New rules under the Foreign Account Tax Compliance Act (FATCA) will require significant changes to the way foreign financial institutions (FFI) and non-financial foreign entities (NFFE) conduct business. FFIs and NFFEs will now have to take proactive steps to identify U.S. account holders, U.S.-owned foreign entities, and substantial U.S. owners. Failure to do so on a timely basis will cause them to become subject to the new FATCA withholding tax. In addition, U.S. financial institutions will have to change their withholding procedures as well. Lastly, foreign affiliates of U.S. financial institutions can themselves be FFIs.
Listed below are the Top 10 provisions U.S. and foreign businesses and individuals need to know about FATCA.
1. FFIs Are Not Just Banks
Under FATCA, payments of U.S. source income to FFIs are subject to a 30% withholding tax unless the FFI is a participating FFI or otherwise exempt from withholding. The term FFI includes banks, but also includes a large number of other financial and non-financial institutions. For example, insurance companies which issue insurance policies with a cash surrender value or which provide for investment options with respect to the cash surrender values are considered FFIs.
In addition, foreign entities which are engaged primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, notional principal contracts, and insurance or annuity contracts are also considered FFIs. This would include mutual funds, hedge funds, private equity funds, leveraged buyout funds, collateralized bond funds, and similar funds. Lastly, many pension and other retirement plans will constitute FFIs unless they meet certain stringent requirements set out in the Proposed Regulations.
There are exclusions for holding companies whose main activity is to hold stock of one or more subsidiaries engaged in a trade or business, and which are not themselves FFIs, start-up companies during the 24-month period starting when they were formed, and foreign Section 501(c) entities (including foreign charities).
2. Participating FFIs – FFI Agreement and KYC Rules
In order to avoid the FATCA withholding tax on payments to FFIs, an FFI can become a participating FFI by entering into an FFI agreement with the IRS. The Proposed Regulations address in detail what provisions are expected to be included in a model FFI agreement, which is expected to be released as a Revenue Procedure issued later in 2012. The requirements imposed by the FFI agreement will be extremely burdensome for many foreign FFIs. In the FFI agreement, the FFI will be obligated to deduct and withhold tax on pass-thru payments to recalcitrant account holders and nonparticipating FFIs, including local branches and local FFIs. The IRS has indicated that it will publish a list of participating FFIs for review by withholding agents to allow withholding agents to confirm that an FFI is a participating FFI and thus not subject to the FATCA withholding tax.
The FFI will have to agree to obtain from each account holder through its due diligence procedures sufficient information to allow the FFI to determine the status of each account holder. It will have to adopt written policies and procedures governing its due diligence procedures, and conduct periodic reviews to determine that its employees are complying with its documented due diligence procedures. The proposed regulations set out a list of U.S. indicia which must be taken into account in determining whether a particular account is a U.S. account, including a U.S. mailing address, U.S. telephone number, or U.S. place of birth. If an account has U.S. indicia, the FFI must obtain either a Form W-9 confirming the account holder’s U.S. status and taxpayer identification number, or a Form W-8 confirming that the account holder is not a U.S. person. Records must be maintained for a six-year period. For existing accounts, the participating FFI must review its know your customer (KYC) and other account information to identify U.S. account holders within one year of the effective date of its FFI agreement.
The IRS may verify compliance with the FFI agreement through an audit by an external auditor if the IRS has concerns about compliance failures. A key provision of the FFI agreement will be that the FFI must agree to comply with requests by the IRS for additional information regarding its U.S. account holders, allowing the IRS to obtain information on U.S. account holders without having to comply with applicable foreign laws on bank secrecy.
In addition, the FFI will have to report annually to the IRS specified information as to its U.S. account holders, including recalcitrant account holders. If foreign law prevents the reporting of U.S. accounts to the IRS, the FFI must agree to either obtain an effective and valid waiver of such law from each account holder, or if a waiver is not obtained in a reasonable time, close the account.
3. Participating FFIs – Not All Group Members Have to Participate
Frequently, an FFI is a member of a group of companies which includes other FFIs. In this case, under the proposed regulations, each member of the group which is an FFI must become either a participating FFI or a registered deemed-compliant FFI as to all accounts maintained at any of its branches, offices and divisions, and must agree to report its U.S. accounts to the IRS, withhold on pass-thru payments, and close accounts of U.S. persons who do not waive any restrictions on reporting.
