Implementing the New US Withholding Tax Rules

This update reports on the status of implementation in Swiss banks of the new US non-resident withholding tax regulations of 1997, which will enter into force on January 1 2001. It outlines the effect of the new rules on the design, implementation and administration of foreign entities (ie, foreign companies and foreign trusts) which are account holders in Swiss banks. It also examines the impact of the regulations on Swiss banking secrecy, and the documentation required of foreign legal entities as Swiss account holders in order to comply with the new rules under the qualified intermediary regime.

Background

As reported in Impact of New US Withholding Tax Rules for Customers of Swiss Financial Institutions, the new qualified intermediary regime will take effect in Switzerland on January 1 2001. It will both to Swiss financial institutions that have been awarded qualified intermediary status by the US Internal Revenue Service (IRS), and to Swiss institutions that have not, or that have opted to retain the non-qualified intermediary status.

In either case, proper documentation of client account holders in Swiss banks that hold US securities will be required to be in place, identifying the so-called 'beneficial owner' of income deriving from these securities under US tax rules (but not under Swiss banking 'Know Your Customer' (KYC) rules).

At present, under the Swiss-US double taxation treaty (ie, the so-called 'address system' in effect until December 31 2000), a Swiss bank client investing in US securities is entitled to a reduction in the 30% US withholding tax rate at source to 15% on dividends paid to Swiss individual residents and Swiss companies for portfolio investment purposes, that is, a net dividend of 85%. The Swiss bank pays the remaining 15% to the Swiss federal tax authorities for refund upon application made by the client.

A reduction to 0% of the US withholding tax rate on dividends is paid to recognized pension funds and on interest paid to any Swiss resident under the portfolio exemption rule, that is, net interest at 100%. A foreign resident Swiss bank client from a treaty country likewise receives a reduction in the US withholding tax rate on dividends to 15% paid to his Swiss bank address, that is, a net dividend of 85%. The remaining 15% is retained by the IRS, available for refund by application of the double tax treaty between the United States and the client's country of tax residence. Finally, Swiss bank clients from non-treaty jurisdictions with respect to the United States suffer the 30% US withholding tax non-treaty rate on US source dividends, receiving a net 70% dividend.

Effect of New Regime

As of January 1 2001 the 'address system' will be replaced by the new US withholding tax rules. A US withholding tax rate of 30% will be retained on US-source dividends and interest arising from US securities and paid abroad, irrespective of the address of the payee.

The only exceptions to this level of US withholding tax for Swiss banks will be where the Swiss bank has proper qualified intermediary documentation on its client, the beneficial owner of the income. The Swiss bank must provide its US withholding agent with this documentation in the case of US-person clients who consent to such disclosure, as well as for so-called 'flow-through' or 'transparent' legal entity account holders. It must further provide its US withholding agent with the appropriate withholding rate pools or basket reporting information for the different US withholding tax rates to be levied by qualified intermediary bank client and US source income categories. These are as follows.

* 'Non-documented' in this respect means that no qualified intermediary documentation has been completed, signed and remitted to the Swiss bank by the account holder. It is therefore a default category. Under Swiss KYC banking rules, however, this category of banking client does not exist, since a Swiss bank is required to know its client, which means in most cases the physical person who is the beneficial owner in the Swiss KYC sense. This requirement is specified in the Agreement on the Swiss Banks' Code of Conduct With Respect to the Exercise of Due Diligence, the current version of which is effective as from July 1 1998 (the Due Diligence Agreement).

One of the undertakings of Swiss bank qualified intermediaries under the agreement which each Swiss bank signs with the IRS is the correct treatment of US-person Swiss bank clients under the new qualified intermediary rules.

Until December 31 2000 US-person Swiss bank clients that wish to disinvest in US securities may instruct their Swiss banks to sell the securities without the consequences of the 31% back-up withholding otherwise applicable as from January 1 2001. In these cases the Swiss bank will no longer permit its US-person client to invest in US securities under the new US withholding tax regime, unless he consents to disclosure by instructing the Swiss bank to file a completed and signed W-9 form on his behalf with its US withholding agent. Thereafter, that client may freely invest in US securities through his Swiss bank without having further US withholding tax levied by his Swiss bank under the qualified intermediary system.

If a US-person Swiss bank client refuses to consent to the sale of his US securities by December 31 2000 and further refuses to consent to disclosure through a W-9, the Swiss bank is required as a qualified intermediary to back-up withhold 31% on all interest, dividends and sale proceeds of US securities as from January 1 2001. In addition, the bank must periodically (ie, at least twice a year) request the client to consent to disclosure or sale of these securities, up until December 31 2001. At this date, the Swiss bank must liquidate the client's undisclosed unsold US securities, effecting the 31% back-up withholding on the total sale proceeds. As of January 1 2002 US securities accounts for undisclosed US-person Swiss bank clients will not be permitted under the qualified intermediary system.

Effect on Swiss Banking Secrecy

The qualified intermediary regime is available only to financial institutions located in jurisdictions whose KYC banking rules have been approved by the IRS. As such, the bankers associations of several countries, including the Swiss Bankers Association, have negotiated with the IRS on this subject. The number of KYC jurisdictions is continually under review, and the list of approved jurisdictions are increasing. As of September 2000 the IRS had approved the KYC banking rules of Belgium, Canada, Denmark, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Singapore, Sweden, Switzerland and the United Kingdom.

