FATCA enters into force January 1, 2013. The US Internal Revenue Service has issued two Notices setting forth its preliminary thinking as to how FATCA will be implemented. The IRS is in the process of drafting regulations to provide more comprehensive guidance.
This article provides a brief overview of FATCA, summarizes two significant issues that may affect the implementation of FATCA, briefly reviews Notice 2010-60, provides a more detailed overview of Notice 2011-34 and suggests how affected entities should proceed in deciding how to navigate FATCA.
- What is FATCA? FATCA, as it is colloquially known, refers to Chapter 4 of the US Internal Revenue Code (Code), which was enacted by the Hiring Incentives to Restore Employment (HIRE) Act on March 18, 2010. FATCA requires non-US foreign financial institutions (FFIs), to include banks, investment banks, brokers, trust companies, investment funds, life insurance/reinsurance companies and all other investment vehicles, and non-US non-financial entities (NFFEs) to identify and disclose their US account holders and members or become subject to a new 30 percent US withholding tax (the FATCA withholding tax) with respect to payments of US source income and proceeds from the sale or disposition of US stocks and securities.
- Effective date. FATCA applies to payments made to FFIs and NFFEs effective as of January 1, 2013 (subject to a grandfathering rule).
- Purpose. The purpose of FATCA is to identify US taxpayers who hold assets abroad, directly or through non-US entities, in order to counter US tax evasion. The ultimate goal of the legislation is for the United States to obtain information with respect to offshore accounts and investments beneficially owned by US taxpayers, rather than the collection of tax through the FATCA withholding tax.
- Impact on FFIs. FATCA will have a direct and profound impact on FFIs that have US proprietary investments, US account holders or US financial dealings. FATCA’s impact will be magnified by the cascading of international financial transactions flowing through financial entities. Each time an FFI receives or makes a payment that is a Withholdable Payment, it will be impacted by FATCA. Under US law, an FFI is a US withholding agent.
- FFI options. FFIs have a simple choice to make as to whether they comply with FATCA or not. Global FFIs and FFIs that would like to continue to invest on their own behalf or on behalf of US clients in the US capital markets will have to agree to comply with the new provisions by becoming a Participating FFI and entering into an agreement with the IRS to identify and report US account holders and withhold on “Passthru” payments; alternatively, some FFIs may be treated as Deemed Compliant, in which case they would not have to enter into an IRS Agreement but still would have to undertake certain obligations. FFIs, based on a cost/benefit analysis, that do not agree to comply with the new provisions, i.e., Non-Participating FFIs, will suffer the FATCA withholding tax on Withholdable Payments. These institutions will be in an uncompetitive position compared to Participating FFIs with respect to investments in US capital markets. Certain FFIs, rather than incurring the FATCA withholding tax, may simply choose to cease to hold US securities for their own account and terminate their US account holders (provided they can do so under local law). Even those FFIs will be impacted by FATCA through the application of the Passthru payment rules, as currently drafted.
- IRS agreement. Under the IRS agreement, the FFI must (i) determine whether it has US account holders, (ii) comply with IRS verification and due diligence procedures with respect to the identification of US accounts, (iii) annually report US account information to the IRS, (iv) withhold the FATCA withholding tax on Passthru payments, (v) comply with additional IRS information requests with respect to US account holders and (vi) attempt to obtain a waiver in any case in which any foreign law would (but for the waiver) prevent the reporting of information as required under FATCA, and, if a waiver is not obtained within a reasonable period of time, close the account.
- Passthru payments. As currently drafted, a Recalcitrant Account Holder or a Non-Participating FFI that receives a Passthru payment from a Participating FFI is subject to FATCA withholding tax, even though the payment would not be subject to US taxation but for FATCA. This rule is so broad that it includes any payment to a Recalcitrant Account Holder or Non-Complaint FFI by a Participating FFI that has US assets in its asset base (or holds US assets in a custodial capacity) and encompasses synthetic exposures to US assets as well.
- Deemed Compliant FFI. In certain limited circumstances, an FFI may be excepted from entering into an IRS agreement if the FFI complies with IRS procedures to ensure that (i) the FFI does not maintain US accounts and meets certain other requirements or (ii) the FFI is a member of a class of institutions that the IRS has determined poses a low risk of tax evasion. The initial guidance relating to deemed compliant status is narrowly drawn.
