Legislation creating a new reporting and taxing regime for foreign financial institutions with US account holders is almost certain to be part of any jobs bill that passes Congress in the next few months. The legislation adds a new Chapter 4 to the Internal Revenue Code, which would essentially require foreign financial institutions, which are broadly defined to include hedge funds and other private funds, to identify from among all of their customers any US persons and any US-owned foreign entities and then report to the IRS on all payments to, or activity in the accounts of, such persons.
The Foreign Account Tax Compliance Act would essentially present foreign financial institutions, foreign trusts, and foreign corporations with the choice of entering into agreements with the IRS to provide information about their U.S. accountholders, grantors, and owners or be subjected to 30 percent withholding.
The major focus of the legislation is tax compliance by U.S. persons that have accounts with foreign financial institutions. The legislation imposes substantial new reporting and tax withholding obligations on a very broad range of foreign financial institutions that could potentially hold accounts of U.S. persons. The reporting and withholding obligations imposed on the foreign financial institutions would serve as a backstop to the existing obligations of the U.S. persons themselves, who have a duty to report and pay U.S. tax on the income they earn through any financial account, foreign or domestic. These new reporting and withholding obligations for financial institutions would be enforced through the imposition of a 30 percent U.S. withholding tax on a very broad range of U.S. payments to foreign financial institutions that do not satisfy the reporting obligations.
The legislation provides substantial flexibility to Treasury and the IRS to issue regulations to fill in the numerous details on how the new reporting and withholding tax regime will work. It also provides Treasury with broad authority to establish verification and due diligence procedures with respect to a foreign financial institution’s identification of any U.S. accounts.
It is anticipated that thousands of foreign investment entities, including hedge funds, private equity funds, mutual funds, securitization vehicles and other investment funds, would be required to enter into agreements with the IRS pursuant to new Chapter 4. It is anticipated that implementation of new Chapter 4 will present many operational challenges and expenses for foreign financial institutions.
New Chapter 4 also provides for withholding taxes to enforce new reporting requirements on specified foreign accounts owned by specified US persons or by US-owned foreign entities. The provision establishes rules for withholdable payments to foreign financial institutions and for withholdable payments to other foreign entities.
The legislation would impose a thirty percent (30%) withholding tax on certain income from U.S. financial assets held by a foreign financial institution unless the foreign financial institution agrees to disclose the identity of any U.S. individual with an account at the institution, or the institution’s affiliates, and to annually report on the account balance, gross receipts and gross withdrawals and payments from such account. Foreign financial institutions would also be required to agree to disclose and report on foreign entities that have substantial U.S. owners.
These disclosure and reporting requirements would be in addition to any requirements imposed under the Qualified Intermediary program. It is expected that foreign financial institutions would comply with these disclosure and reporting requirements in order to avoid paying this withholding tax.
In addition to requiring 30 percent withholding on the expanded category of withholdable payments for financial institutions that do not enter into an agreement with the IRS, new Code Section 1474(b)(2) would deny a credit or refund to a foreign financial institution that is the beneficial owner of a payment except if and to the extent that said institution is eligible to a reduced treaty rate of withholding. The section would also deny interest on refunds.
The scope of application of the new regime would go beyond traditional financial institutions and cover virtually every type of foreign investment entity. The legislation broadly defines foreign financial institutions to comprise, not only foreign banks and foreign custodial businesses, but also any foreign entity engaged primarily in the business of investing or trading in securities, partnership interests, commodities or any derivative interests therein. According to the Joint Committee on Taxation, investment vehicles such as hedge funds and private equity funds will also fall within the scope of this regime. In addition, commentators are of the view that the measures will also extend to other investment vehicles, whether widely held or privately owned
The new regime also brings within its scope fund entities, and fund managers, who are not within the scope of the Qualified Intermediary regime. The Act goes beyond the QI regime in imposing a new withholding tax or a new information reporting requirement that applies for the first time directly to funds and fund managers, as opposed to their custodian banks. The broad definition of a foreign financial institution and the requirement that such an institution enter into agreements with the IRS and provide annual reporting in order to avoid new withholding tax rules on US source investment income and on US related gross proceeds will have profound implications.
Also affected by the legislation are typical offshore securitization vehicles that hold U.S assets and issue their own equity and debt securities, such as a collateralized debt obligation (CDO) issuer. They would be considered foreign financial institutions under the legislation. As a result, such a securitization vehicle would be required to enter into an information reporting agreement with the IRS and report on U.S. holders of non-publicly traded debt and equity that it had issued, or otherwise be subject to the withholding tax on its U.S. investments. Foreign securitization vehicles currently in existence have invested billions of dollars in the United States, particularly in loans and other debt instruments issued by U.S. companies.
A typical CDO is structured as an offshore corporation that invests in loans and other debt instruments issued by U.S. companies. Such CDOs in turn issue several classes of non-publicly traded debt and equity securities themselves, which divide up the cash flows on the underlying U.S. investments. Another example of a typical securitization vehicle is a grantor trust that invests in U.S. debt or equity investments and in turn issues pass-through certificates that represent the cash flows on those investments. Pass-through interests in U.S. investments could also be structured as shares of an offshore cell company.
Substitute Dividends and Dividend Equivalent Payments–Derivatives Transactions
Under present law, dividend payments made to foreign investors are subject to withholding tax at a rate of 30%, unless otherwise reduced by an applicable tax treaty. In order to avoid this withholding tax, foreign investors have entered into transactions that provide them with substitute dividend payments and derivative transactions that provide them with dividend equivalent payments that are not subject to withholding. Foreign persons seek to avoid the 30% withholding tax imposed on U.S. source dividends by temporarily converting U.S. stock into an economically equivalent derivative investments such as total return swaps. Under current law, payments to foreign persons pursuant to equity swap transactions are not subject to U.S. withholding.
The legislation would end this scenario by treating dividend equivalent amounts as generally U.S. source, thereby subjecting them to the withholding tax. Provisions applicable to payments made 90 days or more after the date of enactment of the legislation would provide that dividend equivalent payments on such equity swap transactions would be subject to a 30 percent U.S. withholding tax.
The Act would require withholding on substitute dividend payments and any dividend equivalent payments that are included in notional principal contracts, such as total return swap agreements, and would authorize Treasury to adopt rules requiring withholding on substitute dividends and dividend equivalent payments that are included in other financial arrangements.
The example of a total return swap referencing stock of a domestic corporation (an example of a notional principal contract to which the provision generally applies), illustrates the consequences of this rule. Under a typical total return swap, a foreign investor enters into an agreement with a counterparty under which amounts due to each party are based on the returns generated by a notional investment in a specified dollar amount of the stock underlying the swap.
The investor agrees for a specified period to pay to the counterparty an amount calculated by reference to a market interest rate (such as the London Interbank Offered Rate (LIBOR)) on the notional amount of the underlying stock and any depreciation in the value of the stock. In return, the counterparty agrees for the specified period to pay the investor any dividends paid on the stock and any appreciation in the value of the stock. Amounts owed by each party under this swap typically are netted so that only one party makes an actual payment. The provision treats any dividend-based amount under the swap as a payment even though any actual payment under the swap is a net amount determined in part by other amounts (for example, the interest amount and the amount of any appreciation or depreciation in value of the referenced stock).
Accordingly, a counterparty to a total return swap may be obligated to withhold and remit tax on the gross amount of a dividend equivalent even though, as a result of a netting of payments due under the swap, the counterparty is not required to make an actual payment to the foreign investor.