Preparing for FATCA

  • Author : Ozzie A Schindler
  • Author : Erika G Litvak
  • Date : August 2011
ABOUT THE AUTHORS: Ozzie A Schindler TEP and Erika G Litvak TEP are shareholders with the law firm of Greenberg Traurig, PA. Erika is also a member of the Board of Directors of STEP Miami

On 18 March 2010, the Foreign Account Tax Compliance Act (FATCA) was enacted into law in the United States. FATCA imposes a 30 per cent withholding tax on certain payments of US source income (‘withholdable payments’) to a foreign financial institution (FFI) or a non-financial foreign entity (NFFE), unless certain reporting obligations are met, which vary depending on whether the payee is an FFI or an NFFE.

If the payee is an FFI, then FATCA requires that the FFI enters into an agreement with the Internal Revenue Service (IRS) whereby the FFI agrees to obtain information from its clients, identify US clients or US owners of foreign entities that hold accounts at the FFI (to the extent that the US owners meet certain ownership thresholds), and provide the IRS with certain information regarding those US clients and their accounts (account number, account balance, etc). On the other hand, if the payee is an NFFE, then the obligation to obtain information from US clients and report to the IRS is on the withholding agent. An NFFE is not required to enter into any agreement with the IRS or comply with any procedures directly with the IRS. The information must simply be provided to the withholding agent, who in turn must report it to the IRS. Hence, the important first step is to determine whether an institution is an FFI or an NFFE.

The scope of FATCA is so broad and the effects so significant that FFIs and NFFEs worldwide are keeping a very close eye on its development. In the case of the Caribbean region, with so many international financial centres, the effects will be considerable. As we will show below, FATCA affects not only banks, but also wealth advisors, trust companies, non-US trusts, corporate service providers (which generally provide director services to offshore personal holding companies), hedge funds, private equity funds, pension plans and insurance companies, to name just a few examples. All of these entities are covered by FATCA one way or another and will be affected by this new regime.

‘Offshore funds will need to pay close attention to FATCA as all of its requirements apply to them as well’
What is an FFI?

Under current guidance, an FFI is any foreign entity (except entities formed in a US possession, which are not considered foreign for these purposes) that:

aaccepts deposits in the ordinary course of a banking or similar business (ie, a bank)bas a substantial portion of its business, holds financial assets for the account of others (ie, a broker/dealer, custodian or trust company), orcis engaged (or holds itself out as being engaged) primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, or any interest (including a future or forward contract or option) in such securities, partnership interests, or commodities (ie, a hedge fund or private equity fund, etc).
‘Exposure to FATCA is not just based on having US clients but also, more importantly, because of US investments’

Nonetheless, the Department of the Treasury and the IRS intend to issue regulations excluding certain entities from the definition of an FFI, such as certain holding companies, startup companies (but only for a limited period of time), non-financial entities that are liquidating or emerging from reorganisation or bankruptcy, and hedging/financing centres of a non-financial group. The Treasury and the IRS also intend to carve out certain FFIs (‘deemed-compliant FFIs’) from the requirement to enter into an agreement with the IRS to the extent that they follow certain procedures that ensure they do not have US clients and they follow certain procedures with respect to accounts held by other FFIs in such FFI. A deemed-compliant FFI would still need to follow certain procedures with the IRS, including obtaining a special employer identification number and providing certain periodical certifications to the IRS to maintain its deemed-compliant status.

Importantly, the scope of the definition is quite broad and not only includes the more ‘common’ financial institutions, but also other entities that may not generally be considered financial institutions, such as funds. Offshore funds will need to pay close attention to FATCA as all of these requirements apply to them as well.

