Tuesday, January 22, 2013

Final FATCA Regulations Amplify Broad Sweep of Legislation for Securities and Banking Industry and Confirm Inter-Governmental Agreements

The Treasury and IRS have adopted final regulations implementing the Foreign Account Tax Compliance Act (FATCA). The regulations provide additional certainty for financial institutions and government counterparts by finalizing the step-by-step process for U.S. account identification, information reporting, and withholding requirements for foreign financial institutions, other foreign entities, and U.S. withholding agents.

The final regulations also build on intergovernmental agreements the U.S.Treasury has entered into with foreign governments to facilitate the effective and efficient implementation of FATCA by eliminating legal barriers to participation, reducing administrative burdens, and ensuring the participation of all non-exempt financial institutions in a partner jurisdiction. In order to reduce administrative burdens for financial institutions with operations in multiple jurisdictions, the final regulations coordinate the obligations for financial institutions under the regulations and the intergovernmental agreements. 

Passed in 2010 as part of the Hiring Incentives to Restore Employment Act (HIRE), FATCA creates a new reporting and taxing regime for foreign financial institutions with U.S. accountholders. FATCA 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. According to the Joint Committee on Taxation, investment vehicles such as hedge funds and private equity funds fall within this definition. Firms meeting the definition must enter into agreements with the IRS and report information annually in order to avoid a new U.S. withholding tax.

The final regulations broadly define financial institution and investment entities to effectuate the purposes of the Act to effectively and efficiently combat offshore tax evasion.  The regulations define a financial institution as, among other things, an investment entity which, in turn, is defined as an entity that primarily conducts as a business one or more of the following activities or operations for or on behalf of a customer: (1) Trading in money market instruments (checks, bills, certificates of  deposit, derivatives, etc.); foreign currency; foreign exchange, interest rate, and index instruments; transferable securities; or commodity futures; (2) Individual or collective portfolio management; or (3) Otherwise investing, administering, or managing funds, money, or financial assets on behalf of other persons. Moreover, the entity functions or holds itself out as a collective investment vehicle, mutual fund, exchange traded fund, private equity fund, hedge fund, venture capital fund, leveraged buyout fund, or any similar investment vehicle established with an investment strategy of investing, reinvesting, or trading in financial assets. Reg. § 1.1471-5(d).

The legislation’s principal focus is tax compliance by U.S. persons that have accounts with foreign financial institutions. The Act imposes substantial new reporting and tax-withholding obligations on a 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 will 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 obligations for financial institutions will be enforced through the imposition of a 30-percent U.S. withholding tax on a wide 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 detailing how the new reporting and withholding tax regime will work. It also gives Treasury broad authority to establish verification and due-diligence procedures with respect to a foreign financial institution’s identification of any U.S. accounts.

Chapter 4 also provides for withholding taxes as a means to enforce new reporting requirements on specified foreign accounts owned by specified U.S. persons or by U.S.-owned foreign entities. The provision establishes rules for withholdable payments to foreign financial institutions and for withholdable payments to other foreign entities. The Act essentially presents 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 becoming subject to 30-percent withholding.

The legislation’s principal goal is to collect tax from .S. taxpayers who have evaded their responsibilities by investing through foreign financial institutions and foreign entities not subject to IRS reporting obligations. To achieve this goal, the legislation imposes the risk of a withholding tax on a broad class of U.S.-related payments (including gross proceeds) to a broad class of foreign investors, unless the foreign financial institutions and foreign entities agree to provide information to the IRS regarding their U.S. account holders and owners. Essentially, the withholding tax will function as a “hammer” to induce reporting.

Many of the foreign financial institutions that hold accounts on behalf of U.S. persons fall outside the reach of U.S. law. As a result, the current ability of the United States to require foreign financial institutions to disclose and report on U.S. account holders is significantly limited. Although these foreign financial institutions are outside the direct reach of U.S. law, many of them have substantial investments in U.S. financial assets or hold substantial U.S. financial assets for the account of others.

The federal government imposes a tax on the beneficial owner of income, not its formal recipient. For example, if a U.S. citizen owns securities that are held in street name at a brokerage firm, that U.S. citizen (and not the brokerage-firm nominee) is treated as the beneficial owner of the securities. A corporation (and not its shareholders) ordinarily is treated as the beneficial owner of the corporation’s income. Similarly, a foreign complex trust ordinarily is treated as the beneficial owner of income that it receives, and a U.S. beneficiary or grantor is not subject to tax on that income unless and until he or
she receives a distribution.