- Reclaims. An FFI can reclaim FATCA withholding tax (without interest) only if the FFI is the beneficial owner of the income and can benefit from a reduced rate with respect to such payment under a double tax treaty with the United States (DTT); NFFEs that are the beneficial owner of a payment subject to the FATCA withholding tax can reclaim the withholding tax under the Code or a DTT.
- Interaction with foreign law. FATCA is a US-centric law that imposes expansive extraterritorial account holder and account information identification, reporting and withholding obligations. The nature and extent of these obligations are likely to bring FFIs and NFFEs into direct conflict with local laws, thereby creating potential legal exposures.
- An FFI is broadly defined to encompass non-US banks, private banks, investment banks, trust companies, brokerage firms, investment funds, trusts, certain life/reinsurance companies and products and all types of investment vehicles, to include family investment vehicles, retirement plans and pension plans.
- A Financial Account means a depository or custodial account maintained by the FFI and any non-publicly traded debt or equity interest in an FFI.
- A US Account is a financial account which is held by one or more Specified US Persons.
- De Minimis Account Rules. Note, unless the Participating FFI elects otherwise, an account is a non-US account if (i) the account is a depository account; (ii) each holder of such account is a natural person; and (iii) the balance or value of such account as of the end of the calendar year preceding the effective date of the FFI's Agreement does not exceed $50,000 (or the equivalent in foreign currency). So too, unless a Participating FFI elects otherwise, an account of a natural person, such as a securities account, is a non-US account if the balance or value of the account as of the end of the calendar year preceding the effective date of the FFI's FFI Agreement does not exceed $50,000 (or the equivalent in foreign currency).
- A Specified US Person is a US citizen or resident alien, privately owned US corporation or US Owned Foreign Entity.
- A US Owned Foreign Entity is a foreign entity which has one or more Substantial US Owner.
- A Substantial US Owner means, with respect to a corporation, any specified US person that owns, directly or indirectly, more than 10 percent of the stock of such corporation by vote or value. Comparable rules are provided for ownership in partnerships and trusts; for investment funds; the 10 percent ownership rule does not apply, which means that an investment by a US person below 10 percent is reportable.
- A Non-Participating FFI means an FFI that is not a Participating FFI, a Deemed Compliant FFI or otherwise excluded from the application of FATCA.
- A Recalcitrant Account Holder is an account holder that fails to comply with reasonable requests for information pursuant to IRS mandated verification and due diligence procedures to identify US Accounts, to provide a name, address and TIN or fails to provide a bank secrecy waiver upon request.
- A Passthru payment means any Withholdable Payment or other payment to the extent attributable to a Withholdable Payment.
- A Withholdable Payment is comprised of all US revenues, such as interest, dividends, rents, royalties and services fees and gross proceeds (not income) from the sale or disposition of US stocks and securities.
Where we are now
FATCA will enter into force January 1, 2013. Congress, in enacting FATCA, granted broad regulatory authority to the IRS to implement FATCA. The IRS has set forth its preliminary thinking on a variety of issues in the two Notices that have been published to date. Persons affected by FATCA (stakeholders) have submitted numerous comments prior to and after the publication of the Notices as to how FATCA should be implemented.
In our view, FATCA raises two fundamental issues, which, if not resolved, may impede the effective implementation of FATCA to achieve its stated objectives. Further, the IRS still needs to provide much guidance with respect to the implementation of FATCA.
Fundamental issues. The interaction of FATCA with local laws and Passthru payments.
Interaction with local laws. As mentioned, FATCA is a US-centric law that imposes expansive obligations, particularly on FFIs. A number of these US obligations may conflict with local law prohibitions with respect to privacy, disclosure, anti-discrimination and withholding “foreign” taxes if local law does not permit an FFI to undertake the required FATCA obligation or if the account holder or member does not otherwise consent to the actions, thereby exposing FFIs to potential regulatory sanctions, civil lawsuits and possible criminal exposures. Until these issues are resolved on a country-by-country basis, FFIs may be unable to comply with FATCA. Therefore, it will be necessary to resolve these conflicts prior to the effective implementation of FATCA.
