Foreign Account Tax Compliance Act and Its Importance and Impact on the Rest of the World
Christopher Klug – Business Tax Attorney , Washington DC
Globalization, emerging markets and increased regulation are transforming the global tax framework and presenting complex and arduous challenges for financial institutions around the world. The Foreign Account Tax Compliance Act (“FATCA”) presents a significant structural change in the US’s efforts to improve tax compliance.
FATCA is intended to detect and deter the evasion of US tax by US persons who hide money outside the US. FATCA creates greater transparency by strengthening information reporting and compliance by providing rules around the processes of documenting, reporting, and withholding on a payee. These rules not only impact the financial services sector, but also many entities outside of the traditional financial services sector with operations both in and outside the US.
FATCA¹ requires foreign (non-US) financial institutions (“FFI”)² and non-financial foreign (non-US) entities (“NFFE”) to identify and disclose their US account holders and members or become subject to a 30% withholding tax with respect to certain US source income.
The Foreign Account Tax Compliance Act was enacted on March 18, 2010 by the United States Congress through the Hiring Incentives to Restore Employment Act (a/k/a “Hire Act”). FATCA was enacted as a result of the US effort to target offshore tax evasion and recoup offshore tax revenue. The legislation was also prompted by the prosecution of Swiss banks that aided US account holders in US tax evasion.
The purpose of FATCA is to detect, deter, and discourage offshore tax abuse through increased reporting and strong sanctions. The goal of the legislation is for the US Internal Revenue Service (“IRS”) to obtain information about offshore accounts and investments beneficially owned by US taxpayers.
It is important to remember that FATCA imposes compliance obligations on FFIs that are subject to local laws and oversight that may be contrary to the reporting requirements mandated under FATCA. FATCA requires that FFIs obtain, verify, and transmit information to the IRS, close accounts of certain recalcitrant account holders and/or collect a 30% withholding tax on withholdable payments made to recalcitrant account holders or noncompliant FFIs. Where local law is contrary to the requirements of FATCA, the FFIs are not exempt from FATCA reporting obligations. The IRS guidance provides under these circumstances the FFI should attempt to obtain a waiver to release the information from the account holder, or if a waiver is not obtained, to close the account holder’s account.
Under FATCA, a Recalcitrant Account Holder is an account holder who (i) fails to comply with reasonable requests for information pursuant to IRS mandated verification and due diligence procedures to identify US accounts, or (ii) fails to provide a waiver upon request.
FATCA uses a two-prong approach to ensure US Persons ³ report their income from non-US accounts and assets. First, FATCA requires FFIs to report their US account holders either directly to the IRS or to the local jurisdiction who will exchange the information with the IRS. Second, FATCA requires US Persons to file a Form 8938 with their US income tax filing to report their foreign assets.
While the basic premise of FATCA is a worthy cause, combatting US tax evasion, many around the world see FATCA as another instance of the US burdening the rest of the world to further only US interest. In fact, the US has enlisted FFIs as agents to report their US account holders. As part of the FFI’s due diligence in determining their US account holders, non-US individuals and entities are required to certify they are not US Persons. Non-US entities are further classified as FFIs and non-financial foreign entities. With the level of due diligence required, it is certainly understandable why many around the world would object to certifying they are not US Persons.
The first logical question is why would FFIs agree to report their US account holders to the IRS. The US has used a big stick to encourage FFIs to comply with FATCA. An FFI that elects not to comply with FATCA will be subject to a 30% withholding tax on their US source fixed, determinable, annual, and periodic (“FDAP”) income and gross proceeds from securities producing US source income. Examples of FDAP income include US source interest and dividends, rents, salaries, wages, premiums, annuities, compensation, emoluments, and other FDAP gains, profits, and income.
Reporting and Compliance for FFIs
FATCA requires FFIs to (i) create due diligence procedures to identify US Persons; (ii) report the US Persons’ accounts and income generated in the accounts to the IRS; and (iii) collect the 30% withholding tax on US FDAP and gross proceeds from the sale or other disposition of any property of a type which can produce US-source interest or dividends, regardless of whether there was gain on the disposition with respect to the property. One international financial institution has stated they have spent in the nine figures to implement their FATCA reporting due diligence procedures. The FFIs cost of compliance is significant, but the cost is necessary due to the alternative 30% withholding tax.
A key aspect of FATCA is to require a broad group of US and foreign persons to identify and document payees in new ways and to disclose additional information to the IRS. In order to lessen the likeliness of possible foreign legal barriers to the requirements of FATCA, the US Treasury Department has negotiated intergovernmental agreements (“IGA”) with foreign governments.
FATCA, through the 30% withholding tax, offers significant financial incentives for FFIs to follow the reporting and withholding obligations imposed under FATCA. FFIs carry the most significant burden under FATCA with the reporting, withholding, and documentation requirements.