Bank branches located in jurisdictions without approved KYC banking rules may still qualify as qualified intermediaries if the ultimate parent bank is located in an approved KYC jurisdiction and agrees to apply its KYC banking rules to its branches. Bank subsidiaries located in non-approved KYC jurisdictions are excluded from this possibility, although bank subsidiaries located in approved KYC jurisdictions - even with parent banks located in non-approved KYC jurisdictions - may qualify for qualified intermediary status. Finally, the IRS stated that those qualified intermediaries or their branches which are located in tax-haven jurisdictions or in jurisdictions applying strict banking secrecy, and which do not cooperate with the United States in reforming their banking practices relating to transparency and the provision of tax-related information/judicial assistance, may be subject to heightened scrutiny, including stricter audit and/or enforcement and/or default standards under the qualified intermediary regime. (This was stated in IRS Announcement 2000-48 of May 15 2000, which provides further guidance for foreign financial institutions contemplating applying for qualified intermediary status). Pursuant to, for example, the Swiss-US double tax treaty and Swiss criminal law, Switzerland is not one such jurisdiction (see Switzerland under Scrutiny from International Financial Sector). For Swiss purposes, bank subsidiaries of Swiss parent banks located in non-approved KYC jurisdictions are listed in Appendix A(3) of the Model Application for Qualified Intermediary Status (published by the IRS at Revenue Procedure 2000-12, 2000-4 IRB 387 and attached as Annex 1 to Swiss Bankers Association Circular 6995 of July 25 2000).

In the most recent Swiss Bankers Association Circular 7020, dated November 15 2000, a solution has been found for foreign bank subsidiaries located in non-KYC approved jurisdictions that have parent banks located in KYC approved jurisdictions. Under Section 8832 of the Internal Revenue Code, such a foreign subsidiary may file an election with the IRS under Section 8832 of the Internal Revenue Code to be treated for US tax and qualified intermediary purposes as a ‘disregarded’ entity. As a result of this election, the subsidiary will be regarded by the IRS for qualified intermediary purposes as a branch of its owner, the foreign parent bank located in a KYC-approved jurisdiction, which will then apply its KYC rules to its subsidiary.

The IRS recognized the legitimacy of continuing Swiss banking secrecy under Swiss law, as negotiated by the Swiss Bankers Association, not only in respect of Swiss bank non-US person clients holding US securities, but also for those clients who are US persons holding US securities but who refuse to consent to the Swiss bank's disclosure of their identity to the US withholding agent and the IRS in the transitional period from January 1 2001 to December 31 2001. As the qualified intermediary system applies only in respect of US securities, the continued ownership of non-US securities under present Swiss banking secrecy remains unaffected by the introduction of the qualified intermediary regime. This is also the case for present Swiss banking secrecy over continued ownership of US securities by non-US Swiss bank clients, except as regards so-called 'transparent' or 'flow-through' account holders, discussed below. Even here, however, the refusal of a non-US person Swiss bank client, as a transparent or flow-through entity/beneficial owner, to consent to disclosure will be respected by the respective Swiss bank under existing Swiss banking secrecy rules, although the client will fall into the undocumented category for qualified intermediary US withholding tax and reporting purposes, with the effect of default treatment.

Under the qualified intermediary regime, whenever a Swiss bank account holder is not the beneficial owner under US tax rules (regardless of whether this is the case for Swiss KYC purposes), the identities of both the intermediary and the beneficial owner(s) must be disclosed to the Swiss bank's US withholding agent, and to the IRS if the relevant account contains US securities. Disclosure is subject to the consent of the direct account holder to waive Swiss banking secrecy. With respect to transparent or flow-through Swiss bank account holders, this disclosure obligation applies irrespective of whether the beneficial owners of the legal entities are US or non-US persons.

The amendments to the US withholding regulations made by the IRS in May 22 2000 provide for the possibility of a declaratory statement made by the foreign-person bank client in lieu of the standard non-renewable qualified intermediary documentation (Federal Register Volume 65, Number 99, p32208 in respect of Rule 1.6049-5(c)(4)(i)/(ii) on US bank deposit interest and US short-term original issue discount which are subject to reporting after December 31 1982). This declaratory statement enables the foreign client to avoid the 'non-documented' person category, and consequent default status and treatment under the qualified intermediary US withholding tax rules. Admittedly, this rule is intended to prevent abuse of the rules by a foreign intermediary on behalf of a US-person beneficial owner.

Accordingly, Swiss banks have overwhelmingly acted to obtain qualified intermediary status with the IRS, since through this regime they continue to be able to obtain US treaty benefits for their Swiss and foreign clients under existing Swiss banking secrecy, without disclosure of sensitive client information (eg, name, passport number, address and country of tax residence) to their US withholding agent or to the IRS, except as noted above. They can therefore continue to offer US securities to their clientele under the qualified intermediary regime. This constitutes a competitive advantage over financial institutions that are non-qualified intermediaries and are thus unable to procure US treaty benefits except under onerous beneficial ownership disclosure requirements.

