In February 2012, the Internal Revenue Service issued proposed regulations regarding the implementation of the Foreign Account Tax Compliance Act (FATCA), a statute that was included in the Hiring Incentives to Restore Employment (HIRE) Act of 2010 as a revenue raiser.1 Congress drafted FATCA as a reaction to the disclosure in recent years of unreported accounts held by U.S. taxpayers at Swiss and other overseas financial institutions. These accounts were either reported by several overseas banks as part of a settlement with U.S. judicial and regulatory authorities or self-disclosed by U.S. individuals who participated in the various voluntary disclosure (amnesty) programs that the IRS has set up in recent years. 

FATCA introduces a reporting regime that will require a foreign financial institution (FFI) to enter into a disclosure agreement with the IRS or, generally, starting on Jan. 1, 2014, face automatic withholding of 30 percent of U.S. source income. U.S. source income for FATCA purposes includes not only dividend and interest, but also gross proceeds from the sale of assets that produce dividends or interest originating from the United States.

 

FFI

FATCA broadly defines an FFI to include banks, investment funds, insurance companies and pension funds. Basically, an FFI, for FATCA purposes, is any foreign entity that accepts deposits in the ordinary course of banking or similar business and for which a substantial portion of its business consists of holding financial assets for the accounts of third parties. Under this definition, banks are clearly FFIs, but FATCA goes on to consider as an FFI any foreign entity that’s engaged primarily in the business of investing, re-investing or trading in securities, commodities or partnership interests. Under this definition, many overseas hedge and private equity funds will be considered FFIs and subject to FATCA reporting. Once an FFI has entered into an agreement with the IRS, it will be subject to certain ongoing reporting on financial accounts requirements, as detailed below. 

 

Affiliated Groups

If an FFI is part of an expanded affiliated group (globally operating banks and investment funds), special transitional rules apply. Basically, all FFIs that are part of such a group must sign up with the IRS before any individual member of the group can become a compliant FFI. The proposed regulations only contain temporary relief under special conditions for FFIs with affiliates/branches that can’t enter into an agreement with the IRS under the laws of their home jurisdiction (for example, because of bank secrecy rules). Such limited branches and FFIs have until Jan. 1, 2016 to, along with all FFI members of their group, sign an agreement with the IRS. Unless all members of such an expanded group of affiliates have signed an agreement by Jan. 1, 2016, no member of the group will be considered a participating FFI. These rules require that globally operating financial organizations coordinate FATCA compliance closely for their entire group of affiliates or face the consequences of being subject to blanket FATCA withholding. Thus, only FFI members based in jurisdictions with rules that would prohibit withholding or reporting under FATCA would delay group-wide compliance prior to Jan. 1, 2016. However, note that under the transitional rules, FFIs that have qualified for limited branch status under FATCA are still required to report existing accounts that are considered U.S., and they can’t open new accounts that could be considered U.S. under FATCA.

FATCA also imposes an automatic withholding of 30 percent on U.S. source income paid to non-financial foreign entities (NFFEs) that don’t comply with certain informational reporting requirements.

 

NFFEs

With respect to non-FFIs, FATCA distinguishes between exempted beneficial owners and NFFEs and non-exempted NFFEs. Along with active NFFEs, the following overseas entities are generally exempted from FATCA reporting and withholding: 

 

Foreign governments, international organizations and foreign central banks;

Publicly traded companies and entities within their expanded group of affiliates;

Entities organized under the laws of a U.S. possession or governments of such possessions; and

Active NFFEs that receive less than 50 percent of their gross income from assets that are held for the production of passive income and receive less than 50 percent of their income from passive investments.  

 

Financial Accounts

FATCA broadly defines a financial account to include bank and brokerage accounts, as well as interests in investment vehicles and certain insurance products. Bank, checking, savings, depository and custodial accounts (held for the benefit of a beneficiary other than the account holder) are included. Insurance products that are subject to FATCA reporting are primarily contracts that include an investment component, such as annuities. Pure life insurance policies aren’t considered financial accounts for FATCA.

