Tax Provisions In Hire And Health Care Legislation

The HIRE Act effectively requires a "foreign financial institution" to enter into a far reaching reporting agreement with the Treasury, prior to 2013, by providing that a foreign financial institution that fails to enter into such an agreement will generally be subject to a 30% US withholding tax on all "withholdable payments," which term encompasses the payment of interest (including original issue discount), dividends, and other US source payments traditionally subject to US withholding tax, and any gross proceeds from sale or other disposition of US stocks, bonds, or other debt instruments, made after December 31, 2012, with a grandfathering exception for debt obligations outstanding on March 18, 2012 (the two year anniversary of the HIRE Act).

With limited exceptions,¹ the foreign financial institution must agree with the Treasury: (i) to obtain information on all of its accounts to determine which accounts are "United States accounts;" (ii) to verify such information through required due diligence; (iii) to annually report information on its United States accounts to the Treasury; (iv) to withhold in respect of any "passthru payments"² to any account holder that fails to produce the required information (a "recalcitrant account holder") or to another foreign financial institution that itself does not comply with these rules³ (alternatively, the foreign financial institution may elect to allow counterparties to withhold on the portion of any withholdable payments to it that are allocable to a recalcitrant account holder or to another non-compliant foreign financial institution);⁴ (v) to comply with any requests by the Treasury for additional information on United States accounts; and (vi) to attempt to obtain a waiver of any foreign law from each US account holder that would prevent the foreign financial institution from reporting to the Treasury any required information so obtained and if such waiver is not obtained, to close the account.

For purposes of these rules:

• A "foreign financial institution" is any foreign entity that is a "financial institution," which is broadly defined to include any institution which: (i) accepts deposits in the ordinary course of a banking or similar business; (ii) holds financial assets for the account of others as a substantial portion of its business; or (iii) is engaged, or holds itself out as being engaged, primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, or any interest (including a future, forward contract, or option) in the foregoing. According to the Joint Committee on Taxation explanation of the HIRE Act, "the term financial institution may include among other entities, investment vehicles such as hedge funds and private equity funds" (emphasis added).⁵
• A "United States account" means a "financial account" (which term includes traditional depository and custodial accounts, and also includes any equity or debt interest in a financial institution, though it does not include interests that are regularly traded on an established securities market) held by one or more "specified United States persons" (which term generally includes all US persons, other than tax-exempt entities, RICs, REITs, and publicly traded corporations and their affiliates) or "United States owned foreign entities" (which term generally includes foreign entities with a "substantial United States owner" – meaning greater than 10% ownership by a specified United States person, or in the case of an investment fund that is a foreign financial institution, any ownership by a specified United States person).

Weaved into this matrix of rules and definitions are a number of very important points of interest. First, these rules will undoubtedly lead to a significant amount of incremental administrative burden for entities that are considered foreign financial entities, even for institutions with well developed compliance infrastructures,⁶ and will presumably lead to a revamp of the information reported under the existing IRS Form W-8 regime (unless a supplemental reporting regime is developed). Second, there may be uncertainty as to what entities are foreign financial institutions, particularly in relation to offshore private equity funds, and when a foreign entity will be treated as a United States owned foreign entity, particularly in relation to offshore funds (including feeder funds). Third, these rules will create adverse timing and compliance burdens on foreign entities affected by these rules that are entitled to the benefits of income tax treaties with the United States. For example, a US tax treaty may generally reduce or eliminate US withholding tax on certain payments to a foreign financial institution, but if that entity does not enter into the agreement described above, it will be subject to full withholding at the time of payment and will need to seek a refund (or credit).

The HIRE Act effectively requires any "non-financial foreign entity" (which is defined as any foreign entity that is not a financial institution – i.e., that is not a foreign financial institution) receiving withholdable payments beneficially owned by it, or by another non-financial foreign entity, to disclose its substantial US owners or certify that it does not have any substantial US owners. A non-financial foreign entity that fails to disclose the required information will be subject to 30% US withholding tax on all withholdable payments made after December 31, 2012 (i.e., as if it were a non-compliant foreign financial institution). Although there are limited carve-outs⁷ this provision would generally include all offshore hedge funds and private equity funds that are not considered foreign financial institutions because, as investment funds, they will be subject to the special rule described above that all specified United States persons are deemed to be substantial United States owners.