Passthru payments. This concept was added to the legislation to incentivize Recalcitrant Account Holders to come into compliance by giving an FFI the information it needs to report, and to prevent a Participating FFI from being used as a “blocker” through which Non-Participating FFIs might benefit from indirect investments in US assets without being subject to FATCA withholding or entering into an FFI Agreement, thereby circumventing the policy goals of FATCA. The Passthru payment rule is extremely broad. The rule, inter alia, likely will impact the smooth functioning of financial systems; is contrary to local law prohibitions on withholding “foreign” taxes; will impose expansive and costly compliance burdens on Participating FFIs and, through the publication of the PPP (as hereafter defined), will require FFIs to divulge information that may be viewed as proprietary with respect to their asset allocations. The IRS has requested additional comments on Passthru payments, and hopefully will revise these rules to better target its concerns when regulations are issued.
Implementation issues. It is hoped that in drafting guidance to implement FATCA, the IRS will endeavor to construct a workable information reporting and withholding system that can be effectively implemented and utilized by US withholding agents and non-US entities affected by the legislation to obtain information consistent with the purposes of the legislation and in a manner that will not discourage or disrupt foreign investment in US capital markets.
This notice presented the preliminary thinking of the IRS on a number of topics, to include (i) grandfathered obligations; (ii) the definition of a financial institution, (iii) entities excluded from the definition of a financial institution and/or otherwise exempt from some or all of the FATCA obligations, (iv) the identification and collection of information with respect to persons by FFIs and NFFEs – in this regard, the Notice detailed the protocols for the identification of direct and indirect US account holders, (v) the reporting of US accounts and (vi) made observations and requested comments on a number of issues.
Notice 2010-60 contained protocols to determine whether individual account holders are to be treated as US persons or other persons, and protocols to determine whether entity accounts are US accounts or other accounts and the classification of such other accounts. Essentially, an FFI will have to determine whether a person is a US person or other person, and whether account holders that are entities are to be treated as US persons, Participating FFIs, Deemed Compliant FFIs, Non-Participating FFIs, non-US persons excepted from FATCA, Recalcitrant Account Holders, NFFEs excepted from FATCA, other NFFEs and other accounts. Separate screening rules will apply for pre-existing financial accounts held by individuals, new financial accounts held by individuals, pre-existing financial accounts held by other entities and new financial accounts held by other entities.
Overview. The preliminary guidance relates to (i) revised identification procedures for pre-existing individual accounts from those provided by the earlier notice, (ii) Passthru payments that are subject to the FATCA withholding tax, (iii) the requirements for deemed-compliant status for certain types classes of FFIs, (iv) revised reporting requirements for US accounts, (v) qualified intermediaries (QIs) and the requirement that such entities be Participating FFIs and (vi) rules related to affiliated FFIs.
Revised identification procedures. The Notice totally revises the preexisting individual account procedures of the earlier Notice to provide for a five-step identification procedure (with a retest in later years (step 6)) for direct US account holders. Among the highlights of this procedure are the following elements:
(i) The US$50,000 de minimis exclusion rule for US accounts that originally applied only to rule depository accounts (Step 1) is expanded to include non-depository accounts (such as securities accounts) (Step 2); in addition, an FFI can elect to have each branch report information regarding accounts it maintains to avoid local law privacy constraints.
(ii) A new US account identification procedure for “private banking accounts” broadly defined (Step 3) requires a rigorous inquiry of US indicia to determine whether there are US account holders: previously, the IRS allowed FFIs to limit their searches to electronically searchable information maintained by the FFI; now, for these types of accounts, the FFI’s private banking relationship manager must perform a diligent review of paper and electronic files for each client to determine whether the account has indicia of US ownership and provides protocols to make determinations of US status.
(iii) For accounts not covered by the first three steps, an FFI is required to determine whether its electronically searchable information (now defined) with respect to these accounts includes indicia of US ownership (Step 4) and provides protocols to make determinations of US status.
(iv) The last search (Step 5) is established for accounts of US$500,000 or more, which requires a diligent review of electronically searchable and paper documentation to determine indicia of US ownership and provides protocols to make determinations of US status.
(v) An account holder that does not provide the required documentation or bank waivers within prescribed periods within each step will be treated as a Recalcitrant Account holder and subject to the Passthru payment rule.
(vi) Certification procedures are provided relating to the five-step US account identification procedures and the required promulgation of written policies and procedures prohibiting FFI employees from advising US account holders on how to avoid having their US accounts identified; in addition, effective from the publication of the Notice, April 8, 2011, and the effective date of the FFI Agreement, the FFI’s chief compliance officer must certify that the FFI did not engage in any activity, or have any formal or informal polices and procedures in place directing, encouraging or assisting account holders with respect to strategies for avoiding identification of their accounts as US accounts. This type of activity also could expose an FFI to potential local criminal liability.
