Final verdict

  • Author : Kurt Rademacher
  • Author : Samantha Moore
  • Author : Sloane Jumper
  • Date : April 2013
ABOUT THE AUTHORS: Kurt Rademacher TEP, Samantha Moore and Sloane Jumper are members of the business services group at Butler Snow

Following a series of scandals involving US taxpayers sheltering their assets from the US Internal Revenue Service (IRS), Congress enacted the Foreign Account Tax Compliance Act (FATCA) on 18 March 2010 as part of the Hiring Incentives to Restore Employment Act. FATCA’s requirements were sweeping, and the financial world waited for the US Treasury to issue guidance. After a series of notices, on 8 February 2012 the Treasury finally issued its proposed FATCA regulations. After allowing for almost a year of practitioner review and commentary, the Treasury issued final FATCA regulations on 17 January 2013.

FATCA overview

FATCA categorises non-US entities as either foreign financial institutions (FFIs) or non-financial foreign entities (NFFEs). Generally, if a non-US entity is not an FFI, it is categorised as an NFFE. FFIs are entities that fall into the following groups:

  • Depository institutions that accept deposits in the ordinary course of banking or similar business.
  • Custodial institutions that hold, as a substantial portion of their business, financial assets for the benefit of one or more other persons.
  • Investment entities that trade and manage financial assets on behalf of customers.
  • Insurance companies that issue or are obliged to make payments with respect to a cash value insurance or annuity contract.

FATCA offers FFIs a choice: (1) enter an FFI agreement with the IRS and comply with US-style reporting requirements, or (2) subject payments of specified types of (primarily) US-source income made to the FFI to a 30 per cent withholding tax.

FFIs that enter FFI agreements (participating FFIs) agree to comply with myriad requirements, including performing due diligence to identify any accounts they maintain for US persons, reporting specified information on US account holders acquired during due diligence, closing the accounts of ‘recalcitrant account holders’, and withholding on specified types of ‘passthru payments’.

The regulations allow specified FFIs (deemed-compliant FFIs and exempt FFIs) to avoid withholding without entering FFI agreements. Exempt FFIs include, among others, specified foreign governments, central banks and retirement funds. Deemed-compliant FFIs are low-risk FFIs that include registered deemed-compliant FFIs, which must register with the IRS; certified deemed-compliant FFIs, which do not need to register with the IRS but must give withholding agents specified documentation; and owner-documented FFIs.

An owner-documented FFI is an FFI that meets certain specified requirements, including:

  • The FFI must be an FFI solely because it is an investment entity.
  • Generally, the FFI’s withholding agent must be a US financial institution or participating FFI.
  • The withholding agent must agree to satisfy the FFI’s reporting requirements with respect to any specified US persons who hold an interest in the FFI.
  • The FFI must provide its withholding agent with certain specified information, including:
    • a withholding certificate identifying the FFI as an owner-documented FFI that is not acting as an intermediary; and
    • either (1) an owner reporting statement and valid documentation with respect to each person identified as an owner, or (2) a letter (‘substitute letter’) from an attorney or auditor who is licensed in the US or whose firm has a location in the US, signed no more than four years before the date of the payment, that verifies that the FFI complies with the owner-documented FFI requirements and that certifies that the attorney or auditor has reviewed the FFI’s documentation with respect to all of its owners and debt holders. If the FFI opts to provide a substitute letter, it must still provide an FFI owner reporting statement and a Form W-9 with any applicable waiver for each specified US person that owns a direct or indirect interest in, or specified debt interest in, the FFI; and
    • any details relating to a change in circumstances.

