Originally published by Thomson Reuters Accelus at http://accelus.thomsonreuters.com, March 2012. Reprinted with permission.
The enactment of the Foreign Account Tax Compliance Act (FATCA) as in March of 2010 has sent shock waves through financial institutions and investment fund management companies. FATCA aims to obtain information to prevent U.S. persons from evading taxation through the use of foreign entities. Although the law does not fully enter in force until January 1, 2013, the effort to become compliant with FATCA should begin immediately. Some tips on how to do so are noted below.
The legislation is the direct result of the events that led to UBS’ admission that it helped U.S. taxpayers evade U.S. income tax on U.S.-source income. While the goal is the increased collection of tax, the intention is not to create any new tax. FATCA’s goal is accomplished by adding an entirely new chapter to the Internal Revenue Code devoted to due diligence, reporting and withholding. Failure to comply will result in withholding tax at the rate of 30 percent, including withholding on items understood not to be taxable in the hands of foreign persons. While the proposed regulations reduce the burden that initially may have been expected, especially through reduced due-diligence requirements, FATCA compliance still will be an involved and costly process for many financial institutions and investment funds. To the surprise of many, when the proposed regulations were issued, so was a joint statement from the United States, United Kingdom, France, Germany, Italy and Spain regarding an intergovernmental approach to improving international tax compliance and implementing FATCA. These countries have agreed to enact legislation to enforce FATCA and increase tax compliance among the various countries.
FATCA in General Terms
FATCA generally divides the universe of foreign entities into two broad categories: foreign financial institutions (FFIs) and non-financial foreign entities (NFFEs). A withholding agent (generally anyone who has control of payments, including participating FFIs) must withhold tax at 30 percent on any “withholdable payment” to an FFI, unless such FFI is a “participating FFI.” A participating FFI is an FFI that has reached an agreement with the Internal Revenue Service (IRS) to obtain certain information, provide certain information to the IRS and withhold on certain payments. These requirements are discussed further below.
A withholding agent must withhold tax at 30 percent on any withholdable payment to an NFFE, unless the NFFE: (a) certifies that it has no U.S. investors that own 10 percent or more of such NFFE or (b) identifies U.S. investors that own 10 percent or more of such NFFE.
Is Payment Made to an FFI?
The characterization of an entity as an FFI or NFFE has the most critical impact on the obligation of a withholding agent with respect to payments made to the entity, as well as the recipient entity’s obligations under FATCA. An FFI is a foreign entity that:
This broad definition is designed to pick up investment funds, including mutual funds, private equity funds, venture capital funds and hedge funds.
Who Is in the FFI's Expanded Affiliated Group?
All members of the Expanded Affiliated Group (EAG) must be either participating FFIs or deemed compliant, or all members may be subject to withholding. The EAG generally is a group of companies connected by greater than 50 percent ownership. For this purpose, various constructive ownership rules apply. Moreover, the EAG may include non-corporate entities. Based on the current drafting of the proposed regulations, an EAG may consist entirely of non-corporate entities.
The proposed regulations contain a transition rule. Participating FFI groups can have members that cannot meet the requirements because of the application of local law (a limited branch) through 2015. However, at least one member of the EAG must not be subject to the rules that prevent compliance (even if it is U.S.), and the limited branch must conduct due diligence and identify U.S. persons to FFIs that are not limited branches. The participating FFIs that are not limited branches must report information about U.S. accounts to the IRS to the extent permitted under the law of the branches’ jurisdiction.
Becoming a Participating FFI
To avoid 30 percent withholding, an FFI must enter into an agreement with the IRS to comply with certain requirements. These agreements will require the participating FFI to:
Draft model FFI agreements are supposed to be available in early 2012, with final models available in the fall. The IRS has indicated that online registration will be available by January 1, 2013. FFIs generally must have completed the process by June 30, 2013, or risk not having their FFI-EIN (the identification number that withholding agents will need to receive to remit withholdable payments without withholding) in time to avoid withholding.
FFI Due Diligence
FFIs must perform due diligence to determine their U.S. account holders. The proposed regulations limited due diligence to electronic records for account balances under $1,000,000. Moreover, due diligence generally is not required with respect to preexisting accounts with values under $50,000 ($250,000 for preexisting entity accounts with no additional diligence required until the account reaches $1,000,000) or for insurance policies with values with a value not greater than $250,000. The proposed regulations also provide for cases with FFIs may rely on their existing account opening procedures (i.e., know your client or anti-money laundering) for identifying U.S. accounts.
Participating FFIs will be required to withhold on certain payments to non-participating FFIs, recalcitrant holders (i.e., holders who refuse to provide information required by the FFI under the proposed regulations or who refuse to waive provisions of foreign law that would preclude reporting to the IRS) and participating FFIs that elect to be subject to withholding rather than withhold. Withholding obligations begin in 2014 (2015 for gross proceeds and 2017 for certain payments of foreign passthrough payments, discussed below).
Participating FFIs are themselves withholding argents. A participating FFI also has to comply with its FFI agreement with respect to withholding obligations with respect to withholdable payments made to NFFEs.
What Is a Withholdable Payment?
An FFI’s withholding obligations (discussed above) apply to withholdable payments. Withholdable payments are:
The proposed regulations exclude many types of U.S. source FDAP from the definition of withholdable payments, including:
Withholdable payments also include foreign passthrough payments. The Proposed Regulations are reserved as to the meaning of this term. The intention is to prevent the avoidance of withholding on distributions that are themselves foreign source, where they relate to U.S. source income.
FFI’s will be required to report identifying information and account balances or values for U.S. accounts and recalcitrant holders beginning September 30, 2014, and annual reporting for reportable amounts beginning March 15, 2015.
Is the FFI Deemed Compliant?
FFIs can avoid 30 percent withholding if they are deemed compliant. Registered deemed compliant FFIs still must perform diligence to identify U.S. accounts, and must register with the IRS. Registered deemed compliant FFIs are:
Generally, requirements applicable to be a registered deemed compliant FFI must be satisfied by all members of the FFI’s EAG. Registration must be renewed every three years.
Certified, compliant FFIs must certify that they are compliant to withholding agents, but need not register with the IRS. These organizations are:
In addition, certain FFIs are treated as deemed compliant with respect to payments from withholding when they agree to report to the IRS all the necessary information and to which the FFI provides with all of the necessary documentation.
FATCA COMPLIANCE BEST PRACTICES
Although FATCA does not fully enter into force until January 1, 2013, work to become compliant with FATCA should begin immediately. Here is a list of the things that persons responsible for FATCA should begin doing immediately.
- members of the EAG obtain sufficient information to comply with FFI agreements from account holders
- the documents permit any FATCA holding with respect to recalcitrant holders and non-participating FFIs may be withheld from payments due to those holders
- holders and potential holders are aware of the fact that their identities and account information may be disclosed to the IRS, the information they need to provide and the fact that the FFIs will withhold on payments if they fail to comply
- they contain any statements required in order to comply with deemed compliant requirements (e.g., in certain cases that no U.S. person may hold an account in the FFI)
- these documents permit the FFI to close the account/redeem recalcitrant holders as required by FATCA.
Steven D. Bortnick
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.