Effect on Foreign Entities holding Swiss Bank Accounts

On May 22 2000 the IRS published extensive amendments to the non-resident withholding tax regulations, effective January 1 2001, including guidance on various legal entities and in particular with respect to trusts and estates (Federal Register Volume 65, Number 99, p 32152 ff). The Swiss Bankers Association annexed these regulations as Annex 4 to its Circular 6995 of July 25 2000, and began to promote the use of these guidelines by member banks when dealing with the proper qualified intermediary documentation and US tax qualification of Swiss bank account holders who are foreign entities. On August 24 2000 the Swiss Bankers Association complemented the previous circular with Circular 6999, entitled Trusts, Foundations and Offshore Companies, which examines in detail the treatment, from a US tax perspective, of foreign legal entities holding Swiss bank accounts under the new qualified intermediary regime.

Circular 6999 emphasizes the US tax notion of 'beneficial ownership' as prevailing over the Swiss KYC banking notion of 'beneficial ownership' which is contained in the Due Diligence Agreement.

US federal income tax law defines a 'beneficial owner' as the person who under US tax rules is the owner of the relevant income for tax declaration purposes, and who therefore beneficially owns that income arising from US securities. Where the Swiss bank account holder is not the beneficial owner in this sense, it is considered under the qualified intermediary regime to be an intermediary. It is thus required to file with its Swiss bank a Form W-8IMY, and to obtain a Form W-8BEN/W-9 for each beneficial owner for whom it receives income arising from US securities. The Swiss bank may only submit these forms to its US withholding agent with the express consent of its direct account holder. If consent to disclosure is refused then this information is covered by Swiss banking secrecy, but the Swiss bank will be required to back-up withhold on the account's US securities at the maximum US withholding tax rates according to the type of US source income and tax residence of the account holder.

The distinction of who is the beneficial owner, under US tax rules, of US source income for tax declaration purposes is therefore crucial to the determination of who beneficially owns that income under the qualified intermediary system.

Generally, a physical person is treated as the owner of income received by that person. He/she is therefore considered under US tax rules as the beneficial owner eligible under the qualified intermediary system to file the IRS Form W-8BEN or Swiss Bankers Association-approved equivalent form 'Declaration of Non-US Person Status' (DNUS), to the extent that the person would be required under application of US tax principles to include that income in his gross income on his tax declaration.

However, a person who receives income as a nominee, custodian or agent for another person, or who is to be considered as a mere conduit, may not be considered under US tax rules as the beneficial owner of that income. Under the qualified intermediary system this person is an intermediary acting only to receive income on behalf of an undisclosed beneficial owner. It must therefore file IRS Form W-8IMY indicating its intermediary status, and attach a Form W-8BEN/W-9 for each beneficial owner and indicate each beneficial owner's interest in the gross income received by the intermediary. Even a presumably non-transparent entity (eg, a per se corporation or legal entity treated as a corporation) may act as an intermediary, in which case the above principle would likewise apply.

Form W-8IMY, 'Certificate of Foreign Intermediary, Foreign Partnership, or Certain US Branches (of foreign banks) for US Withholding Tax', must be completed and signed by any foreign bank, corporation or partnership, as well as by certain US branches of foreign banks acting as an agent or nominee or conduit on behalf of beneficial owners or other intermediaries.

Form W-8BEN is the standard beneficial owner form used by the IRS which must be completed and signed by foreign persons with Swiss bank accounts. During negotiations between the Swiss Bankers Association and the IRS, the parties agreed on the possibility of substituting Form W-8BEN with the equivalent Swiss form DNUS. Unlike Form W-8BEN, the Swiss form need not be renewed every three years as long as the information therein remains correct and valid. Form W-8BEN, 'Certificate of Foreign Status of Beneficial Owner for US Withholding Tax', applies to any foreign-person Swiss bank client - including non-resident aliens and non-US corporations, partnerships, estates and trusts - who is the beneficial owner of income arising from US securities and who is entitled to the portfolio interest exemption or reduced US withholding tax treaty relief. The IRS frequently refers to this class of beneficial owners as 'non-exempt non-US persons', to distinguish them from other foreign persons claiming exemption from US withholding tax by virtue of (i) US source income arising from effectively connected income (ie, income effectively connected with a trade or business in the US (Form W-8ECI)), or (ii) being a foreign government, international organization or non-governmental organization, foreign central bank of issue, foreign tax-exempt organization or foreign private foundation (Form W-8EXP). Analysis of these other 'exempt' foreign-person beneficial owners under the qualified intermediary regime is beyond the scope of this update.

Qualification of the Swiss bank direct account holder as a transparent/flow-through intermediary or non-transparent entity beneficial owner is of utmost priority, as this indicates which US Form W-8 form/Swiss form DNUS and procedure is applicable. Form W-8BEN/Swiss form DNUS for non-transparent Swiss account beneficial owners is held with the Swiss bank under Swiss banking secrecy, and disclosed neither to the Swiss bank's US withholding agent nor to the IRS. On the other hand, Form W-8IMY from a Swiss bank account holder considered to be a transparent/flow-through intermediary, together with Form W-8BEN for the foreign beneficial owners/Form W-9 for US person beneficial owners of the account, must be disclosed by the qualified intermediary Swiss bank to its US withholding agent and the IRS. Disclosure is subject to the consent of the Swiss bank direct account holder. The direct account holder's refusal to waive Swiss banking secrecy results in non-disclosure by the Swiss bank, but also in full back-up withholding on the account's US source income deriving from US securities.

