On Jan. 17, 2013, the U.S. Treasury and Internal Revenue Service published their final regulations regarding the Foreign Account Tax Compliance Act (FATCA).  FATCA is a statute that was enacted in 2010 as part of the Hiring Incentives to Restore Employment Act and that, starting on Jan. 1, 2014, will generally impose 30 percent withholding tax on many forms of payment of U.S.-source income unless U.S. ownership is reported.

The published regulations contain more than 500 pages of guidance and are intended to address many of the issues that have been raised by stakeholders in FATCA in comment letters to and meetings held with the U.S. Treasury and IRS.  The U.S. government clearly intends to simplify processes and minimize implementation costs associated with FATCA.

Let’s briefly summarize some key highlights from the recently published FATCA regulations for wealth management professionals.

 

Investment Entity Defined

The regulations incorporate an amended definition of investment entity to align it with the definition that was used in the FATCA intergovernmental agreements (IGAs).  It covers any entity that primarily conducts certain financial business on behalf of a customer, such as individual or collective portfolio management or any entity otherwise investing, administering or managing funds or money on behalf of other persons, regardless of whether the entity holds financial assets.  It also includes any entity with a gross income that consists primarily of investing, reinvesting or trading in financial assets and is professionally managed by a bank, custodial institution, insurance company or an investment entity that’s a professional investment advisor.  Also included in this definition is any entity that holds itself out as a collective investment vehicle, mutual fund, exchange traded fund, private equity fund, hedge fund, venture capital fund or, leveraged buy-out fund or similar investment vehicle.  This new definition of investment entity will mean that overseas professional money managers will be considered foreign financial institutions (FFIs) and that only non-professionally managed passive non-commercial portfolio investment companies and trusts are considered passive non-financial foreign entities (NFFEs). This distinction is significant because of the differences in FATCA compliance requirements.  Whereas passive NFFEs only have to report their substantial U.S. beneficial owners (10 percent or more direct/indirect ownership), FFIs must enter into a formal agreement with the IRS and report on all its U.S. accounts.

 

Examples

Here are four examples from the regulations that highlight the importance for all professional managers and trustees to properly assess their reporting obligations under FATCA (I’ve used the same numbers for the examples that appear in the regulations):

Example 1: Investment advisor.  Among its various business operations, an investment entity fund manager organizes and manages a variety of funds, including Fund A, which invests primarily in equities.  The fund manager hires an investment advisor, a foreign entity, to provide advice about the financial assets in which Fund A invests.  The investment advisor earned more than 50 percent of its gross income for the last three years from providing services as an investment advisor.  Because the investment advisor primarily conducts its business by providing investment advice on behalf of its clients, the investment advisor is an investment entity.

Example 2: Entity that’s managed by an FFI. The facts are the same as in Example 1.  In addition, in every year since it was organized, Fund A has earned more than 50 percent of its gross income from investing in financial assets.  Accordingly, Fund A is an investment entity because it is managed by a fund manager and investment advisors, and its gross income is primarily attributable to investing, re-investing or trading in financial assets.

Example 5:Trust managed by an individual.  On Jan. 1, 2013, X, an individual, establishes Trust A, a non-grantor foreign trust for the benefit of X’s children, Y and Z. X appoints Trustee A, an individual, to act as the trustee of Trust A.  Trust A’s assets consists solely of financial assets, and its income consists solely of income from those financial assets.  Pursuant to the terms of the trust instrument, Trustee A manages and administers the assets of the trust.  Trustee A doesn’t hire any entity as a third-party service provider to perform any of the activities.  Trust A isn’t an investment entity because it’s managed solely by Trustee A, an individual.

Example 6: Trust managed by a trust company. The facts are the same as in Example 5, except that X hires Trust Company, an FFI, to act as trustee on behalf of Trust A. As trustee, Trust Company manages and administers the assets of Trust A in accordance with the terms of the trust instrument for the benefit of Y and Z.  Because Trust A is managed by an FFI, Trust A is an investment entity and an FFI and subject to the following regulations:

 

-       Pre-existing accounts.  The regulations generally consider any account that’s outstanding on Dec. 31, 2013 as a pre-existing account.  FFIs that participate in FATCA and withholding agents must complete due diligence on pre-existing accounts of prima facie FFIs1 by July 1, 2014.  Participating FFIs must complete the due diligence for high value individual accounts by Jan. 1, 2015. For all other pre-existing accounts, participating FFIs and withholding agents must complete due diligence by Jan. 1, 2016;  

-       Bearer shares.  Investment funds that have issued shares in bearer form must perform new account identification procedures for pre-existing obligations in bearer form at the time that this share is presented for payment.  Furthermore, a fund that’s issued bearer shares in the past can qualify as deemed compliant if it: (1) ceased issuing bearer shares after Dec. 31, 2012, (2) retires all bearer shares upon surrender, and (3) implements procedures to redeem or immobilize bearer interests prior to Jan. 1, 2017.

Coming Up

Here’s what’s expected in the near future.

-       Registration portal.  The IRS is expected to offer FFIs access to this portal by July 15, 2013. It will be the main avenue for FFIs to interact with the IRS in terms of their FATCA reporting obligations.  The IRS intends to issue a global intermediary identification number (GIIN) to FFIs once their registration has been approved. FFIs can provide this GIIN to withholding agents to avoid FATCA withholding.  On Dec. 2, 2013, the IRS will electronically post a list of participating FFIs and deemed compliant FFIs. FFIs must register by Oct. 25, 2013 to be included on this list.  This list will be updated on a monthly basis after Dec. 2, 2013;

-       New forms. In the coming months, the IRS will revise existing forms such as W-8, 1042 and 1042-S and introduce a new form 8966 (FATCA report);

-       More IGAs.  The published regulations make clear that more IGAs will be concluded.  These IGAs will cover some more jurisdiction-specific entities and arrangements.  Generally speaking, IGAs result in a more favorable treatment of FFIs.

 

More Clarification Needed 

Despite the extensive recent guidance provided by the regulations, many areas of FATCA still need to be clarified, which provides challenges for FFIs that have to register before Oct. 15, 2013 to obtain a GIIN and implement FATCA reporting by Jan. 1, 2014.

Endnote

1. Prima facie FFIs (obvious FFIs) are entities identified as qualified intermediaries or nonqualified intermediaries and, for accounts maintained in the United States, entities that have codes issued under the Standard Industry Classification or North American Industry Classification System, which indicate they are financial institutions.