FFIs need a FATCA compliance program to ensure all necessary FATCA classifications, documentation, monitoring, and reporting are properly completed. This should be set forth in a series of procedures and policies to ensure that there are controls in place to establish compliance. The compliance program should highlight changes required in business practices that are necessary to ensure the FFI’s compliance with FATCA.
Types of FFIs
FFIs are classified into three categories. A participating FFI is an FFI that enters into an FFI agreement with the IRS and follows the due diligence and reporting procedures. A participating FFI is not subject to the 30% withholding tax. A nonparticipating FFI is an FFI that does not enter into an IRS agreement and otherwise does not fall within another exception from entering into an IRS agreement. A nonparticipating FFI will be subject to the 30% withholding tax. Deemed compliant FFIs are not required to enter into an IRS agreement and are not subject to the 30% withholding tax. A FFI will be deemed compliant if either:
The FFI complies with such procedures as the IRS may prescribe to ensure that the FFI does not maintain US accounts and the FFI meets such other requirements as the IRS may prescribe, with respect to accounts of other FFIs maintained by the FFI; or
- The FFI is a member of a class of institutions with respect to which the IRS has determined that the application of the agreement/withholding provisions is not necessary.
FFI Records on Account Holders
To avoid the 30% withholding tax, an FFI must enter into an agreement with the IRS and agree to:
- Obtain information on all account holders in order to determine their US accounts;
- Comply with required due diligence and verification procedures and provide certification of completion of the procedures;
- Report the US accounts to the IRS;
- Withhold 30% tax on passthru payments to recalcitrant account holders or FFIs that are not participating FFIs or deemed compliant FFIs;
- Comply and respond to IRS information request; and
- In jurisdictions where bank secrecy or other limitations would prevent the FATCA reporting, attempt to obtain a waiver of the applicable laws from account holders or close the account if the account holder will not provide the waiver.
The IRS created a web-based portal for FFIs to register with the IRS to confirm the FFI is compliant with their FATCA reporting obligations and confirming the FFIs participating FFI status. The IRS will review the application and issue a Global Intermediary Identification Number (“GIIN”). The participating FFI will provide withholding agents their GIIN to confirm its participating FFI status in order to avoid the 30% tax withholding.
Under FATCA, a withholding agent means all persons/entities, in whatever capacity, having control, receipt, or custody, disposal, or payment of any withholdable payment.
Registration as a participating FFI will require a designation of a responsible officer and other persons acting as points of contact for the IRS. The FFI’s responsible officer will be required to electronically sign the FFI agreement with the IRS.
FFI Due Diligence and Withholding
As part of its due diligence procedures, FFIs will need to identify (i) US accounts; (ii) each account holder that is a specified United States person; (iii) each US Owned Foreign Entity; (iv) each Substantial US Owner of such entity; and (v) the classification of company account holders or transactions as FFI (including type), non-FFI, governmental, or other exempt entity, corporation, etc.
A nonparticipating FFI will be subject to a 30% withholding tax on withholdable payments. Withholdable payments include:
- Payments of US-source interest and dividends, rents, salaries, wages, premiums, annuities, compensation, emoluments, and other FDAP gains, profits, and income; and
- Gross proceeds from the sale or other disposition of any property of a type which can produce US-source interest or dividends, regardless of whether there was gain on the disposition with respect to the property.
As part of their FATCA obligations, participating FFIs will need to withhold a 30% tax on any passthru payment to any recalcitrant account holders or nonparticipating FFIs. This will require the participating FFI to develop a strategy to manage recalcitrant account holders both short and long term.
Types of Intergovernmental Agreements
In order to report under FATCA, there are different methods depending on whether the FFI is located in a jurisdiction that has entered into an Intergovernmental Agreement (“IGA”) with the US. There are two model IGAs that the IRS has entered into relating to FATCA reporting.
Under a Model 1 IGA, the FFIs will not enter into a FFI agreement with the IRS, but will report their US account holders and other information required under the due diligence procedures to their local government. The local government will then report the information on the US account holders to the IRS. The Model 1 IGA is the most enacted IGA. This is also the basis for the proposed reporting standards under the Common Reporting Standard (Briefly discussed below).
Under a Model 2 IGA, the FATCA partner jurisdiction agrees to direct and enable all relevant FFIs located in the jurisdiction to report their US account holders and other information required under the due diligence procedures directly to the IRS. The participating FFI will enter into a FFI agreement with the IRS.
FFIs located in a non-FATCA partner jurisdiction will register through the IRS portal and agree to comply with the terms of an FFI agreement in order to avoid being treated as a nonparticipating FFI subject to withholding tax.