Owner reporting statements contain details of the FFI’s interest holders, including the name, address and taxpayer identification number of every individual and specified US person who owns a direct or indirect equity interest in the FFI. For instance, a non-US trust that qualifies as an FFI would need to disclose information not only on its US beneficiaries (if any), but also on its non-US beneficiaries. This raises privacy concerns. Therefore, FFIs that are eligible to claim owner-documented status should consider obtaining a substitute letter to protect the privacy of their non-US interest holders. If the FFI does choose to obtain a substitute letter, it should consider the fact that engaging an attorney (as opposed to an accountant or auditor) will allow the FFI to claim legal privilege in relation to information shared with that attorney, so any sensitive information disclosure can be managed appropriately. Such privilege could become important in protecting the FFI if, for instance, the FFI’s due diligence procedures uncover one or more rogue employees who have engaged in questionable activities. If the FFI chooses instead to engage an accountant who is not an attorney, communications between the FFI and the accountant will not be protected by legal privilege and may therefore be discoverable.

NFFEs have a less onerous reporting and withholding regime. Like FFIs, they must report certain information to avoid 30 per cent withholding. However, unlike FFIs, NFFEs do not need to enter an agreement with the IRS to avoid withholding, but must simply give the withholding agent specified information on any ‘substantial US owners’ or certify that they have no substantial US owners.

What about trusts?

The proposed regulations and notices did little to address the treatment of trusts and trust companies. The final regulations provide some clarity while leaving other areas open to speculation.

Trust companies

The final regulations define ‘financial institution’ to include depository institutions that accept deposits in the ordinary course of a banking or similar business. Banking or similar business is defined to include providing fiduciary services to customers. Therefore, under the final regulations, it seems that the IRS will treat non-US trust companies as FFIs. As such, every non-US trust company must decide whether to enter an FFI agreement or subject part of its income to a 30 per cent withholding tax.

Grantor trusts and estates

Under the FFI regime, an FFI that has entered an FFI agreement is obliged to report information regarding its US accounts. A US account is any financial account maintained by an FFI that is held by one or more specified US persons or US-owned foreign entities. The general rule for trusts is that the trust is the account holder. However, if the trust is a grantor trust, the trust is not treated as the account holder. Instead, the ‘owner’ of the grantor trust is treated as the account holder. Under the grantor trust rules, the owner is typically the individual who funds the trust. Therefore, an account held by a grantor trust with a non-US owner should not be categorised as a US account. As such, an FFI that holds an account of a non-US grantor trust with a non-US grantor should not be required to report the account even if there are US-person beneficiaries.

The final regulations also provide that accounts held by estates are excepted from the definition of a financial account.

Non-grantor trusts: FFIs or NFFEs?

The proposed regulations left unresolved whether non-grantor trusts would be treated as FFIs or NFFEs. The final regulations attempt to resolve this issue, but many questions remain.

Under the final regulations, FFIs are any non-US entities that fall into the categories of depository institutions, custodial institutions, investment entities or insurance companies. A custodial institution is an entity that holds, as a substantial portion of its business, financial assets for the benefit of one or more other persons. An entity is deemed to hold financial assets for the benefit of others as a substantial portion of its business if the entity’s gross income attributable to holding financial assets and related financial services equals or exceeds 20 per cent of the entity’s gross income in the prior three years. Income attributable to holding financial assets and related financial services includes, but is not limited to, income generated from custody, account maintenance and transfer fees. Therefore, it seems that the IRS could categorise a trust as an FFI under the FFI custodial institution category. However, the IRS does not address this issue. Instead, the IRS implies in the preamble to the final regulations that trusts will fall into the ‘investment entity’ category.

An investment entity is defined broadly, but includes any entity that primarily conducts any of the following activities as a business on behalf of a customer: trading in certain financial instruments; individual or collective portfolio management; or otherwise investing, administering or managing funds, money or financial assets on behalf of others. An investment entity also includes any entity whose gross income is primarily attributable to investing, reinvesting or trading in financial assets if the entity is managed by another FFI. An entity is managed by another FFI if the managing FFI performs, either directly or through another third-party service provider, any of the activities described above on behalf of the managed entity. An entity is treated as primarily conducting as a business one or more of the activities described above if the entity’s gross income attributable to such activity or activities equals or exceeds 50 per cent of the entity’s gross income during the three-year period ending on 31 December of the preceding year. The final regulations provide the following examples for clarification:

  • ‘Example 5. Trust managed by an individual. On January 1, 2013, X, an individual, establishes Trust A, a non-grantor foreign trust for the benefit of X’s children, Y and Z. X appoints Trustee A, an individual, to act as the trustee of Trust A. Trust A’s assets consists [sic] solely of financial assets… Pursuant to the terms of the trust instrument, Trustee A manages and administers the assets of the trust. Trustee A does not hire any entity as a third-party service provider to perform [financial instrument trading; individual or collective portfolio management; or investing, administering or managing funds, money or financial assets]. Trust A is not an investment entity… because it is managed solely by Trustee A, an individual.’
  • ‘Example 6. Trust managed by a trust company. The facts are the same as in Example 5, except that X hires Trust Company, an FFI, to act as trustee on behalf of Trust A. As trustee, Trust Company manages and administers the assets of Trust A in accordance with the terms of the trust instrument for the benefit of Y and Z. Because Trust A is managed by an FFI, Trust A is an investment entity [by virtue of being managed by an entity that provides at least one of these services: trading in certain financial instruments; individual or collective portfolio management; or otherwise investing, administering or managing funds, money or financial assets on behalf of other persons] and an FFI.’

The examples make it clear that if a trustee or grantor does not engage a third-party FFI to manage any aspect of the trust, the trust should not be an FFI under the investment entity definition.1

Additionally, if a grantor or trustee engages a trust company as trustee, the examples make it clear that the trust will be treated as an FFI. The final regulations also imply that if an individual trustee manages the daily aspects of the trust, but the trustee or grantor engages an FFI to manage the trust portfolio, the IRS would treat the trust as an FFI in the investment entity category. Under this analysis, any trust with a professionally managed portfolio (i.e. almost any sizeable trust) will be treated as an investment entity and, as such, an FFI subject to reporting and withholding in its own right.

Despite treatment as FFIs, many trusts should be eligible to claim owner-documented FFI status.2 As noted above, this would allow eligible trusts to protect the privacy of non-US beneficiaries through the substitute letter mechanism and to avoid withholding without entering an FFI agreement.

A trust classed as an FFI that opts to forgo owner-documented FFI status must enter a formal FFI agreement obliging it to perform the due diligence required to identify and report information about its beneficiaries, including ‘substantial US owners’. For investment entities, including trusts that so qualify, a substantial US owner means a US beneficiary with any interest at all.3 Therefore, generally, a trust treated as an FFI will have to report specified information to the IRS on all of its US beneficiaries. However, the regulations provide a de minimis exception that states that a US person is not treated as a substantial US owner if the fair market value of the distributions to that person during the calendar year are USD5,000 or less and, in the case of a person entitled to mandatory distributions, the value of that person’s interest in the trust is USD50,000 or less.

A trust treated as an NFFE is subject to relaxed reporting requirements, and must simply provide the withholding agent with specified information on any substantial US owners or certify that it does not have any substantial US owners. For purposes of a trust classified as an NFFE, a substantial US owner is any specified US person that holds, directly or indirectly, more than 10 per cent of the beneficial interests of the trust. An individual holds a beneficial interest if they have the right to receive, directly or indirectly, a mandatory distribution or they may receive, directly or indirectly, a discretionary distribution from the trust. Importantly, a person’s proportionate interest in a non-US trust is aggregated with related persons who also hold beneficial interests in the trust. Generally, a person is treated as holding more than 10 per cent of the beneficial interest of a trust if:

  • the beneficiary receives only discretionary distributions from the trust and the fair market value of the distributions from the trust to that person in the prior calendar year exceeds 10 per cent of the value of either all the distributions made by the trust during that year or all the assets held by the trust at the end of that year
  • the person is entitled to receive mandatory distributions from the trust and the value of the person’s present interest in the trust exceeds 10 per cent of the value of all the assets held by the trust; or
  • the person is entitled to receive mandatory distributions and may receive discretionary distributions from the trust and the value of the person’s interest in the trust, determined as the sum of the fair market value of all of the discretionary distributions made from the trust during the prior calendar year to the person and the value of the person’s present interest in the trust at the end of that year, exceeds either 10 per cent of the value of all distributions made by the trust during the prior calendar year or 10 per cent of the value of all the assets held by the trust at the end of that year.

