The Foreign Account Tax Compliance Act of 2009 (FATCA), introduced on October 27, 2009 and supported by many, including President Obama and Treasury Secretary Timothy Geithner, seeks to combat tax evasion through the use of offshore intermediaries by increasing disclosure and withholding obligations on a host of parties. The Joint Committee on Taxation estimated that FATCA would prevent the evasion of $8.5 billion of taxes over the next ten years. Rep. Richard E. Neal (D - MA), who co-introduced the bill, believes FATCA will be enacted before the end of the year.
On December 9, 2009, the House approved the Tax Extenders Act of 2009 (TEA), which includes (with some modification) most of the provisions of FATCA. The Ways and Means Committee estimated that its modified version of FATCA in TEA would raise $7.688 billion over ten years.
If enacted, the effect of FATCA/TEA on hedge, private equity and venture capital funds and their investors will be considerable. The most important provisions of FATCA/TEA are summarized below.
Additional Withholding Obligations
Generally. FATCA would add a new chapter to the Internal Revenue Code that provides for withholding taxes to enforce new reporting requirements on specified foreign accounts owned by specified U.S. persons or by U.S.-owned foreign entities.1
Withholding on Payments for Foreign Financial Institutions (FFIs). Under FATCA, withholding agents would be required to withhold 30 percent on any "withholdable payment" made to an FFI that fails to satisfy specified requirements. As discussed below, the definition of an FFI is broader than its name suggests and includes various investment funds.
To avoid withholding, the FFI must enter into an agreement with the United States to:
obtain information from each of its account holders as is necessary to determine which, if any, of such accounts are held by U.S. persons2 or foreign entities that have one or more 10-percent U.S. owners3
comply with verification and due diligence procedures that the United States may require
in the case of any U.S.-owned account, annually report to the IRS the name, address, and taxpayer identification number of each U.S. owner, the account number, the account balance or value, and the gross receipts and withdrawals from the account4
comply with requests for additional information from the IRS.
TEA also would require:
either obtain a valid and effective waiver of any foreign law that would prohibit the foregoing disclosure or close the account, and
agree to deduct and withhold a 30 percent tax on payments made to account holders that fail to comply with reasonable requests for information from the FFI or that fail to provide a waiver of any foreign law that would prohibit the FFI’s disclosures ("recalcitrant account holders"), account holders that are FFIs that fail to satisfy all of the requirements for avoiding withholding, and "Specially Electing FFIs."
Withholding on Payments to Other Foreign Entities. FATCA also would require tax withholding at the rate of 30 percent on any "withholdable payment" made to a "non-financial foreign entity" if the beneficial owner and withholding agent fail to meet certain requirements.
To avoid withholding under this rule, the beneficial owner of the payment or the payee must provide the withholding agent with either a certification that it does not have any 10-percent U.S. owners or provide the name, address, and taxpayer identifying number of each 10-percent U.S. owner. Additionally, the withholding agent must not know or have reason to know that such information is incorrect, and must report the information received from the beneficial owner to the IRS.
The term "withholdable payment," for purposes of the rules discussed above, includes fixed or determinable annual or periodical income (such as interest and dividends) as under current law. It also includes gross proceeds from the sale of any property that would produce U.S.-source interest or dividends. Because current law generally exempts gains derived from the sale of property by a foreign person from U.S. tax, FATCA expands the categories of income subject to U.S. withholding. Moreover, as withholding would be required on gross proceeds, the statute does not have a mechanism for reducing withholding in the case of a sale in which there is no inherent gain. TEA provides that a withholdable payment does not include any item of income that is effectively connected with a U.S. trade or business.
A "foreign financial institution" is any non-U.S. entity that accepts deposits in the ordinary course of a banking business or is engaged in the business of holding financial assets for the account of others. Significantly, the term FFI also includes a non-U.S. entity that is engaged, or holding itself out as being engaged, primarily in the business of investing, reinvesting or trading in securities, partnership interests, or commodities. Thus, the term FFI "may include among other entities, investment vehicles such as hedge funds, private equity funds and venture capital funds."5
A "non-financial foreign entity" is any non-U.S. entity that is not an FFI.