Passthru payments. The Notice provides computational rules for Passthru payments. Passthru payments are determined on a formulary rather than a tracing basis.
A Passthru payment can arise from a custodial payment in which the FFI acts as a custodian, nominee or agent for the benefit of an account holder or where the FFI makes a payment from its own assets. In either case, the amount subject to the FATCA withholding tax is determined by reference to a Passthru Payment Percentage (PPP). In the case of a custodial payment, the PPP is that of the entity that issued the interest or instrument to the FFI in its custodial capacity. In the case of any other payment, the PPP is determined by reference to the FFI’s total gross US assets (as defined in the Notice) and other assets, unreduced by liabilities, as of its quarterly testing dates, by dividing the sum of its US assets held on each of the last four quarterly dates by the sum of its total assets held on those dates. The definition of US assets encompasses interests in financial accounts other than custodial accounts (such as depositary accounts) held by another FFI; the amount of these assets that constitutes a US asset is equal to the value of the account with the lower-tier FFI, multiplied by the lower-tier FFI’s PPP, which the FFI may rely upon if the lower-tier FFI publishes its PPP. This makes for extremely detailed data gathering and complex computations.
The FFI must publish the quarterly PPP in a way that is publicly accessible. When a participating FFI does not publish its PPP, it will be assumed to have a PPP of 100 percent. A Non-Participating FFI has a PPP of zero.
Deemed Compliant entities. The Notice provides that certain entities can be deemed to be compliant if such entity (i) applies for deemed compliant status with the IRS, (ii) obtains an FFI number from the IRS and (iii) certifies every three years to the IRS that it meets the requirements for such treatment. These procedures create a streamlined agreement procedure for FFIs that the IRS considers unlikely to have US accounts. The entities enumerated in the Notice that can qualify for this procedure are (i) local banks that, among other requirements, have procedures in place to not open or maintain accounts for non-residents or Non-Participating FFIs, (ii) local FFI members of Participating FFI groups and (iii) investment funds that are open only to participating FFIs and Deemed-Compliant FFIs. The requirements for deemed compliant entities are narrowly drafted and likely not to have broad application. The IRS has requested additional comment in this area. Note, a Deemed Compliant entity nonetheless may be required to determine its PPP.
Reporting requirements. The Notice modifies the US account reporting procedures from those outlined in the earlier Notice to simplify the frequency to year-end determinations and the amounts to be reported; provides that tax basis reporting will not be required; and allows branch reporting, which avoids local law privacy constraints that would prevent consolidating account information across branches or affiliates located in different jurisdictions.
Other. The Notice requires qualified intermediaries to become Participating FFIs (unless they qualify as Deemed Compliant FFIs). The Notice also contains rules relating to requirements for FFI affiliates in an FFI group and for execution of FFI Agreements and their oversight.
Items not covered. The Notice does not provide guidance for retirement plans, pension plans, charities, pooled investment vehicles, trusts and insurance/reinsurance companies (whose products have an investment element; those without an investment element, such as P&C policies are excluded).
What FFIs Should Do Now
The comment period on Notice 2011-34 has closed, although comments received after that date will be considered. The IRS is currently in the process of drafting proposed regulations, which are anticipated to be published later this year, setting forth comprehensive FATCA guidance. The IRS also plans to publish drafts of FFI agreements and associated forms that will be utilized in administering FATCA. Finally, it is understood that the IRS may publish certain transitional relief to include limiting the FATCA withholding, particularly with respect to Passthru payments.
At this stage, FFIs need to determine whether they will become Participating FFIs, Deemed Compliant FFIs or Non-Participating FFIs. This will require a cost/benefit analysis. FFIs will not be able to revise their IT systems until more definitive guidance is published, although there are certain actions that can be taken now. This is a serious problem, as it is understood that it may take from 18 to 24 months to revise IT systems and develop implementing protocols. In addition, FFIs need to consider the interaction of FATCA and local laws, as it is understood that in many countries, the FATCA rules relating to account openings, closing and withholding without the consent of the account holder will be contrary to local laws. Finally, it should be noted that the costs for FFIs to implement and comply with FATCA may be disproportionate to the estimated revenue pickup, which is US$7.7 billion dollars over 10 years; these costs ultimately will be borne by the FFIs and the countries in which the FFIs are resident.