The U.S. Treasury and IRS recognized that not all members of a group of FFIs might be able to satisfy the reporting and other requirements to become a participating FFI or a registered deemed-compliant FFI. Accordingly, for a limited period of time, one or more members of the group of FFIs can elect to be treated as limited branches or limited FFIs. A limited branch or limited FFI is one which cannot either report U.S. accounts to the IRS or close or transfer such U.S. accounts to a group member which is a participating FFI, or with respect to recalcitrant account holders cannot block, close, or transfer such U.S. accounts. Payments by a participating FFI to a limited branch or limited FFIs are subject to FATCA withholding.
A participating FFI will cease to qualify as such unless all of its affiliated limited branches and limited FFIs become participating FFIs on or before December 21, 2015. This effectively gives an affiliated group of financial institutions until 2016 to become fully FATCA compliant.
4. Local FFIs and Certified FFIs – No Need for an FFI Agreement
Registered deemed-compliant FFIs do not need to enter into an FFI agreement with the IRS. A local FFI is one type of registered deemed-compliant FFI and is one that satisfies eight requirements, including that the FFI must be licensed and regulated under the laws of the country in which it is incorporated as a bank, securities broker or investment advisor; it must not have a fixed place of business outside of that country; all members of the affiliated group must be incorporated in the same country; it must not solicit account holders outside of that country and cannot target U.S. customers; at least 98% of its customers must be residents of that country (U.S. customers who are residents of that country count towards the 98% test); and it must have identified its U.S. account holders. An FFI which qualifies as a local FFI must register with the IRS, obtain a U.S. taxpayer identification number, and its chief compliance officer must certify on a regular basis to the IRS that all of the requirements for qualifying as a local FFI have been satisfied. They will have to provide withholding agents with an appropriate form, likely an updated version of Form W-8, which identifies it as a registered deemed-compliant FFI and includes its FFI-EIN. The withholding agent is required to match the FFI-EIN against the published IRS list.
Certain banks may qualify as non-registering local banks – if they do so they do not need to register with the IRS or enter into an FFI agreement, but instead must certify to a withholding agent that they qualify as a certified deemed-complaint FFI. Non-registering local banks must be licensed and operate solely as banks in the country in which they are incorporated, cannot conduct business outside of that country, must not solicit customers outside of that country, can have no more than U.S. $175 million in assets, or if part of an affiliated group, the group can have no more than U.S. $500 million in total assets, and all members of the affiliated group must satisfy these requirements.
It should be noted that hedge funds, private equity funds, and other entities which qualify as FFIs because they invest primarily in securities cannot qualify for local FFIs or non-registering local banks status.
5. Foreign Persons Can Be Withholding Agents
Any person who has control, receipt, custody, disposal, or payments of U.S. source income to an FFI or NFFE is a withholding agent. This includes both U.S. and non-U.S. persons. Accordingly, a foreign bank which holds U.S. government securities in an investment account for a foreign investor would qualify as a withholding agent, and would be subject to the provisions of FATCA unless it is a participating FFI and otherwise complies with the requirements of FATCA. In addition, a foreign financial institution which is a counterparty to an equity-linked swap based upon a U.S. equity is a withholding agent as well since the payments under the swap will be characterized as U.S. source income. Withholding would be required unless the other party to the swap was a participating FFI or is otherwise exempted from withholding.
Persons who are withholding agents will need to obtain a U.S. taxpayer identification number and file Forms 1042 and 1042-S with the IRS to report the payments which are subject to U.S. withholding tax. They will also need to pay over to the IRS any withheld tax.
6. Grandfathered Obligations – No Withholding Required
Withholding is not required under FATCA on obligations which are outstanding as of January 1, 2013. For these purposes, the term “obligation” includes any legal agreement which produces or could produce a withholdable payment, including debt instruments, agreements to extend credit, certain insurance contracts, certain annuity contracts, and derivative transactions under an ISDA Master Agreement. It does not include, however, equity instruments and savings or demand deposits which do not have a stated maturity date.
Note that if a grandfathered obligation is materially modified after January 1, 2013, then it will cease to be a grandfathered obligation and will become subject to FATCA withholding.
7. When Does FATCA Withholding Start
Under the statute, FATCA withholding under Section 1471 is required for withholdable payments to FFIs made after December 31, 2012. The proposed regulations have extended the date for withholding to payments made after December 31, 2013. Accordingly, fixed and determinable, annual or periodic payments of U.S. source income made on or after January 1, 2014 are subject to withholding unless the FFI is a participating FFI or is otherwise exempted from withholding under the final regulations. Withholding on U.S. source gross proceeds from a sale or disposition has also been extended and will be required for sales or dispositions occurring after December 31, 2014.
