role is even more essential. It’s a fallacy and wishful thinking that FROs can be lax or “lite” under the IGA. While certain FRO procedures differ between IGA 1 and IGA 2, the net results are the same – and the IRS has consistently expressed its expectations that FROs deliver robust FATCA compliance and high-quality FATCA information from either procedure. Whoever says otherwise has not been paying attention and we all know how this story ended for Switzerland. Key considerations for a FRO under the IGA include:

Willfully submitting any fraudulent or materially false document to the IRS is a Federal offence. [IRC, §7206(2) & 7207]

CRFI’s self-certification as a Reporting Financial Institution to withholding agents will entail signing the IRS Form W-8 under penalties of perjury.

Compliance Program requires application of the due diligence procedures in Annex I to all Financial Accounts. [IGA, Article 1, 1.(y)]

CRFI must report any change in circumstances that results in discovery of U.S. indicia. [IGA, Annex I, I. B.2 et. al.]

The truth about FATCA

Whether out of lack of knowledge, preparedness or self-interest, those who are propagating these myths are not doing themselves or the investors in Cayman Islands fund industry any favors. Fortunately, many CRFIs are already well advanced in preparing and registering for FATCA, but the laggards need to get their act together – fast.

The last time the Cayman Islands tried to play cute and clever with our international tax obligations (i.e. TIEAs), our jurisdiction ended up on the OECD “gray list” and the stakes are much higher this time around. We should have all learned and been chastened from that experience as the direct penalties under FATCA for our CRFIs are far more severe.

Facts, they say, are stubborn things. And the ones about FATCA are particularly obstinate. Everyone is entitled to their opinions of course, but not their own facts. The truth is – FATCA is not going away – despite the denial, tortured logic and aimless speculation to the contrary. Nor can it be wished away, however unpalatable some may think it is. Naturally, the U.S. Congress could pass a new law tomorrow, the Cayman Islands could renege on its agreement, and the sky may fall. But we have been hearing that for the past four years now and wouldn’t bet the interests of investors on it.

While promoting these myths maybe convenient, and in the self-interest of those seeking to distract attention away from their own lack of preparedness and resources to effectively serve the interests of CRFIs in complying with FATCA, prudence would dictate putting the interests of the CRFIs and their investors first. It’s time for all CRFIs to be actively consulting with their U.S. tax advisors and counterparties on the known, concrete facts and risks of FATCA – as they exist today – to prepare for inevitable FATCA registration.

The plain truth is nobody knows what happens beyond July 1 if a CRFI does not register with the IRS, but there is no logical reason why any CRFI should tempt fate and assume this operational risk when – absolutely nothing – prevents the CRFI from simply registering with the IRS before July 1 to remove this uncertainty.

DMS FATCA Task Force

DMS FATCA Task Force is a specialist group of attorneys, CPAs, and U.S. compliance experts dedicated to serving Cayman Islands investment funds in complying with the Foreign Account Tax Compliance Act. To learn more about FATCA and the DMS FATCA SolutionSM, please contact the DMS FATCA Task Force.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances


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