The regulations provide the following example:

‘Example 3. Determining the 10 per cent threshold in the case of a beneficial interest in a foreign trust. U, a US citizen, holds an interest in FT1, a foreign trust, under which U may receive discretionary distributions from FT1. U also holds an interest in FT2, a foreign trust, and FT2, in turn, holds an interest in FT1 under which FT2 may receive discretionary distributions from FT1. U receives USD25,000 from FT1 in Year 1. FT2 receives USD120,000 in Year 1 and distributes the entire amount to its beneficiaries in Year 1. The distribution from FT1 is FT2’s only source of income and FT2’s distributions in Year 1 total USD120,000. U receives USD40,000 from FT2 in Year 1. FT1’s distributions in Year 1 total USD750,000. U’s discretionary interest in FT1 is valued at USD65,000 at the end of Year 1 and therefore does not meet the 10 per cent threshold… U’s discretionary interest in FT2, however, is valued at USD40,000 at the end of Year 1 and therefore meets the 10 per cent threshold.’

The regulations provide a de minimis exception allowing a beneficiary to avoid substantial US-owner treatment if the fair market value of the distributions from the trust to such person during the prior calendar year were USD5,000 or less and, for a person entitled to mandatory distributions, the value of their interest in the trust is USD50,000 or less.

Intergovernmental agreements

As an alternative to the withholding and reporting regime required under FATCA, several countries have entered into intergovernmental agreements (IGAs) with the US. Under the Model 1 IGA, FFIs can report FATCA-like information directly to the revenue agencies of their home countries. These revenue agencies will then share information regarding US account holders directly with the IRS.

There are two versions of the Model 1 IGA: reciprocal and non-reciprocal. Under the reciprocal version, the US agrees to share information collected in the US on non-US account holders with the other country. Under the non-reciprocal version, the US does not agree to share information. For the US to enter a reciprocal IGA, the non-US country must have ‘protections and practices’ that the US Treasury and the IRS have determined to be adequate to ensure that the exchanged information remains confidential and is used solely for tax purposes. It is unclear what criteria the US Treasury and the IRS will actually use to judge which countries’ ‘protections and practices’ meet this standard.

Under the Model 2 IGA, FFIs request permission from account holders to share information with the IRS. If account holders refuse, FFIs can report information on all of their non-consenting account holders in aggregate to the IRS. If the IRS requests extra information from a particular FFI, the FFI would report that detail to its home country revenue agency, which would then provide it to the IRS.

FFIs in jurisdictions that have signed Model 1 IGAs should comply with the IGA in effect in their jurisdictions. Note, however, that in certain instances Model 1 IGAs give FFIs the option to comply with the requirements set forth in the regulations, as opposed to the IGA. FFIs in jurisdictions that sign Model 2 IGAs will be expected to comply with the regulations, except to the extent provided in their IGAs.

As of February 2013, the US Treasury Department reports that the UK, Denmark, Mexico and Ireland have entered IGAs with the US.4

The US–Mexico FATCA Agreement

After two years of negotiations, on 19 November 2012 the Agreement to Improve International Tax Compliance and to Implement FATCA was executed between the US Department of the Treasury and the Mexican Ministry of Finance.

As of January 2013, Mexico and the US have committed to coordinate efforts to collect financial information and exchange it automatically, aiming to improve international tax compliance.

The US Treasury Department will collect information on certain financial accounts and products held by Mexican residents in the US. Financial institutions will exchange that information with the Mexican Ministry of Finance. In reciprocity, the Mexican authority will collect and provide equivalent information about US residents with accounts in Mexico. As a result, both governments expect to increase supervision and obtain higher levels of tax compliance.