Beginning in 2011, US individual taxpayers will be subject to expanded reporting obligations (and substantial penalties for failure to satisfy such reporting obligations) with respect to any interest in any "specified foreign financial assets," which generally include any financial account maintained in a foreign financial institution (which includes equity of the foreign financial institution), and, to the extent not held in an account maintained by a financial institution, stocks and securities of, financial instruments with a counterparty that is, or contracts issued by, a foreign entity, or any interest in a foreign entity. This provision would require disclosure by US individual taxpayers of most investments in offshore hedge funds and private equity funds.

It should be noted that this provision potentially overlaps with certain of the reporting requirements imposed by Treasury Department Form TD F 90-22.1, "Report of Foreign Bank and Financial Accounts" (the "FBAR"). The FBAR rules require reporting with respect to "foreign financial accounts" (as defined under the FBAR rules), and there has been significant uncertainty as to whether that term included interests in offshore hedge funds and private equity funds. The Treasury recently announced in Notice 2010-23 that, for purposes of FBARs with respect to calendar years 2009 and earlier, it would not interpret the term "foreign financial account" to include interests in offshore hedge funds and private equity funds, and the proposed FBAR regulations issued in connection with such notice stated that the Treasury was still considering whether the term "foreign financial account" would encompass interests in offshore hedge funds and private equity funds for purposes of FBARs with respect to calendar years 2010 and later.

The statute of limitations for assessment of tax is extended to six years on an understatement of gross income in excess of $5,000 that is attributable to a specified foreign financial asset that generally is required to be reported as described above. Previously, the six year statute of limitations was reserved for substantial omissions of income (which generally required an omission of gross income exceeding 25% of the amount of gross income reported on the applicable tax return).

PFIC shareholders are required to file an annual report containing any information required by the Treasury. In this regard, we note that, for purposes of the PFIC rules, US persons are treated as owning both directly held stock and certain indirectly held stock. Until these information requirements are specified, the impact of this rule will remain uncertain, but this could create access to information problems of the type currently faced by investors in PFICs seeking to make QEF elections and could have broad applicability.

The HIRE Act amends the rules with respect to bearer bonds – affecting both holders and issuers – by removing such bonds from the list of instruments that qualify for the portfolio interest exemption from US withholding tax and denying the deduction for interest on such bonds. These changes apply to bonds issued after March 18, 2012 (the two year anniversary of the HIRE Act), so all bonds issued prior to that date will be fully grandfathered.

With respect to payments made on or after September 14, 2010 (180 days after the enactment of the HIRE Act), "dividend equivalent payments" will be subject to US withholding tax in the same manner as corresponding US source dividends. A "dividend equivalent payment" is any payment pursuant to a securities lending or sale-repurchase transaction or certain notional principal contracts8 that are contingent upon, or determined by reference to, the payment of a dividend from sources within the United States. With respect to payments made after March 18, 2012 (the two year anniversary of the HIRE Act), all dividend equivalent payments on any notional principal contract will also be subject to these rules, unless excepted by the Treasury.9

The Health Care Act/Reconciliation Act would increase the Medicare tax imposed on individuals from wages and self employment income by 0.9% (i.e., 3.8% in total when combined with the employer portion), beginning in 2013, on wages and self employment income in excess of $200,000 per year ($250,000 per year in the case of married individuals filing jointly). Employers will be required to withhold the extra 0.9% Medicare tax on an employee's wages in excess of $200,000 per year, regardless of the wages earned by the employee's spouse. The Health Care Act/Reconciliation Act would not eliminate the cap on Social Security taxes.

The Reconciliation Act would impose an additional Medicare tax on individuals, beginning in 2013, equal to 3.8% of the lesser of the individual's (i) "net investment income" or (ii) its adjusted gross income in excess of $200,000 per year ($250,000 per year in the case of married individuals filing jointly). This "lesser of" test ensures that all taxpayers get the benefit of the $200,000 per year floor ($250,000 per year in the case of married individuals filing jointly) but effectively means that any taxpayer with earned income in excess of the floor will be subject to the new Medicare tax on all of its unearned income. For purposes of this rule, net investment income includes: (i) income from interest, dividends, annuities, royalties, and rents (other than income derived from any trade or business not described in clause (ii)); (ii) income from a trade or business that is a passive activity with respect to the individual or consists of trading financial instruments or commodities; and (iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property (other than property held in a trade or business not described in clause (ii)). Net investment income is determined after taking into account the deductions properly allocable to the income included therein. The Reconciliation Act would also impose the 3.8% Medicare tax on a trust or an estate to the extent of the lesser of its (i) undistributed net investment income for such year or (ii) adjusted gross income in excess of the amount at which the highest ordinary income tax bracket for trusts and estates begins for such year.