8. Hedge and Other Funds and Their Substantial U.S. Owners
Participating FFIs are required to report to the IRS all of their U.S. accounts, which includes both specified U.S. persons and U.S.-owned foreign entities with substantial U.S. owners. For these purposes, a substantial U.S. owner is a U.S. person who owns more than 10% of the equity of the foreign corporation, more than 10% of the profits or capital of a foreign partnership or more than 10% of the beneficial interests in a foreign trust. Special rules apply, however, to certain FFIs such as hedge funds, private equity funds and partnerships primarily in the business of investing in securities. With respect to such FFIs, the threshold for determining who is a substantial U.S. owner is reduced from 10% to 0%. Accordingly, for hedge funds and other similar FFIs, each U.S. owner is considered to be substantial and thus must be reported to the IRS, no matter how small their actual ownership interest.
There are attribution rules and constructive ownership rules which apply to determine whether a foreign entity has a substantial U.S. owner; those rules essentially look through corporations, partnerships and trusts to U.S. investors. Accordingly, foreign hedge funds which invest in U.S. securities must investigate the actual beneficial ownership of each of their investors to determine if any U.S. persons are directly or indirectly owners of the entity investing in the hedge fund. If so, they must collect certain information as to those U.S. owners and report them to the IRS in order to avoid the FATCA withholding.
9. Excepted NFFEs – No Withholding Required
Payments of U.S. source income to an NFFE are also subject to withholding under FATCA unless the NFFE reports its substantial U.S. owners to the withholding agent who will in turn report them to the IRS. Withholding is not required, however, for payments to excepted NFFEs. Excepted NFFEs include, among others, certain publicly traded corporations, members of an affiliated group whose parent company is publicly traded, and active NFFEs. Excepted NFFEs will be required to certify their status as an excepted NFFE to withholding agents, likely on an updated Form W-8.
Foreign companies will satisfy the publicly traded requirement if one or more classes of stock representing more than 50% of the total combined voting power and value of their stock are traded on the recognized stock exchange, trades are made during at least 60 days during the prior calendar year, and the aggregate number of shares traded are at least 10% of the average number of shares outstanding in the prior calendar year. Foreign companies which do not satisfy the publicly traded requirements may qualify as an excepted NFFE if they meet the requirements of an active NFFE. An NFFE will qualify as an active NFFE if less than 50% of its gross income in the prior calendar year is passive income or less than 50% of its assets held during the prior calendar year produce passive income. For these purposes, passive income includes dividends, interest, rents, and royalties that are not derived from an active conduct of a trade or business, and net gains from commodity transactions or foreign currency transactions.
10. FATCA Applies to U.S. Institutions As Well
U.S. financial institutions are going to be subject to the FATCA rules for two reasons. Firstly, they will often be withholding agents. They will need to adopt new FATCA oriented withholding procedures to ensure proper compliance with FATCA’s rules. In addition, they will have to modify their computer programs to capture and report additional information to the IRS. Secondly, foreign affiliates such as banks, sponsored hedge funds, etc. may be FFIs who need to become participating FFIs.
Conclusion...FATCA is Expensive and Intrusive
Complying with the requirements of FACTA, particularly for FFIs who want to be a participating FFI, will be a time-consuming, expensive, and intrusive process. As noted above, participating FFIs have one year from the date of their FFI Agreement to review all of their existing accounts to identify U.S. accounts. They will have to update their computer systems to comply with the new recordkeeping and IRS reporting requirements, draft and adopt written due diligence policies, train their staff on the new compliance requirements, determine how local banking and other laws effect their ability to disclose U.S. accounts to the IRS, obtain W-9s or W-8s from many of their account holders, enter into an extensive FFI agreement, and file certifications with the IRS.
Similarly, NFFEs will have to investigate their investors to determine if any of them are U.S. persons who qualify as substantial U.S. owners. If one or more investors are substantial U.S. owners, then the NFFE will have to obtain the required information from those investors to report to the IRS. If a particular investor chooses not comply with the requests for information from the NFFE, the NFFE will have a difficult decision to make – either redeem out that investor, or face FATCA withholding on all of its U.S. source income.
The IRS expects to issue a Revenue Procedure later in 2012 setting out a model FFI agreement. However, FFIs who intend to become participating FFIs should not wait until the Revenue Procedure is issued to begin the process of identifying the changes that will be required to their KYC rules, their computer systems, etc. since an FFI has one year from the date of their FFI agreement to identify their U.S. account holders.
Venable’s attorneys can assist foreign entities in developing the KYC documentation and procedures needed to comply with the FFI agreement requirements. If you have questions on the new FATCA provisions or on how to complete part or all of a particular form, please contact one of the authors or a member of Venable’s Tax and Wealth Planning Group.