Tuesday, June 14, 2011

Global Banking Associations Urge Flexibility in IRS Regulations Implementing FATCA

The sheer number of new issues and questions raised by IRS Notice 2010–60 on the implementation of the regulatory regime under the Foreign Account Tax Compliance Act, as well as the approaches adverted to thus far in the Notice, have raised significant concerns in the international banking community as to whether many financial institutions will be able to comply with the regulations even though they are willing to do so. In a letter to Treasury and the IRS, the European Banking Federation and the Institute of International Bankers urged the IRS to exercise the substantial discretion given by FATCA to strike a reasonable balance between FATCA’s legitimate compliance objective and administrability in order to limit the costs and the legal, operational and regulatory risks to non-U.S. financial institutions.

FATCA casts a wide net in search of undisclosed accounts and hidden income. It adds a new Chapter 4 to the Internal Revenue Code, essentially requiring foreign financial institutions to identify their customers who are U.S. persons or U.S.-owned foreign entities and then report to the IRS on all payments to, or activity in the accounts of, those persons. The Act broadly defines foreign financial institution to comprise not only foreign banks but also any foreign entity engaged primarily in the business of investing or trading in securities, partnership interests, commodities or any derivative interests therein

In the view of the banking groups, withholding tax and reporting rules affecting tens of millions of accounts can operate effectively only if the legal rules set forth in FATCA can be reduced to a largely automated back office function that is staffed by reasonably trained personnel who are not U.S.legal experts. Notice 2010-60, by contrast, outlines a highly manual, customer intensive effort with numerous different FATCA categorizations that depend upon a detailed understanding of U.S. tax regulations and associated extensive documentation requirements. The banking groups do not believe that such a system can successfully be implemented without substantial potential tax exposure and reputational risk to the financial institutions attempting to do so.

Rather than maximizing the risk-based concepts in FATCA to pare down to those situations presenting the greatest compliance risks to the United States, noted the federation, the Notice seems to aim more for coverage of as many entities as possible regardless of the potential risk of material U.S. tax evasion. The banking associations urged extensive, largely automatic carve-outs from FATCA for low risk payments, institutions and firms. In that spirit, the banking associations asked that efforts be made to find a reasonable way to reduce the overall population of foreign financial institutions to a manageable level on the basis that certain entities do not present a risk of material U.S. tax evasion. One option might be to exclude altogether any foreign financial institution with less than a specified threshold in assets

They also urged the adoption of a pragmatic and proportional approach to the challenges presented by non-U.S. institutions attempting to identify a very small number of U.S. customers in an overwhelmingly non-US customer base invested in non-US accounts and securities, what the banking groups called a “needle-in-a-haystack” phenomenon of ``epic proportions.’’

Notice 2010-60 contains highly complex and impractical customer identification and documentation requirements as well as the treatment as recalcitrant of account holders with no apparent U.S. nexus or indicia of U.S. status who do not provide information to a withholding agent that is not required under their local law. Further, while the proportion of U.S. to non-U.S. accounts at banks and securities firms based in various other countries is generally de minimis, Notice 2010-60 would require them to engage in a highly manual, customer-intensive effort to properly identify and document the non-U.S. status of huge numbers of accounts.

Notice 2010-60 states that the concept of an institution being in the “business of
investing, reinvesting, or trading” for FATCA purposes is not the same as that used for other U.S. tax law purposes, which typically turns on the existence of substantial business operations, but may instead extend to isolated transactions which would depend upon all the facts and circumstances that would need to be considered pursuant to regulatory guidelines.

The international banking groups asked the IRS to reconsider the concept since it would impose an unnecessary layer of complexity to the already daunting task of identifying Section 1471(d)(5)(C) entities. Indeed, it would appear that an entity could drift into and out of foreign financial institution status from year to year depending upon these isolated transactions, which adds unwarranted uncertainty to FATCA obligations.

Also, the burden of making this determination should not be imposed on the withholding agent, said the groups, who will invariably lack both the necessary factual information regarding its customers and a sufficient number of personnel capable of making this sophisticated U.S. tax judgment. Instead, if this concept is retained, a withholding agent should be entitled to rely on a certification provided by the financial firm as to whether it is a foreign financial institution without performing any independent due diligence, until the firm notifies the withholding agent that its status has changed.

The banking groups understand the Notice 2010-60 framework to envision that a U.S. branch of an internationally headquartered financial firm would need to establish to the satisfaction of each counterparty on each transaction that it enters into that it has in force a valid foreign financial institution agreement, assuming that the branch does not itself have to enter into its own agreement but may be included in its parent’s agreement.

Moreover, the proposed framework would subject transactions involving such U.S. branches to two divergent sets of rules, for chapter 3 purposes U.S branches would effectively be treated by their counterparties in the same manner as U.S. financial institutions, whereas for chapter 4 purposes they would be treated as foreign financial institutions.

Noting that U.S. branches of internationally headquartered firms are active participants in the broad spectrum of capital markets and wholesale financial activity, and daily enter into a large volume of transactions, the banking groups have serious concerns that the approach outlined in the Notice will lead to undue confusion and operational complexities for both U.S. branches and their counterparties that will unnecessarily impede these transactions.

The global banking groups urged that the U.S. branch be treated as a separate U.S. withholding agent and as a distinct and separate person from its head office or other non-U.S. branches with respect to all payments made by the U.S. branch to or for the account of the foreign financial institution, rather than treating the U.S. branch itself as a
foreign person.

Moreover, the groups urged that the presumption in Treasury regulation section 1.1441-4(a)(2)(ii) be applied equally for Chapter 4 as it does for Chapter 3 purposes. Thus, the FATCA rules should apply to the actual and deemed payments made between the U.S. branch and its head office, not to payments made by third parties to the U.S. branch. Similarly, the U.S. branch should be subject to the same FATCA rules as U.S. institutions with respect to payments that it makes to third parties, as is the case for Chapter 3 purposes.

According to the banking groups, the proposed modification of the Notice would result in U.S. branches being treated in the same manner as other U.S. financial institutions in terms of their dealings with the markets, but would nonetheless ensure full compliance with FATCA, especially given the high degree of regulatory scrutiny of such branches.

The federation and institute also believe that participating foreign financial institutions should be able to rebut the presumption of U.S. status by providing know-your-customer documentation that is acceptable under the QI Agreement documentation attachment, and that this standard should apply whether or not the participating foreign financial institution is a QI.

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