A "Specially Electing FFI" is an FFI that elects to be subject to withholding with respect to withholdable payments only to the extent the payments are allocable to accounts held by recalcitrant account holders or FFIs that fail to satisfy all the requirements for avoiding withholding. Various requirements must be satisfied to make this election.
Liability for Tax. As under current law, if a person required to withhold fails to do so, that person is liable for the tax, as well as any interest and penalties.
Claims for Refund. If a beneficial owner of a payment is entitled under an income tax treaty to a reduced rate of or exemption from withholding, that beneficial owner is eligible for a credit or refund of the excess of the amount withheld under FATCA over the amount permitted to be withheld under the treaty. TEA would prohibit a credit or refund with respect to tax properly withheld unless the beneficial owner of the payment provides the IRS with information necessary to determine whether it is a U.S.-owned foreign entity and to identify any substantial U.S. owners.
Effective Date. The additional withholding tax rules are proposed to be effective to payments made after December 31, 2010. The TEA version would extend the effective date to payments made after December 31, 2012.
Eliminate Exceptions to Registration Requirements for Debt Issued to Foreign Persons
Under current law, interest paid on an obligation is deductible only if the obligation is in registered form, except that an obligation need not be in registered form for interest to be deductible if the obligation is a foreign targeted obligation.6 Under FATCA, this exception for foreign targeted obligations would be repealed. Accordingly, interest paid on a foreign targeted obligation would not be deductible unless the obligation is in registered form.
Under current law, interest on an obligation that is not in registered form but which is a foreign targeted obligation still may be treated as "portfolio interest," which can be paid to foreign persons free of U.S. withholding tax. FATCA would repeal the treatment of interest on foreign targeted bearer-form obligations as portfolio interest. Thus, tax generally would have to be withheld on U.S.-source interest paid on a foreign targeted obligation unless the obligations is in registered form.
Effective Date. These changes are proposed to apply to debt obligations issued 180 days after FATCA is enacted. TEA would apply to obligations issued after the date that is two years after the date of TEA’s enactment.
Increased U.S. Investor Reporting
Reporting of Foreign Financial Assets. FATCA would require individuals with an interest in a "specified foreign financial asset" during the taxable year to attach a disclosure statement to their income tax return for any year in which the aggregate value of all such assets is greater than $50,000. This reporting is in addition to the foreign bank account reporting (a.k.a. FBAR7 reporting) that gained much attention earlier this year.
A "specified foreign financial asset" (SFFA) is a depository or custodial account at an FFI, and, to the extent not held in an account at a financial institution, stocks and securities issued by foreign persons, any other financial instrument or contract held for investment that is issued by or has a counterparty that is not a U.S. person, and any interest in a foreign entity.
The individual must disclose information that identifies the asset and its maximum value during the taxable year, plus the name and address of the institution where the account is maintained and the account number; the name and address of the issuer and information to identify the stock or security; and, for assets other than accounts and securities, the information necessary to identify the instrument, contract or interest, along with the names and addresses of all foreign issuers and counterparties.
Individuals who fail to make the required disclosure are subject to a $10,000 penalty, which may increase if the failure to disclose continues after notification from the IRS. Although reasonable cause is a defense to this penalty, foreign law prohibitions against disclosure cannot be relied upon. Moreover, a 40-percent penalty on any understatement of tax will be imposed if the understatement is attributable to an undisclosed foreign financial asset, which includes SFFAs as well as other interests in foreign entities (e.g., controlled foreign corporations (CFCs)).
Additional PFIC Reporting. Each person who is a shareholder of a passive foreign investment company (PFIC) will be required by FATCA to file an annual information return containing such information as the IRS may require. Currently, shareholders of PFICs, which are foreign corporations that generally do not engage, directly or indirectly, in the active conduct of a business, only have reporting obligations if they sell their PFIC stock, receive a distribution with respect to their PFIC stock, or make an election with respect to their PFIC stock. Thus, this would increase reporting obligations for U.S. owners of PFICs.