Information Reported to The IRS by FFIs
The FFI will report to the IRS the name and Taxpayer Identification Number (“TIN”) of each account holder that is a US Person and for all account holders who are a US Foreign Owned Entity, the name, address, and TIN of each Substantial US owner of the US Foreign Owned Entity. Also reported will be each account number, the account balance or value determined at such time and in such manner as the IRS may prescribe, and the gross receipts and gross withdrawals from such accounts.
For purposes of FATCA, a US Foreign Owned Entity means any foreign entity which has one or more Substantial US Owners. A Substantial US Owner is a US Person who owns more than 10% in a foreign corporation, partnership, or trust.
IRS Compliance Forms
The IRS has created forms that the FFIs use or can use to obtain the required information from their account holders as part of the due diligence procedures. There are separate forms for US persons, non-US persons, and non-US entities.
Form W-9 is used to request a TIN of a US person (including a resident alien) and to request certain certifications and claims of exemption from the account holder. Withholding agents may require a signed Form W-9 to document the account holder’s non-foreign status.
Form W-8BEN is used to establish a foreign individual’s non-US status for purposes of the 30% withholding tax on certain FDAP income. The 30% withholding tax is imposed on the gross income received by the foreign individual. By signing Form W-8BEN, the foreign individual certifies their status as a nonresident alien of the US.
Form W-8BEN-E is used by foreign entities to document their status under FATCA, establish that it is a foreign entity, and if applicable, their eligibility to claim treaty benefits. A foreign entity that refuses to document their FATCA status may be treated as a recalcitrant account holder or nonparticipating FFI and will be subject to the 30% withholding tax on withholdable payments.
Reporting and Compliance for NFFEs
A NFFE that derives withholdable payments can avoid the US withholding tax regime by complying with certain informational requests. The NFFE is not required to enter into a FFI agreement with the IRS. The NFFE will have to provide the withholding agent with either (i) a certification that the NFFE does not have a Substantial US Owner or (ii) the name, address, and TIN of each Substantial US Owner.
As long as the NFFE completes the proper form and certifications, and the withholding agent does not know or have reason to know, that any information that was provided by the NFFE was incorrect, the NFFE will not be subject to the 30% withholding on withholdable payments. The withholding agent will have to report the information to the IRS in such manner as the IRS provides.
Common Reporting Standard
The Common Reporting Standard (“CRS”) is an information standard for exchange of tax and financial information on a global level, which the Organization for Economic Co-operation and Development developed in 2014. The purpose, like FATCA, is to combat tax evasion. The CRS has over 80 nations that agreed to implement the rules, with the first reporting beginning in September of 2017. The CRS is based on the US FATCA.
Each participating country in the CRS will annually automatically exchange the following information with the other participating countries:
- Name, address, taxpayer identification number, and date and place of birth of each Reportable Person;
- Account number;
- Name and identifying number of the reporting financial institution; and
- Account balance or value as of the end of the relevant calendar year.
The OECD allows participating countries to determine what accounts are reportable.
Notably, the US will not participate in the automatic exchange of information under the CRS. The US prefers the FATCA approach and the bilateral agreements with other nations. The US has also indicated they are concerned with the security of the information that would be sent to some of the countries that are part of the CRS.
Under the reciprocal exchange of information agreement under FATCA, the other nation does not always require as detailed information as the US and owners of accounts held through entities may not need to be reported. Many now see the US as the jurisdiction to establish accounts for privacy. This is truly an odd result since the US is the country that created FATCA.
FATCA is an area evolving rapidly, especially as IGAs and IGA countries implement their own regulations and procedures. It is important that FFIs have developed a compliance plan to ensure their FATCA due diligence and reporting meets the requirements under FATCA.
Contact us should you need help on FATCA compliance.
FATCA provisions are contained in Sections 1471 – 1474 of the US Internal Revenue Code and the related Treasury Regulations.
FFIs are foreign entities that: (i) accept deposits in the ordinary course of a banking or similar business; (ii) hold financial assets for the account of others as a substantial portion of their business; (iii) are foreign investment entities, including entities that conduct certain investment and asset management activities for customers, entities that are managed by other FFIs and the gross income of which is primarily attributable to investing, reinvesting, or trading in financial assets, and certain collective investment vehicles with investment strategies of investing, reinvesting, or trading in financial assets; (iv) are insurance companies that issue investment-like contracts or annuity contracts; or (v) are certain holding companies or treasury centers that are members of corporate groups that include FFIs or that are formed by certain investment vehicles.
US Persons include: (1) US citizens, (2) resident aliens of the US, (3) a nonresident alien who makes an election to be treated as a resident alien for purposes of filing a joint income tax return, (4) nonresident alien who is a bona fide resident of American Samoa or Puerto Rico, and (5) US corporations, partnerships, and trusts.