On March 18, 2010, the President signed into law the Hiring Incentives to Restore Employment Act (the “Act”). The Act contains several provisions that will have a significant impact on the private investment fund industry.

I. Withholding Tax on Certain Payments to Foreign Financial Institutions

The Act requires a “foreign financial institution,” including a bank, broker, hedge fund or private equity fund formed under the laws of a foreign country, to enter into an agreement with the U.S. Treasury to report certain information about its “United States accounts.” If a “foreign financial institution” does not enter into such an agreement, then it will be subject to a 30% U.S. withholding tax on any “withholdable payment,” including U.S. source dividends and interest, and, significantly, capital gains from U.S. securities.

In general, a “United States account” includes any account (i) held by one or more U.S. persons or (ii) held by a foreign entity which is more than 10% owned by a U.S. person. The Act provides exceptions for accounts held by publicly-traded corporations, banks, tax-exempt organizations, individual retirement accounts, federal, state and local governments, real estate investment trusts, regulated investment companies and common trust funds. These exceptions also apply in determining whether a foreign entity has a 10% U.S. owner. Therefore, the primary impact will be on U.S. taxable investors in offshore funds.

In order to avoid the withholding tax, a “foreign financial institution” must enter into an agreement with the Internal Revenue Service (the “IRS”) to:

• determine whether each of its accounts is a “United States account”;
• comply with verification and due diligence procedures with respect to its “United States accounts”;
• annually report certain information about its “United States accounts” (the name, address and tax identification number of the United States account holder; the account number; the account balance; and the gross receipts and gross withdrawals or payments from the account) to the IRS;
• comply with requests by the IRS for additional information with respect to its “United States accounts”; and
• obtain a waiver from each United States account holder of any foreign law confidentiality provisions with respect to such holder’s “United States account” (or to close the account if such waiver is not obtained).

These withholding provisions, which are effective for payments made to a foreign financial institution after December 31, 2012, are expected to have a significant compliance impact on private investment funds and prime brokers as they will require offshore funds to identify their “United States accounts” and enter into agreements with the IRS regarding such accounts. It is anticipated that the IRS will issue additional guidance on the procedures for complying with these requirements. We will keep you advised of such guidance and any necessary revisions to fund documents and procedures.

II. New Reporting Obligations Regarding Foreign Financial Assets

The Act also requires any U.S. individual who holds certain “specified foreign financial assets,” including an interest in an offshore hedge fund or private equity fund, to report the ownership of such assets to the IRS on his or her tax return if the aggregate value of such assets exceeds $50,000. This provision is effective beginning with the 2011 taxable year. Although this provision as drafted applies only to individuals, the IRS is authorized to issue regulations requiring reporting by any domestic entity which is formed or availed for the purpose of holding specified foreign financial assets.

III. Imposition of U.S. Withholding Taxes on Certain Dividend Equivalent Payments

The Act also provides that dividend equivalent payments determined with reference to an underlying U.S. equity security which are made as part of a “specified notional principal contracts,” a securities lending transaction or a sale-repurchase transaction will be treated as U.S.-source income. Such payments received by a foreign person or entity will therefore be subject to a 30% U.S. withholding tax in the same manner as dividend income (unless reduced by an applicable tax treaty).

A “specified notional principal contract” is any notional principal contract where any of the following conditions are satisfied: (i) the long party to the contract transfers the underlying security to the counterparty to the contract at the outset of the contract, (ii) any short party to the contract transfers the underlying security to the counterparty to the contract at the termination of the contract, (iii) the underlying security is not readily tradable on an established securities market, (iv) in connection with entering into such contract, the underlying security is posted as collateral by the short party to the contract with the long party to the contract, or (v) such contract is identified by the IRS as a “specified notional principal contract.”

Under this provision, dividend equivalent payments paid pursuant to equity swaps on publicly traded U.S. equities will generally not be subject to a 30% withholding tax in the hands of an offshore private investment fund, provided the underlying security is not transferred between the parties as part of the contract or posted as collateral. This provision is effective for payments made on or after 180 days after the date of enactment of the Act.