Under FATCA, the financial world is essentially divided into foreign financial institutions and US financial institutions. US financial institutions have the first compliance obligations under FATCA as the primary withholding agents for withholdable payments made to foreign financial institutions. IRS Notices 2010-60 and 2011-34 provide details regarding how participating foreign financial institutions must identify, report, and withhold on their accounts, and how US financial institutions must identify and withhold on some payments to foreign financial institutions, many details regarding US financial institutions have not yet been provided.

The Act imposes a 30-percent withholding tax on certain income from U.S. financial assets held by a foreign financial institution unless the foreign financial institution agrees to: (1) disclose the identity of any U.S. individual that has an account with the institution or its affiliates; and (2) annually report on the account balance, gross receipts and gross withdrawals and payments from the account foreign financial institutions also must agree to disclose and report on foreign entities that have substantial U.S. owners. These disclosure and reporting requirements are in addition to any requirements imposed under the Qualified Intermediary program. It is expected that foreign financial institutions will 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 Internal Revenue Code Section 1474(b)(2) will deny a credit or refund to a foreign financial institution that is the beneficial owner of a payment except to the extent that the firm is eligible for a reduced treaty rate of withholding. The section will also deny interest on refunds.

The agreement between the IRS and the foreign financial institution must contain several provisions. Specifically, the foreign financial institution must obtain information regarding each holder of each account maintained by the firm as is necessary to determine which accounts are U.S. accounts, to comply with verification and due-diligence procedures with respect to the identification of U.S.accounts, and to report annually information with respect to any U.S. account maintained by the firm. The foreign financial institution must also deduct and withhold 30 percent from any pass-through payment that is made to a recalcitrant account holder or another financial institution that does not enter into an agreement. A pass-through payment is any withholdable payment or payment that is attributable to a withholdable payment.

A “recalcitrant account holder” is defined as any account holder that fails to comply with reasonable requests for information necessary to determine if the account is a U.S. account; fails to provide the name, address, and TIN of each specified U.S. person and each substantial U.S. owner of a U.S. owned foreign entity; or fails to provide a waiver of any foreign law that would prevent the foreign financial institution from reporting
any information required under this provision.

The Act adds a new Section 1472 to the Internal Revenue Code to deal with withholdable payments to non-financial foreign entities, which it defines as any foreign entities that are not financial institutions. Specifically, the legislation requires a withholding agent to deduct and withhold a tax equal to 30 percent of any   withholdable payment made to a non-financial foreign entity if the beneficial owner of the payment is a non-financial foreign entity that does not meet specified requirements.

A non-financial foreign entity meets the requirements of the provision, and payments made to it will not be subject to the imposition of 30-percent withholding tax, if the payee or the beneficial owner of the payment provides the withholding agent with either: (1) a certification that the foreign entity does not have a substantial U.S. owner; or (2) the name, address and TIN of each substantial U.S. owner.

The Act defines a “substantial U.S. owner” as a person who owns more than ten percent of the company’s stock or is entitled to more than ten percent of the profits in a partnership. In the case of an investment firm, however, that limit is reduced from ten percent to zero. Additionally, the withholding agent cannot know or have reason to know that the certification or information provided regarding substantial U.S. owners is incorrect, and the withholding agent must report the name, address and TIN of each substantial U.S. owner to the Secretary.

The legislation provides a carve-out for corporations whose stock is regularly traded on an established securities market. The carve-out is presumably based on a congressional belief that the risk of tax evasion in connection with a publicly-traded corporation is low. Similarly, the legislation provides a carve-out for charitable and other organizations that are exempt from tax under IRC Section 501(a), again presumably because these entities pose a low risk of being used to facilitate U.S. tax evasion. A further carve-out is provided for SEC-regulated investment companies.      

Due Diligence

The final regulations phase in over an extended transition period to provide sufficient time for financial institutions to develop necessary systems. In addition, to avoid confusion and unnecessary duplicative procedures, the final regulations align the regulatory timelines with the timelines prescribed in the intergovernmental agreements. The final regulations allow reasonable timeframes to review existing accounts and implement FATCA’s obligations in stages to minimize burdens and costs consistent with achieving the statute’s compliance objectives.

To limit market disruption, reduce administrative burdens, and establish certainty, the final regulations provide relief from withholding with respect to certain grandfathered obligations and certain payments made by non-financial entities.

To better align the obligations under FATCA with the risks posed by certain entities, the final regulations expand and clarify the treatment of certain categories of low-risk institutions, such as governmental entities and retirement funds. They also provide that certain investment entities may be subject to being reported on by the FFIs with which they hold accounts rather than being required to register as FFIs and report to the IRS. The regulations also clarify the types of passive investment entities that must be identified and reported by financial institutions.

The final regulations provide more streamlined registration and compliance procedures for groups of financial institutions, including commonly managed investment funds, and provide additional detail regarding the obligations of foreign financial institutions to verify their compliance under FATCA.

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