The Foreign Account Tax Compliance Act (“FATCA”) is a  US law aiming to impose new best practices and clamp down on tax dodgers. The FATCA is a significant concern for funds managers with investors and/or investment activity in the USA. From 2013 on the FATCA imposes, among other things, a 30 percent levy on certain types of distributions made by a US-based fund to a foreign fund of funds, unless the taxman is satisfied he knows enough about all the US limited partners involved in the relationship.

Non-US firms will have to provide US tax authorities a look into the financial details of all its US-based investors and limited partners (”LPs”). For funds of funds the law means not only implementing new best practice policies and controls, ensuring its own investors are FATCA compliant, but confirming that any non-US funds within the portfolio are also compliant and apply best practices. Likewise General Partners (“GPs”) taking on a fund of funds as an investor risk a 30 percent tax penalty when exiting certain US assets, should a fund of funds skirt the new tax-avoidance rules.

As a consequence, for funds of funds, compliance and best practice costs hit from both ends, as an investor and as a fund manager. Still the only true safe way for the fund of funds and direct fund to ensure FATCA compliance is to demand the other party guarantees maintaining its tax sharing information agreement with US authorities. Many GPs are expected to balk at this commitment, especially if it means exposing itself to liabilities for the actions of its LPs.

While much depends on the US Treasury Department’s specific regulations for the applications of FATCA, some fund managers find compliance and best practice costs too prohibitive and decide to stop making US investments or taking commitments from US-based investors.

The FATCA poses regulatory challenges to the funds of funds industry. The various regulations on the horizon will mean a great deal of time, energy and money on the part of managers, and perhaps even some changes to certain funds’ investment strategies.