The qualification of foreign trusts, estates and other legal entities for qualified intermediary purposes depends on whether the Swiss bank account holder is a business entity or a non-business entity according to US tax rules.

A legal entity which is a business entity is constituted in order to pursue some commercial business activity. Corporate purposes are either in long form, setting forth all specified objects, or - as is usual today - in short form, specifying the undertaking of any lawful activity permitted by operative statute. A 'business entity' is defined in the Internal Revenue Code of 1986 (Section 301.7701-2) as any entity that (i) is recognized for US federal tax purposes as separate from its owner and (ii) is not properly classified as a trust or otherwise subject to special treatment under the code. Under US tax rules a business entity with two or more members is classified as either a corporation or a partnership. A business entity with only one owner is classified as a corporation or is disregarded. If disregarded, its activities are treated in the same manner as a sole proprietorship, branch or division of the owner. A corporation may also be in the form of an association or a business entity organized under a state statute, if the statute describes or refers to it as a joint stock company or joint stock association. Finally, a 'corporation' is any business entity taxable as a corporation under the Internal Revenue Code other than as an association, including certain foreign entities listed as per se corporations (Section 301.7701-2(b)(8)(i)). Other business entities which are not corporations are, for example, partnerships, which are business entities of a non-corporate nature with least two members. Finally, for wholly owned entities in general, a business entity with a single owner which is not a corporation as defined above is disregarded as an entity separate from its owner.

The other US tax notion which is crucial to the qualified intermediary regime is the distinction between US-person entities and foreign entities. An entity is a domestic entity (ie, a US person for qualified intermediary purposes) if it is created or organized in the United States, or under the law of the United States or of any state therein. An entity is foreign if it is not domestic.

A foreign entity that does not figure on the per se corporation list may elect via Section 8832 of the Internal Revenue Code to be classified as follows.

Where, under local law or the company charter or by-laws, all shareholders/members/owners have only limited liability (ie, no personal liability for the foreign entity's debts or for claims made against the entity by reason of being a shareholder/member/owner), then by default, and without further qualified intermediary-related declaration by the account holder, the foreign entity may be classified as a corporation under US tax rules. For purposes of the qualified intermediary regime, it is therefore treated as a non-transparent business entity separate from its owner(s), and entitled to be treated as the beneficial owner of its gross income for purposes of US federal income tax and under the qualified intermediary rules. However, such a foreign business entity may also elect to be treated as a partnership for US federal income tax and thus qualified intermediary purposes, as a transparent/flow-through business entity, and thus as an intermediary, upon filing the relevant form with the IRS. The Internal Revenue Code lists the four principle characteristics used to distinguish corporations from partnerships (Section 301.7701-2(a)(2)). A business entity that meets three of them will be qualified for US tax purposes as a corporation. A business entity meeting two or less will generally be qualified as a partnership. The characteristics are as follows:

• centralized management and control;
  
  
• liability for corporate debts limited to corporate assets;
  
  
• unlimited duration as legal entity; and
  
  
• free transferability of member's shares/interests.

Where, under local law or the company charter/by-laws, any one shareholder/member/owner has unlimited liability, then in the absence of an election to be treated as a corporation, such a foreign entity will automatically be treated as a partnership for US federal income tax purposes. This makes it an intermediary under the qualified intermediary rules, with concomitant disclosure problems for beneficial owners.

The same rules apply to a foreign entity owned by a single owner. Where the owner's liability is limited, then the single-owner foreign entity will be recognized and treated as a business entity and corporation separate from its owner, and as the beneficial owner of its gross income for US income tax purposes. It will therefore be treated as a non-transparent business entity under the qualified intermediary rules (if it has not elected to be disregarded as a corporation that is separate from its owner). If the liability of the owner is unlimited, on the other hand, then the single-owner foreign entity will be disregarded as a corporation separate from its owner, and recognized and treated as a sole proprietorship, branch or division of the owner (unless it has elected to be treated as a corporation separate from its owner) for US federal income tax purposes. It will thus be treated as a transparent/flow-through intermediary under the qualified intermediary rules, with concomitant disclosure problems for the beneficial owner.

These classifications apply irrespective of the nationalities of the shareholders/members/owners for the purposes of qualified intermediary Swiss bank account holder documentation. US tax rules in respect of taxation of income arising from controlled foreign corporations, personal holding companies, foreign personal holding companies, personal foreign investment companies, qualified electing funds and the like are outside the scope of the qualified intermediary rules and beyond the scope of this update.

The Internal Revenue Code defines an organization or legal entity as a 'trust' for US tax purposes if the entity generally does not have associates, or an objective to carry on a business or trade for profit (Section 301.7701-4). A trust is therefore considered as a non-business entity.

The code further defines 'US person' as, among other things, US citizens, US legal residents, domestic (US) partnerships and corporations, and domestic (US) estates and trusts (Section 7701(a)(30)).