 

Review of Pre-existing Accounts

The level of review of financial accounts of individuals that existed in the books/systems of an FFI prior to the date that it signed the agreement with the IRS depends on the value of the assets in the account. FATCA only requires a full file review for accounts with a value of
$1 million or more. Accounts with a value of $50,000 or less are exempt from review. Accounts with an asset value of more than $50,000 and less than $1 million require only a basic database review of indicia of U.S. ownership. 

Accounts with a value of $1 million or more require a deeper investigation to determine the possibility of U.S. ownership. These indicia include a variety of matters, such as a U.S. address or telephone number, as well as other information that can be derived from the client files (for example, “hold mail” instructions, issuance of a power of attorney to a U.S. person) or from the account manager at the FFI who’s responsible for the account. In many cases, this review process will require a detailed manual review of client accounts. There’s a limited safe harbor from manual review of financial accounts of $1 million or more, and FATCA only exempts files from review in cases in which the following information is electronically stored in the client database: nationality and tax residence of client, full address details of the client, as well as any “care of” and “hold mail” instructions and U.S. signatories for the accounts. FFIs that don’t store this key client data electronically are at a disadvantage and will have to dedicate more resources to a manual review of client files.

Deadline. The pre-existing account review is a one-time review of all accounts maintained at the FFI as of June 30, 2014. The review has two deadlines, depending on the account balance. For accounts valued at $1 million or more at the end of the preceding calendar year, the review must be completed by Dec. 31, 2014. All other account reviews must be completed by Dec. 31, 2015. For pre-existing accounts held by entities, instead of individuals, the review rules are different, and all accounts with a value of less than $250,000 are exempt until the account value surpasses a threshold of $1 million. As long as the balance of such entity accounts remains less than $1 million, FFIs can, generally, rely on information from their “Know Your Customer” files to determine client withholding status for FATCA. Only if such accounts have a balance of $1 million or more is an expanded review required to determine substantial U.S. ownership.

Many financial accounts that are principally owned by non-resident alien (NRA) clients may have indicia of U.S. ownership, because it’s customary for such clients to use “hold mail” instructions or have account statements sent to a U.S. address for convenience (in case they own U.S. residential property or have U.S. resident family members) or because certain NRA clients don’t feel that it’s safe to receive mail in their home country. Also, many NRA clients, in particular those with family members (children) residing in the United States, have issued signature authority to U.S. persons on financial accounts, which will result in additional review to establish that there’s no U.S. ownership for FATCA purposes.   

 

New Accounts

For any individual account opened after the FFI has signed the agreement with the IRS, the FFI will have to review information provided by the accountholder for “Know Your Customer” purposes for indicia of U.S. ownership. If no satisfactory information is obtained from the account holder to establish that there’s no U.S. ownership, the FFI must mark this account holder as recalcitrant. A recalcitrant account holder who isn’t willing to comply with a reasonable request for information required pursuant to the FATCA verification rules, will be subject to full FATCA withholding. It’s expected that, in practice, no new accounts will be opened unless the account holder is prepared to be subjected to full FATCA reporting.

For new accounts opened in the name of entities, the FFI will need to obtain a certification whether the entity has substantial U.S. ownership, unless the account is opened by another FFI in its own name. In practice, FFIs will, therefore, only be required to obtain certification about substantial U.S. ownership from non-exempted NFFEs.

Non-exempted NFFEs must disclose substantial U.S. ownership to the FFI via a certification (revised version of Form W-8BEN-E for entities, revised Form W-8BEN for individuals). Substantial U.S. ownership is generally defined as having 10 percent or greater direct or indirect interest by U.S. persons. This 10 percent interest covers corporate stocks as well as partnerships interest and beneficial interests in non-grantor trusts. Once an NFFE has met this threshold in terms of U.S. ownership, it must report on these U.S. owners to the FFI. In an increasingly interconnected world, many overseas privately held foreign corporations, partnerships and trusts will qualify as NFFEs with substantial U.S. ownership. Just think of the many foreign nationals who move to the United States while retaining a substantial interest in a family business in their home country, as well as the entrepreneurs—many from Asia and other emerging economies—who repatriate after completing their studies in the United States, while keeping their green card. Whereas these individuals should be aware of and fully comply with their respective U.S. tax filing and reporting requirements, they’ll now also trigger a FATCA reporting requirement for the non-exempted NFFE in which they have an interest. These NFFEs may not have had any exposure to U.S. reporting obligations to date, especially if they have only invested in financial instruments in their domestic markets and haven’t had accounts with U.S. financial institutions. 