According to the US-Mexico FATCA Agreement, the US will collect and exchange the following information from the holders of ‘Mexican reportable accounts’:

name, address and tax identification number (or date of birth)

account number and name of the US financial institution where the account is held

interest paid on depository accounts

US-source dividends paid or credited to Mexican reportable accounts; and

other US-source income paid or credited to such accounts (as provided by the agreement and the US Internal Revenue Code).

It is expected that information collected in 2013 by both governments on individuals holding accounts abroad will be exchanged in 2014 and 2015. For subsequent years, the information will be exchanged annually. The Mexican tax authorities may, among other purposes, use the information provided to audit Mexican individuals and residents that hold accounts in the US in order to verify compliance with their tax obligations.

Both governments are expected to continue working on the contents of an ancillary agreement that will establish further procedures for the automatic exchange of information, as well as the rules that will streamline the compliance and enforcement of the US-Mexico FATCA Agreement.

The full content of the US-Mexico Agreement can be found at www.treasury.gov/resource-center/tax-policy/treaties/documents/FATCA-Agreement-Mexico-11-19-2012.pdf

ABOUT THE AUTHOR: Veronica Yepez Reyna TEP is Sales Director of Amicorp Services Ltd (San Diego) and Geralda Buckley TEP is Managing Director of Amicorp Switzerland AG
Implementation timeline

The final FATCA regulations contain various implementation timelines and phase-ins. Below are a few of the most significant:

  • 15 July 2013: the IRS portal allowing FFIs to enter FFI agreements will be open.
  • 25 October 2013: the final day an FFI can enter an FFI agreement that will ensure that the FFI is included on a list of participating FFIs published by the IRS before the start of FATCA withholding.
  • 1 January 2014: withholding begins. All accounts maintained before this date are pre-existing accounts.
  • 31 March 2015: due date for the first information reports for the 2013 and 2014 calendar years.
  • 31 December 2015: deadline to document account holders and payees that are not prima facie FFIs.
  • 1 January 2017: withholding begins on gross proceeds from sales or dispositions of property and on foreign passthru payments.
Conclusion

The final regulations provide much-needed guidance concerning the implementation of FATCA. It seems clear that non-grantor trusts should be tested for FFI status under the ‘investment entity’ category, pending further guidance. Unfortunately, the final regulations also leave uncertainty surrounding the application of FATCA to many non-US trusts by providing only two examples that address vastly different scenarios. The gulf between these two examples leaves room for differing interpretations of whether trusts that are not addressed specifically in the examples qualify as FFIs. Nevertheless, prudence would dictate that unless a trust with US investments5 has no third-party professional involvement or holds relatively few financial assets, it should prepare to either:

1enter an FFI agreement and comply with detailed IRS reporting and due diligence requirements; or2obtain owner-documented FFI status, preferably with a substitute letter to protect the privacy of its non-US beneficiaries.

In either case, life is soon to become more complicated for the trustees and beneficiaries of these non-US trusts.

A trust holding only real estate, art or other non-financial tangible assets should not qualify as an ‘investment entity’. Therefore, assuming (as implied by the preamble to the final regulations) that a trust would only qualify as an FFI under the ‘investment entity’ category, such a trust should be treated as an NFFE pending further guidance.
Owner-documented FFI status is available only to those entities that are FFIs solely under the investment entity category.
FFIs must report all US accounts, which include both accounts held by US persons and accounts held by US-owned foreign entities. A US-owned foreign entity includes any non-US entity that has one or more substantial US owners. For trusts that fall within the investment entity category, a substantial US owner includes any specified US person that holds, directly or indirectly, more than 0 per cent of the beneficial interest of the trust. A person has a beneficial interest in a non-US trust if that person has the right to receive, directly or indirectly, a mandatory distribution from the trust or if that person may receive discretionary distributions from the trust.
IGAs between the US and Spain, Japan, Switzerland and Norway are reportedly in late-stage negotiations.
The final regulations reserved on the definition of ‘passthru payments’, but it is possible that such payments could include payments arising from non-US sources as specified in prior IRS guidance. If passthru payments ultimately include non-US source income, then limiting the trust’s portfolio to non-US investments may not solve the trust’s FATCA withholding tax problem.

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