For purposes of the qualified intermediary regime, a 'US person' is a US citizen, irrespective of dual or multiple citizenships. The notion of 'US citizen' includes, but is not limited to, passport holders, even where the passport has expired, and includes both people born in the US and in certain instances people born outside the US on US territory, as well as to children born abroad to a US-citizen parent who resided in the US for five years prior to the birth of the child. 'US person' also includes US residents, including a lawful permanent resident 'Green Card' holder of an Immigration & Naturalization Service Alien Registration Card I-551, and an individual qualifying as income tax-resident in the US under the so-called 'substantial presence' test. The definition of 'US person' further includes any individual liable for US income tax for any other reason, such as dual tax residence status, election for treatment as a US resident for any purpose, or an election to file jointly the 1040 US tax declaration with a US-citizen spouse. The definition of 'US person' also covers a US citizen who has been expatriated for less than 10 years or a non-resident alien who has given up or abandoned US residence by returning his Green Card after residing under that status in the US for eight of the previous 15 years. As a result of his actions, such a person will be subject to special 10-year US source rules under US expatriation legislation.

A trust, including assimilated family foundations and other similar non-business organizations, is considered to be a US person if a US court has primary jurisdiction over the administration of the trust (the so-called 'court' test) and a US person, in the form of one or more US fiduciaries, has the authority to control all substantial trust decisions (the so-called 'control' test). Both tests must be met in order for the trust to qualify as a domestic trust and thus a US person under US tax rules. This definition of a trust as a US person became effective as of August 20 1996, as part of the Small Business Job Protection Act 1996. For qualified intermediary purposes, a US trust is a US person required to file IRS Form W-9 with its Swiss bank. The disclosure problems mentioned above apply.

A foreign trust is a trust or estate which is not a domestic trust or estate under US tax rules. Under normal circumstances, Swiss bank account holders which are foreign trusts, foreign foundations or similar foreign legal entities recognized and treated as trusts, and which are non-business entities, will not be deemed to be US persons for qualified intermediary purposes. This is because they do not meet the cumulative court and control tests required to make a trust a domestic trust and US person under US tax rules.

On the other hand, US tax rules prevail for qualified intermediary purposes in defining foreign trusts and assimilated foreign non-business organizations, as well as determining the relevant beneficial owners of these structures.

Under US tax principles a trust exists if created by any deed or declaration whereby the trustee takes legal title to property settled on the trust by the settlor, called a 'grantor' under US tax rules, for the purpose of holding and administering said trust property for the benefit of named beneficiaries. The trust exists if its purpose is to vest in the trustee the legal responsibility to protect, conserve and administer the trust property for the benefit of beneficiaries who may not share in the discharge of this legal responsibility, and who therefore are not associated with the trustee in a joint enterprise for the conduct of a trade or business for profit as a business entity.

Trusts are divided under US tax rules into three categories: grantor trusts, simple trusts and complex trusts.

Grantor and simple trusts are qualified as transparent or flow-through entities, and therefore for qualified intermediary purposes as intermediaries which must file Form W-8IMY and attached Forms W-8BEN/W-9, as the case may be, for each beneficial owner under qualified intermediary rules. In respect of grantor trusts, the beneficial owner is considered to be the grantor/settlor, who must file either Form W-8BEN or Form W-9. For simple trusts, the income beneficiary is considered to be the beneficial owner, who is required to file either Form W-8BEN or Form W-9, as the case may be. The Swiss bank must disclose the identities of both the direct Swiss bank account holder trust acting through its trustee, which is deemed to be an intermediary, and the grantor/income beneficiaries, considered as beneficial owners of the account income arising from US securities, to its US withholding agent and the IRS, subject to the trustee's waiver of Swiss banking secrecy.

On the other hand, a complex trust (eg, an irrevocable, discretionary trust) is considered under US tax principles as a non-transparent entity separate from its grantor/settlor and/or income beneficiaries, as the case may be. Acting through its trustee, it is entitled to declare itself as the beneficial owner of its gross income. For qualified intermediary purposes, the trustee of a foreign complex trust may sign on behalf of the trust as direct Swiss bank account holder Form W-8BEN or Swiss form DNUS as a non-transparent foreign legal entity. Under the qualified intermediary regime the trustee is under no obligation to remit additional Form W-8BENs/W-9s for its beneficial owners. Likewise, the Swiss bank is under no obligation to disclose either the identity of the foreign complex trust, or its grantor/settlor or beneficiaries, to its US withholding agent or the IRS. Thus, Swiss banking secrecy continues to protect a foreign complex trust account holder's identity (and those of its grantor/settlor and beneficiaries) to the same extent as for any other foreign, non-transparent Swiss bank account holder owning US and/or non-US securities.

For qualified intermediary purposes, US tax rules set forth various types of trusts which are qualified as either grantor or simple trusts.

The following types of trust are qualified for US federal income tax purposes as grantor trusts, and therefore as transparent/flow-through legal entities and intermediaries, in respect of income arising from US securities under qualified intermediary rules as direct Swiss bank account holders, where the grantor/settlor is still alive:

• a foreign trust settled by a US person for the benefit or potential benefit of US persons, except where trust benefits to US persons are specifically prohibited in the trust deed or declaration. In the absence of this interdiction such an 'outbound' trust is considered as a US person for US federal income tax purposes;
  
  
• a foreign trust settled by a foreign non-US person, if this person becomes a US person within five years of the date of settlement of trust property. Such an 'inbound' trust is considered as a US person from the date on which the foreign grantor/settlor becomes a US person for US federal income tax purposes;
  
  
• a foreign trust settled by a foreign non-US person which is revocable by the grantor/settlor. Such a trust is considered as a non-US person for US federal income tax purposes;
  
  
• a foreign trust settled by a foreign non-US person whereby only the grantor/settlor and/or his spouse may benefit from trust income distributions during the lifetime of the grantor/settlor. Such a trust is considered as a non-US person for US federal income tax purposes; and
  
  
• a foreign trust, settled by a foreign non-US person as a grantor trust on or before September 19 1995, which benefits from the 'grandfathering' clause as a grantor trust under the amended foreign trust provisions to US federal tax legislation, attached as riders to the 1996 legislation passed by the US Congress as the Small Business Job Protection Act 1996, effective August 20 1996.