Extended Statute of Limitations for Unreported Income from SFFA or PFIC. To ensure compliance with the additional SFFA reporting, the statute of limitations for assessment of tax by the IRS would be extended from three to six years if there is an omission of more than $5,000 of gross income and such omission is attributable to a SFFA. In addition, the statute of limitations for assessment with respect to the disclosure of SFFA or PFICs will not expire before the date that is three years after the date the disclosures are made to the IRS.
Effective Dates. The SFFA reporting and its related penalties are proposed to be effective for taxable years beginning after the date of FATCA’s enactment. The additional PFIC reporting is proposed to be effective on the date of FATCA’s enactment. The statute of limitations provisions are effective for returns filed after the date of FATCA’s enactment.
Advisor Reporting and Penalties
FATCA (but not TEA) would require the disclosure of assistance to a U.S. individual in acquiring or forming a foreign entity. Under these proposals, each "material advisor" with respect to a "foreign entity transaction" is required to file an information return setting forth the identity of the foreign entity, the identity of the U.S. person acquiring an interest in a foreign entity, and any other information as the IRS may require.
A "foreign entity transaction" is defined as the direct or indirect acquisition of any interest in a foreign entity (including upon its formation) if a U.S. person would have a U.S. tax disclosure obligation with respect to the acquisition. A "material advisor" is any person that provides any material aid, assistance, or advice with respect to carrying out one or more foreign entity transactions and whom directly or indirectly derives gross income in excess of $100,000 for providing such aid, assistance, or advice during the calendar year. It is expected that the IRS will "broadly construe this $100,000 threshold to include tax and any other advice incident or related in any way to the acquisition of an interest in a foreign entity."8
Failure to file the information return will subject the material advisor to a penalty equal to the greater of $10,000 or 50 percent of the gross income derived by the advisor with respect to the transaction.
Effective Date. The advisor reporting and related penalties is proposed to apply to advice provided after the date of FATCA’s enactment.
If enacted, FATCA will have a considerable effect on the operations of U.S. and foreign hedge funds, private equity funds and venture capital funds, as well as their investors. It seems likely to result in over-withholding of tax, and thus, investors would have to file tax returns in order to obtain refunds. It also will mean additional compliance costs. FATCA comes on the heels of recent scandals involving U.S. persons attempting to avoid the payment of tax through the use of offshore vehicles. In this light, there is significant support. All indications, including its recent inclusion in TEA, point to the enactment of FATCA in the near future. Consequently, funds should begin preparing to adjust their operations to reflect FATCA’s provisions.
2 Publicly traded corporations and their affiliates, tax-exempt entities and IRAs, banks, REITS, RICS, and common trust funds are not treated as U.S. persons for these purposes.
3 An FFI is permitted to rely on a certification from the account holder that it does not have a 10-percent U.S. owner so long as the FFI (and any affiliate of the FFI) does not know and does not have reason to know that the certification is incorrect.
4 Alternatively, the FFI could agree to be subject to the same reporting as U.S. financial institutions.
5 JCT Report, pg 19.
6 An obligation is a foreign targeted obligation if (1) there are arrangements reasonably designed to ensure that such obligation will be sold only to non-U.S. persons, (2) interest is payable only outside the United States, and (3) the face of the obligation contains a statement that any U.S. person who holds the obligation will be subject to limitations under U.S. income tax laws.
7 The nature of the information required to be disclosed under FATCA is similar to the information disclosed to the Treasury Department on Form TD F 90-22.1 (the FBAR), but it is not identical. Moreover, compliance with FATCA is not intended as a substitute for compliance with the FBAR reporting requirements, which are unchanged by FATCA. JCT Report, pg. 34.
8 JCT Report, pg. 43.
Steven D. Bortnick and Timothy J. Leska
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