The FATCA agreement

As mentioned above, FATCA requires that an FFI enter into an agreement with the IRS to obtain information from its clients, identify certain US clients of foreign entities that hold accounts at the FFI, and provide the IRS with information regarding those US clients’ accounts. If the FFI cannot obtain the information (ie, an account-holder does not want to provide it), the FFI must withhold and pay the 30 per cent withholding tax to the IRS. The Treasury and the IRS published preliminary guidance with detailed procedures for identification of accounts that an FFI should follow. These procedures will require FFIs to search their existing records (paper and/or electronic, depending on whether they are identifying existing or new accounts, and depending on whether a private client relationship exists). The Treasury and the IRS are working on proposed regulations that will provide guidance regarding the implementation of FATCA, but it is unclear when the proposed regulations will be published. In the meantime, the Treasury and the IRS have released interim guidance that provides an indication of the amount of effort and resources that the implementation of FATCA will entail.

Goodbye US clients

The initial reaction one might have to FATCA is that institutions that do not have a significant US client base or the resources to comply with FATCA could simply close their doors to US clients, under the impression that getting rid of US clients would avoid having to comply with the FATCA requirements. Even though not having US clients may facilitate the reporting requirements associated with complying with FATCA, that alone will not get an FFI off the hook.

As discussed above, withholding tax under FATCA applies to withholdable payments. A withholdable payment basically consists of US-source passive income (dividend, income, rent, etc) or proceeds from the sale or other disposition of any property of a type that can produce interest or dividends from US sources. It does not include US active business income.

Many FFIs (even those with no US clients) invest in US markets. Almost any payment derived from those US investments would constitute a withholdable payment under FATCA. Therefore, a withholding agent making a payment to an FFI will require proof that the FFI entered into the agreement with the IRS (or proof that the FFI is deemed compliant under any of the relevant guidance or is exempt from FATCA) to avoid withholding. If that evidence is not provided to the withholding agent, the FFI will suffer 30 per cent withholding on the withholdable payment, even if there is no net gain, or, worse, the payment represents a return of capital. This result is unsustainable and, therefore, an FFI will need to either comply with FATCA or stop investing in the United States. Moreover, even if the FFI does not invest in the United States directly, but does so through another FFI, it will still be subject to FATCA requirements because the FFI that is investing in the United States will need to withhold on payments to the second FFI that are either withholdable payments or are attributable to a withholdable payment if the second FFI does not show the payee FFI that it is FATCA compliant. This means that FFIs will need to carefully assess their exposure to FATCA not just based on the fact that they have US clients but also, more importantly, because of their US investments. Almost all institutions invest in US markets, either directly or indirectly, and those investments will trigger FATCA compliance requirements unless an FFI is willing and able to completely avoid investing in the United States or in any FFI that has US investments. This seems unrealistic.

What should an FFI do?

The implementation of FATCA will entail extensive reporting obligations to the IRS or withholding of 30 per cent. Either of these options can be too costly for FFIs. There is a year and a half before FATCA becomes effective (it becomes effective on 1 January 2013). Time flies: FFIs should start preparing.

A foreign entity should identify if it falls under the definition of an FFI (which will require an agreement with the IRS), a deemed-compliant FFI, an excluded/exempted FFI, an NFFE, etc, to understand the obligations associated with its status.

In the case of an FFI, those obligations will most probably require some type of action, such as:

  • (updating information systems to be able to collect and process the information that is required to be disclosed to the IRS (AML and KYC processes may not be sufficient)
  • training personnel on new rules, and this should apply not only to compliance officers, but private bankers also, given the special obligations imposed on private banking relationships
  • explaining new changes to clients in order to justify additional requests for information, as well as disclosure of information to the IRS (which, in certain cases, may require a waiver from clients)
  • creating new internal procedures to implement the FATCA requirements, and
  • engaging professionals to assist with all these issues.

These are just a few examples of actions that should be implemented in advance, given that the analysis should be made on a case-by-case basis, so the plans and procedures are in place by the time FATCA becomes effective in 2013.

The views expressed herein are solely those of the authors and should not be attributed to the authors’ firm or its clients. To ensure compliance with the requirements imposed by the IRS under Circular 230, the authors wish to inform readers that any US federal tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of: (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein.


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