Global Financial Services Industry
What is FATCA?
Seeking to address perceived abuses by U.S. persons with offshore assets, the U.S. Congress enacted the Foreign Account Tax Compliance Act (“FATCA”) in 2010 to assist the IRS in identifying offshore income held by U.S. persons. FATCA identifies offshore income by compelling non-U.S. entities to report the identities of U.S. accountholders to the IRS, using a new U.S.-sourced withholding tax levied against non-cooperative foreign entities to enforce compliance. Similarly, FATCA requires U.S. persons to specifically identify substantial foreign assets (and income related to such assets) beginning on their U.S. tax returns filed in 2012. Comparing the information it obtains from compliant foreign entities with the new U.S. tax return information, the IRS believes it will quickly be able to identify sources of unreported foreign income and discourage tax evasion.
FATCA’s mechanism for compelling compliance, a new 30% withholding tax on U.S. source income, will have a significant impact on all U.S. and foreign financial institutions and it will likely encourage foreign financial institutions (FFIs), as well as other affected foreign entities, to share information with the IRS for the first time. The withholding tax will be imposed in a similar manner to the existing withholding tax on U.S. source income under Chapter 3 of the Internal Revenue Code by requiring payors (or withholding agents) of U.S. sourced income and gross proceeds to withhold 30% on payments to non-U.S. entities that do not certify their compliance with FATCA.To avoid the tax, FFIs must enter into formalized agreements with the IRS to share the identities of U.S. account and asset holders. Other affected non-U.S./non-FFI entities seeking to avoid the tax will be required to provide information to the withholding agents relating to any of their U.S. owners.
In proposed regulations released in February 2012, the U.S. Treasury and IRS have provided detailed requirements that FFIs, U.S. withholding agents, and other non-U.S. entities must comply with to avoid the withholding liability under FATCA. The proposed regulations also detail exceptions and exclusions to the withholding and suggest a broader framework of international cooperation seeking to ease challenges of FATCA compliance on foreign entities. If affected by FATCA, you should understand the implications of these rules, exceptions, and frameworks on your industry and business and prepare to address them. The proposed regulations have eased some of FATCA’s compliance deadlines, but some hurdles (and opportunities) still exist to prepare your processes, systems, and business relationships now for a smooth transition to the new, more transparent international business environment that FATCA attempts to create.
Although the scope of the proposed FATCA regulations casts a relatively broad net over the types of entities and businesses that are defined as financial institutions, foreign entities that conduct banking or similar business (“foreign banks”) are squarely in the center of the net. Under FATCA, a foreign bank is defined as any foreign entity that, in the ordinary course of business with customers, engages in activities that include accepting deposits of funds; making personal, mortgage, industrial, or other loans; purchasing, selling, discounting, or negotiating accounts receivable, among other activities. Where the foreign bank is a member of an affiliated group, all members of the affiliated group must sign FFI agreements to be considered a participating FFI.
The impact of FATCA on foreign banks is pervasive, possibility more than any other entity or business. As with other FFIs, foreign banks are subject to the requirement to report their U.S. account holders to the IRS. Most foreign banks will be required to enter into a formalized agreement (“FFI Agreement”) with the IRS, under which they will agree to additional documentation standards, tax withholding and annual reporting obligations, as well as other requirements described below. Foreign banks that do not sign the agreement by the December 31, 2013 deadline may become subject to 30% withholding on income and gross proceeds from U.S. sources. Certain foreign banks, whose operations are limited to the country in which they are incorporated, and who do not solicit nor have accounts outside of that country may be eligible for “deemed compliant” status, as may certain smaller purely local banks or those with only low value accounts.
The FFI Agreement will require foreign banks to identify and report on new and pre-existing accounts held by U.S. Persons. The regulations generally place reliance on documentation and electronic data that is either collected through the FFI’s existing account opening process or that is normally maintained in the customer file, with specific reference in the preamble to the regulations to reliance on anti-money laundering “Know Your Customer” (“AML/KYC”) information. However, the rules for new accounts require that FFIs maintain hard copies of documentation and periodically renew it. These procedures are often not followed under pre-existing AML/KYC rules. Therefore, while reliance on the foreign bank’s existing documentation procedures may appear to offer the potential to reduce the impact of FATCA requirements on existing account opening and documentation procedures, in reality foreign banks may need to take additional steps to modify their existing programs in order to comply.
The proposed regulations have sought to ease the burden for FFI’s of identifying U.S. accounts from pre-existing accounts by excluding individual accounts with balances of $50,000 or less, and entity accounts with a balance of $250,000 or less. Further, for individual accounts with balances greater than $50,000, the proposed regulations permit reliance solely on electronic searches of customer information to assist identification of pre-existing U.S. accounts, where the account balance is $1 million or less1.
One additional challenge that some foreign banks may be facing is the requirement to close accounts of U.S. account holders that refuse to provide disclosure waivers where foreign law would otherwise prevent the reporting of information to the IRS. Depending on local laws, banks may be restricted from closing accounts, thus placing them at odds with the FFI agreement.
In the coming months, banks will have to perform a review of their operations in order to determine whether or not they expect to have additional reporting and withholding requirements under FATCA. Banks will be expected to answer the following questions in order to determine whether or not they fall under the scope of FATCA as an FFI, and if so, what their obligations are;
- Is the bank domiciled in a foreign jurisdiction?
- A consolidated group must consider its organizational structure and whether any of its entities are domiciled in a jurisdiction outside of the United States.
- They may want to determine whether they qualify for a deemed Compliant status.
- Does the foreign bank intend to be a participating FFI or a non-participating FFI?
- A participating FFI will not be subject to 30% withholding on its U.S. source cash flows; a non-participating FFI will be.
- Subject to transitional measures, all FFIs in an expanded affiliated group will need to be participating FFIs or 30% withholding will be applied to all group FFIs.
- What procedures are in place to identify accountholders?
- The company will need to consider its existing KYC processes to determine that it is able to identify U.S. Persons, and will need to develop systems to report on them in accordance with the FATCA requirements. Withholding will be confined to accountholders that are non-participating FFIs or recalcitrant account holders2.
- Companies should review their books of business to identify U.S. Persons who hold pre-existing accounts.
- The nature of that review is determined by the aggregate account balance whether the accountholder is an individual or an entity.
- Are changes required to account agreements to permit compliance with FATCA requirements?
- Account agreements may need to be revised to include terms that permit reporting of required information and/or the closure of accounts that fail to provide waiver to permit reporting where foreign law would otherwise prevent the reporting of information to the IRS.
- Will existing customer systems be adequate to record and report changes in accountholder’s situation which bring them within the scope of FATCA?
- The FATCA reporting obligations are triggered where an accountholder becomes a U.S. Person after opening an account.
- What are the reporting and withholding requirements of the FFI with respect to the accounts of U.S. Persons and “recalcitrants”?
- The FFI must follow FATCA regulations to report on U.S. persons and withhold and report on payments to recalcitrant account holders;
- Withholding will not be required for obligations outstanding before January 1, 2013 (grandfathered obligations); however, the reporting requirement pertains to all in scope accounts3.
1 Accounts of a single customer or account holder must be aggregated to determine if they meet the thresholds. Aggregation is only required to the extent that the FFI’s computer system links the accounts and allows for account balances to be aggregated
2 Recalcitrant account holder means any account holder if such account holder is not an FFI, the account does not meet an exception to U.S. account status, or does not qualify for any exception from documentation requirements and the account holder fails to comply with requests for documentation or information
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