 

Tiered Reporting System

As “Linked In,” this page, illustrates, FATCA is a tiered reporting system. Every FFI that’s entered into an agreement with the IRS and is part of a chain of FFIs with account holders who get payments of U.S. source income must obtain certifications from its FFI and NFFE account holders. Going forward, an NFFE that has accounts with an FFI will have to disclose information about its shareholders and members if it’s classified as a non-exempted NFFE. NFFEs with substantial U.S. ownership (defined as having U.S. members/owners with an interest of 10 percent or more) must disclose their U.S. members/owners to the FFI. However, even in cases in which these NFFEs have provided all FATCA required disclosures and certifications (in case there’s no substantial U.S. ownership) for the FFI where they have an account, payment of U.S. source income may still be subject to withholding in case there’s a non-compliant lower tier FFI (for instance, in case their local bank invests in U.S. instruments via an offshore bank or fund that’s considered a non-compliant FFI for FATCA purposes), in which case the compliant NFFE will receive its payment after FATCA withholding.

 

Deemed-Compliant FFIs

Certain FFIs are deemed compliant for FATCA purposes and don’t have to enter into an agreement with the IRS to avoid FATCA withholding.

 Broadly speaking, the following three categories of FFIs are deemed compliant for FATCA: 

(1) Registered deemed-compliant FFIs. This category includes local FFIs, non-reporting members of participating FFI groups, qualified investment vehicles, restricted funds and FFIs that comply under an agreement between the United States and a foreign government. Local FFIs in this category are registered and licensed financial institutions that have no establishment and don’t solicit clients outside their home jurisdiction. Furthermore, these local FFIs must have a client base that’s 98 percent resident in their home jurisdiction and for which either informational reporting or withholding to local tax authorities applies. Even though registered deemed-compliant FFIs don’t need to enter into an agreement with the IRS, they must still certify to the IRS that they meet all requirements of their status, monitor this status with a renewed certification to the IRS every three years and advise the IRS in case their status changes.

(2) Certified deemed-compliant FFIs. This category, like the first one, also includes FFIs that are local in terms of their operations, as well as retirement plans and non-profit organizations. 

(3) Owner-documented FFIs. These FFIs are only deemed compliant with respect to accounts held with a withholding agent.

FFIs in the last two categories are required to provide their withholding agent with detailed information that certifies and confirms their status.       

 

Implementation Challenges

FATCA is a complex statute, and although FFIs have been preparing for its implementation and reporting requirements for several years already, many challenges remain that must be addressed before Jan. 1, 2014. FFIs will have to screen their client base and determine into what categories their clients will fall for FATCA reporting purposes (for example, FFI, deemed-compliant FFI, non-exempt NFFE). Also, they’ll have to look for indicia of U.S. ownership within their individual and NFFE client accounts, which may be challenging if client data isn’t stored electronically and a full manual file review is required for FATCA purposes. 

Moreover, FFIs and NFFEs need to be educated about and become familiar with the new Form W-8BEN-E, which is longer and more complex than previous versions that were required for withholding purposes. It’s likely that these updated forms won’t be completed 100 percent timely or accurately until all participants in the global financial markets become more familiar with this version. 

Finally, going forward, both participating FFIs and deemed-compliant FFIs must continuously screen their client database for changes in client status that may result in a change in withholding and reporting status for FATCA purposes. A factual change (such a change of the address of the account holder from an overseas to U.S. address or an issuance of power of attorney to a U.S. person) will require an FFI to perform a deeper investigation and establish whether there’s now substantial U.S. ownership as a result of such changes.     

 

Endnote

1. Please note that this article focuses on the proposed regulations as published in February 2012. On July 26, 2012, Model Intergovernmental Agreements (IGAs) between the United States and Foreign Account Tax Compliance Act partner countries were published and the first one was signed between the United States and the United Kingdom on Sept. 14, 2012. These IGAs are slightly different from the proposed regulations in terms of timelines and certain definitions.