Certain types of trust will be qualified for US federal income tax purposes as simple trusts, and therefore as transparent/flow-through legal entities and intermediaries, in respect of income arising from US securities under qualified intermediary rules as direct Swiss bank account holders, as long as the trust is not a grantor trust. For a trust to qualify as a simple trust, the trustee must also lack discretionary power under the trust deed or declaration to hold and accumulate trust income or capital gains. Instead, he must be required to distribute all trust income annually on a current basis to income beneficiaries, such income being the accounting income for that fiscal year taken into gross income by the trust, and not to distribute or accumulate income or capital gains for charitable purposes, but instead to pay it to income beneficiaries on a current basis for the fiscal year that income or gain is taken into gross income by the trust. He must also be required not to distribute capital or accumulated income in excess of current income to income beneficiaries, such income being the accounting income for that fiscal year taken into gross income by the trust.

If it is possible that the nature of the foreign trust will fluctuate between the categories from year to year, then a new assessment of the entity's status, both under US tax rules and under the qualified intermediary rules, should be made at least annually in light of any new decisions made by the trustee, grantor/settlor or other person holding a power of appointment, or by the foundation council or anstalt board, as the case may be. The assessment should take into account changes in the trustee's power to undertake the following activities, among others:

• vary trust investments;
  
  
• characterize income and its treatment;
  
  
• make income distributions to beneficiaries; and
  
  
• designate or appoint income and/or beneficiaries.

New qualified intermediary documentation may have to be prepared and updated. It is the duty of the Swiss bank direct account holder to inform the Swiss bank immediately of any such changes, and to provide appropriate documentation at the request of the Swiss bank, in order to ensure that qualified intermediary documentation on the account holder is always correct and valid. Failure to do so may provoke reporting penalties for the Swiss bank as qualified intermediary with its US withholding agent and the IRS, and may even constitute an event of default under the qualified intermediary agreement (eg, incorrect treatment of US persons). The failure may also constitute a violation of the Swiss bank's KYC rules under the Due Diligence Agreement, giving rise to a doubt on the part of the bank as to the identification of the bank's contracting partner. This would require extensive documented inquiry, including a probable request for further documentary evidence on the part of the Swiss bank, to enable the bank to resolve the doubt satisfactorily for KYC internal and qualified intermediary auditing purposes. Under these circumstances, failure of the contracting partner to provide the Swiss bank with requested additional beneficial ownership identification documentation which is satisfactory to the bank under the Due Diligence Agreement may oblige the bank to terminate the account relationship.

Foreign family foundations and similar foreign legal entities formed for non-business purposes (ie, preservation of family wealth for the benefit of family members) will be categorized as grantor, simple or complex trusts as a result of analysis of US tax rules and qualified intermediary qualification rules applied to the entirety of their constitutional documents, by-laws and assimilated beneficiary designations. Likewise, foreign trust enterprises and establishments with by-laws assimilated to operative beneficiary provisions for trusts fall under these trust qualification rules for US federal income tax purposes, and as a result of their characterization under qualified intermediary rules as transparent or non-transparent foreign legal entities.

Most of these hybrid trust-like foreign entities may not be formed with commercial purposes without meeting other local law requirements (eg, to maintain audited financial statements, file income tax declarations and comply with other statutory conditions applicable to corporations/business entities under local law). Thus, the fact that such a legal entity does in fact pursue commercial purposes in a corporate fashion would make it possible under US tax principles for the foreign legal entity to elect under Section 8832 of the Internal Revenue Code to be treated as a business entity, whether corporation, partnership or disregarded corporation treated as a sole proprietorship. For qualified intermediary purposes, in most cases such an election would be made to enable the entity to be treated as a corporation separate from its owner, and thus as a non-transparent foreign legal entity and beneficial owner entitled to file Form W-8BEN/Swiss form DNUS indicating its election to be treated as a corporation.

Notwithstanding the pursuit of corporate or business purposes in such an non-conventional organizational form, however, other qualified intermediary-related issues remain to be resolved in terms of reviewing and analyzing the entity's constitutional documents as regards the qualification of beneficial ownership under US tax rules and under the qualified intermediary rules. These issues must be addressed in order to ensure that the Swiss bank account holder entity in question, whether in the legal form of a business entity or trust, is not acting as a nominee, custodian, agent or mere conduit to receive income in its name but on behalf of undisclosed beneficial owners, and therefore considered for qualified intermediary purposes as an intermediary with concomitant disclosure obligations.

If the Swiss bank account holder is a foreign legal entity which is an underlying trust-owned company with limited liability, or corporation acting as a business entity, such that the foreign non-business entity acts only a shareholder of the account holder, then the account holder is a non-transparent business entity both under the US tax rules for US federal income tax purposes and under the qualified intermediary rules for entity qualification purposes. It is thus entitled to file Form W-8BEN/Swiss form DNUS as sole beneficial owner of the account income arising from US securities.

Non-business entities acting as Swiss bank account holders which are qualified as transparent/flow-through entities and intermediaries must restructure their assets now so that on January 1 2001 beneficial ownership information is still protected under Swiss banking secrecy provisions. This can be done by, for example, transferring trust/foundation/anstalt assets to a per se corporation or other business entity treated as a non-transparent entity under US tax rules and qualified intermediary rules, whereby such business entity becomes an underlying trust-owned company or its equivalent. Further measures may be taken with respect to non-business entities which are direct Swiss bank account holders but which do not wish to effect such a transfer of trust/foundation/anstalt assets to an underlying wholly-owned non-transparent business entity by, for example, modifying their operative beneficiary, trustee investment or income distribution power provisions, or all three, in order to make such provisions discretionary in respect of the trustee's investment of trust assets, designation of beneficiaries and/or income distribution to beneficiaries, and otherwise conform to the requirements necessary for the non-business entity to be qualified as a complex trust or its equivalent.

Finally, consideration should even be given to liquidation of directly held US securities from a transparent account holder's portfolio by December 31 2000, such that henceforth only non-US securities, including indirectly held US securities via qualified foreign non-transparent investment funds in the form of per se corporations, are held in the client portfolio. Thus, the Swiss bank account holder will not figure among the Swiss bank's qualified intermediary clients.

Documentation of Account Holders

In terms of qualified intermediary documentation flow for Swiss bank account holders who are legal entities, including trusts and estates, the Swiss bank and its internal compliance officer or auditor must resolve a series of questions leading to the determination of non-transparent or transparent status for each Swiss bank account holder holding US securities as from January 1 2001. The account holder must make the resulting qualified intermediary declaration via Form W-9, Form W-8BEN/Swiss form DNUS or Form W-8IMY with attached Forms W-8BEN and W-9, as the case may be. As part of Swiss KYC rules, Swiss bank account holders who are legal entities are required upon opening an account to provide their Swiss bankers with certified and often legalized copies of their constitutional documents and registry certificates, as applicable. They must also provide appropriate additional corporate documentation indicating the identity of the executive corporate bodies and their capacity to bind the account holder as legal entity with respect to the Swiss bank. For qualified intermediary documentation purposes, the copies made by the Swiss bank of this KYC corporate documentation will serve as the basis for the Swiss bank's corporate analysis of its direct account holder, resulting in its qualification as a non-transparent or transparent legal entity.

The first question is whether the Swiss bank is dealing with a trust or estate as client. The issue framed is thus whether the direct account holder is a trust/estate, that is, a non-business entity or a business entity/corporation.

If the account holder is not a trust/estate, then the focus shifts for the Swiss bank to non-trust foreign business entities in the corporate realm.

The second issue raised in this context is to query whether the foreign legal entity is a listed per se corporation pursuant to the Internal Revenue Code list (Section 301.7701-2(b)(8)(i)), in respect of the definition of business entities in the code, and in particular foreign entities treated as per se corporations for US federal tax purposes. If the account holder is incorporated as a legal entity in a jurisdiction appearing on this list, then the direct account holder is a non-transparent foreign business entity in the form of a corporation and is considered under US tax rules as the beneficial owner of its income, including that arising from US sources. This determination is conclusive, irrespective of the nationalities of the physical persons who are the beneficial owners under Swiss KYC rules. As such, the directors of the foreign corporation sign Form W-8BEN/Swiss form DNUS indicating the foreign legal entity as a corporation and as beneficial owner for qualified intermediary purposes.

If the foreign legal entity is not on the Internal Revenue Code list of per se foreign corporations, then the next issue is whether this foreign legal entity nonetheless provides in its charter/by-laws for limited liability of its members/shareholders/owners, such that these persons are not personally liable for the debts of the legal entity or claims made against the legal entity by reason of being a member/shareholder/owner. This will be the case for most limited companies, whether limited by shares or guarantee, which are incorporated in most tax haven jurisdictions and excluded from the per se foreign corporation list mentioned above. This may even include the more recent newer-age limited liability companies formed in several tax haven jurisdictions, many of the organizational charters of which specifically provide for the limited liability of members. If the answer to this question is affirmative, the foreign legal entity will be qualified for qualified intermediary purposes as a corporation, whether under an Internal Revenue Code election or by indicating on the Swiss form DNUS treatment as a per se corporation for qualified intermediary purposes. In such cases, the directors of the Swiss bank account holder will sign Form W-8BEN/Swiss form DNUS as a non-transparent foreign legal entity in the form of a corporation, indicating itself as a corporation and beneficial owner of account income for qualified intermediary purposes, again irrespective of the nationalities of the beneficial owners determined under Swiss KYC rules.

If, in response to the query of limited liability, the foreign legal entity has unlimited liability for any of its members/shareholders/owners, then it will be construed as a transparent/flow-through intermediary. Under the qualified intermediary rules it will be required, as Swiss bank direct account holder, to file with its Swiss bank Form W-8IMY under its transparent status and to attach individual Form W-8BENs/W-9s for each underlying beneficial owner, indicating the percentage or nature and conditions of that beneficial owner's interest in the intermediary and US source income arising from US securities.

Returning to the initial question of whether the Swiss bank is dealing with a trust or business entity, if the answer is that the entity is a trust, then the Swiss bank and its internal compliance officer/auditor must query whether the trust in question is a US or foreign trust. The question is therefore whether the trust is settled under US law or under the laws of a state of the United States, and thus whether a US court (ie, the 'court' test) has primary jurisdiction over the trust. If the answer to this question is yes, then the next question concerns the 'control' test, that is, whether the trust is controlled by a foreign non-US person fiduciary. If the answer is no, then the trust in question is a US trust and a US-person Swiss bank client will be required to file Form W-9 with the Swiss bank. Upon receiving a waiver of Swiss banking secrecy from the trust, the bank will then forward the W-9 to its US withholding agent for onward forwarding to the IRS.

If the answer under the 'court' test is negative, that is, the trust is settled under the laws of a foreign non-US jurisdiction, then the trust in question is a foreign trust. Likewise, even where the trust is settled under US law in the first instance, but is controlled by a foreign fiduciary in respect of any substantial decision of the trust, it fails the two-pronged domestic trust test and is qualified as a foreign trust.

Once it has been established that the trust is foreign, the question arises as to what type of trust is the Swiss bank account holder. The first issue is whether the trustee has the power and discretion to vary trust investments, or whether the trust is a grantor/settlor-directed non-discretionary trust in this sense. Where the trustee has this discretionary investment power, the foreign trust is considered a foreign complex trust and non-transparent foreign non-business entity for qualified intermediary purposes, entitled to file Form W-8BEN/Swiss form DNUS as the sole beneficial owner of income arising from US securities on its account. This form remains with the Swiss bank and is not disclosed to the bank's US withholding agent or the IRS.

If the trustee has no discretionary power to vary the trust investments, then a second question must be asked regarding whether the trustee has discretionary powers to appoint or distribute trust income to beneficiaries. If the answer is affirmative, then the subsidiary question involves the identity of the trust beneficiaries in the case of income distribution. If the trust income beneficiary is not the grantor/settlor or his spouse, then again the trust is qualified under the qualified intermediary rules as a foreign complex trust and thus a non-transparent foreign non-business entity entitled to file Form W-8BEN/Swiss form DNUS as the sole beneficial owner of account income arising from US securities. As stated above, this form remains at the Swiss bank protected by Swiss banking secrecy.

Where the trustee has the discretionary power to appoint or distribute trust income but that income is distributed to the grantor/settlor or his spouse, the trust is qualified as a grantor trust and transparent/flow-through entity and intermediary, required to file Form W-8IMY with the Swiss bank and attach Form W-8BENs/W-9s, as the case may be, for each beneficiary. Under the qualified intermediary regime the Swiss bank must disclose intermediary Swiss bank account holders and their beneficial owners to its US withholding agent, and onward to the IRS, irrespective of the nationality of the trust beneficiaries. This is a consequence of the income tax treatment of grantor trusts under US tax rules.

Where the trustee does not have the discretion to appoint or distribute trust income, the trust is qualified as a simple trust and transparent/flow-through entity. The intermediary is thus required to file Form W-8IMY with the Swiss bank, attaching Form W-8BENs/W-9s, as the case may be, for each income beneficiary indicating the amount, percentage and conditions of trust income entitlement of such beneficiary. As stated above, the Swiss bank must disclose these forms to its US withholding agent, irrespective of the nationality of the trust beneficiaries, due to the income tax treatment of simple trusts under applicable US tax rules. The Swiss bank may forward the forms only after receiving a waiver of Swiss banking secrecy from the trustee acting for the trust as direct account holder. However, failure to consent will cause the various maximum back-up withholding measures addressed at the beginning of this update for 'undocumented' account holders to be implemented by the Swiss bank. It remains to be seen whether failure to provide the proper qualified intermediary form at the request of the Swiss bank may also result in violation of Swiss KYC rules under the Due Diligence Agreement, with the potential negative consequences raised above in respect of possible termination of the account relationship by the Swiss bank.

Conclusion

Qualification of foreign business and non-business entities as transparent intermediaries or non-transparent beneficial owners under the qualified intermediary rules is critical from the point of view of maintaining Swiss bank client confidentiality and Swiss banking secrecy in connection with the identification of Swiss bank account holders, their beneficial owners and ownership of US securities.

When establishing their qualified intermediary systems prior to January 1 2001, many Swiss banks may decide to exclude transparent/flow-through clients from the scope of their qualified intermediary agreements with the IRS. It will be difficult for Swiss banks to cope with the burdensome reporting requirements imposed on them in respect of intermediary client accounts. Therefore, the easiest way to avoid having such clients may well be for Swiss banks to exclude them from qualified intermediary coverage, whether by strongly encouraging transparent intermediary clients to disinvest in US securities, thereby taking those clients outside the scope of the regime, or by encouraging these clients to restructure either their account assets or their legal nature in order to provide for a non-transparent beneficial owner business entity as Swiss bank direct account holder.

As a consequence, Swiss bank account holders which are transparent entities must take appropriate measures immediately in order to avoid the adverse effects of the new qualified intermediary regime on them and their US securities holdings, if clients decide to maintain their holdings of directly held US securities in their Swiss bank account portfolios after January 1 2001.

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