Congress, in 2010, enacted a new set of rules on the required reporting and withholding with respect to foreign financial accounts and nonfinancial foreign entities in Pub. L. No. 111-147, §501 (2010)(the “HIRE ACT”). This legislation added Chapter 4 of Subtitle A of the Code which was originally introduced as part of the Foreign Account Tax Compliance Act of 2009 This Chapter consists of Sections 1471 through 1474. 

The Service had previously issued preliminary guidance on Chapter 4. Notices 2010-60, 2010-37 I.R.B. 329, 2011-34, 2011-19 I.R.B. 765 and 2011-53, 2011-32 I.R.B. 124. See also Proc. Reg. §601.601(d)(2). Chapter 4 was enacted into law by Congress to extend the scope of the U.S. information reporting rules to include foreign financial institutions that maintain U.S. accounts. New disclosure obligations are imposed on certain nonfinancial foreign entities that present a high risk of tax avoidance. As an additional development, the Treasury Department and the IRS have been in consult with several foreign countries concerning the adoption of an alternative approach whereby an foreign financial institution could satisfy Chapter 4’s requirements if: (i) the foreign financial institution collects the information required under Chapter 4 and reports this to the residence country; and (ii) the residence country enters into an agreement to report such information annually to the IRS under Chapter 4, an income tax treaty, TIEA or other agreement with the U.S. The countries consulted with include France, Germany, Italy, Spain, and the United Kingdom.

The rules require foreign financial institutions (FFIs) as well as other foreign entities (nonfinancial foreign entities or NFFEs) to report to the Service information on financial accounts as well as other interests of U.S. persons. For foreign entities, where compliance with new reporting rules may prove difficult, Congress requires, under FATCA, payors to withhold tax at 30% with respect to U.S. source payments made to foreign entities, including interest, dividends, and royalties, and from the proceeds of sales of items producing interest or dividends from U.S. sources. The withholding tax applies whether the foreign entity receives the payments as beneficial owner or as agent for a client and whether the beneficial owner is a U.S. or foreign person. The special FATCA withholding tax of 30% is imposed on items that previously were not subject to withholding such as portfolio interest and capital gains of foreign investors. The special withholding rule overrides any treaty provision that the U.S. has entered into. A foreign financial institution (FFI) may avoid the obligation to make the 30% withholding by entering into an agreement with the IRS by which it agrees to make timely reports to the IRS on accounts of U.S. persons. A FFI may have previously entered into a qualified intermediary agreement (QI) for purposes of withholding on investment income, e.g., dividends, interest, royalties, and other fixed or determinable annual or periodical income. See §§1441, 1442. The FATCA withholding applies in addition to FDAP withholding under a QI agreement but provisionson the 30% FATCA withholding may be added to the agreement. Other foreign based entities (NFFEs) can avoid the 30% withholding tax by supplying required information as to their U.S. owners to U.S. withholding agents.

Generally, FATCA becomes effective for payments made after 2012. However, payments on an “obligation outstanding on” March 18, 2012, are exempt from withholding under FATCA as are the proceeds of a sale or other disposition of such an obligation but not for purposes of Sections 1441 or 1442. A “signification modification” of a debt instrument that was otherwise within the grandfather rule will trigger application of the FATCA provisions. A three year phase-in period was allowed by Congress to allow foreign entities to understand and implement compliance guidelines and procedures.

The summary to the proposed regulations incorporate the guidance already published under the FATCA Notices that had been issued and also provide guidance not previously addressed. Significant modifications and additions to the FATCA Notices listed included:

  1. Expansion of Definition of “Grandfathered Obligations”. As mentioned, the HIRE Act grandfathers in and thus avoids FATCA withholding on obligations outstanding on or before March 18, 2012 or from the proceeds from the disposition of any such obligation. The proposed regulations exclude from the definition of “withholdable payment” and “passthru payment’ any payment made under an obligation outstanding on January 1, 2013 and any gross proceeds from the disposition of such an obligation.
  2. Transitional Rules for Affiliates with Legal Prohibitions on Compliance. Section 1471(e) provides that the requirements of the FFI agreement shall apply to the U.S. accounts of the participating FFI and, except as otherwise provided by the Secretary, to the U.S. accounts of each other FFI that is a member of the same expanded affiliated group. Notice 2011-34 states that the Treasury Department and the IRS intend to require that each FFI that is a member of an expanded affiliated group must be a participating FFI or deemed-compliant FFI in order for any FFI in the expanded affiliated group to become a participating FFI. Recognizing that some jurisdictions have in place laws that prohibit an FFI's compliance with certain of chapter 4's requirements, the proposed regulations provide a two-year transition, until January 1, 2016, for the full implementation of this requirement. During this transitional period, an FFI affiliate in a jurisdiction that prohibits the reporting or withholding required by chapter 4 will not prevent the other FFIs within the same expanded affiliated group from entering into an FFI agreement, provided that the FFI in the restrictive jurisdiction agrees to perform due diligence to identify its U.S. accounts, maintain certain records, and meet certain other requirements. Similar rules apply to branches of FFIs that are subject to comparable restrictions.
  3. Modification of Due Diligence Procedures for Account Identification. Section 1471(b) requires FFIs to identify their U.S. accounts. Guidance is provided in Noticies 2010-60 and 2011-34 on the subject. Comments received by the Treasury suggested modifications be made to that guidance, in particular with respect to preexisting accounts, to reduce the administrative burden on FFIs. In response, the proposed regulations rely primarily on electronic reviews of preexisting accounts. For preexisting individual accounts that are offshore obligations, manual review of paper records is limited to accounts with a balance or value that exceeds $1,000,000 (unless the electronic searches meet certain requirements, in which case manual review is not required). In addition, the proposed regulations provide detailed guidance on the precise scope of paper records required to be searched. Additionally, with respect to preexisting accounts, individual accounts with a balance or value of $50,000 or less, and certain cash value insurance contracts with a value of $250,000 or less, are excluded from the due diligence procedure. Other rules are set forth in the proposed regulations.
  4. Guidance on Procedures Required to Verify Compliance. Section 1471(b)(1)(B) requires a participating FFI comply with issued verification procedures. Notice 2010-60 provides that the government is looking into possibly relying on written certifications by high-level management employees regarding the steps taken to comply with chapter 4, and Notice 2011-34 provides further guidance on the certifications to be provided by officers of a participating FFI. The proposed regulations modify and supplement the guidance in Notices 2010-60 and 2011-34 by providing that responsible FFI officers will be expected to certify that the FFI has complied with the terms of the FFI agreement.
  5. Modification of Definition of Financial Account. Section 1471(d)(2) defines a financial account to mean, except as otherwise provided by regulation or notice, depository accounts, custodial accounts, and equity or debt interests in an FFI, other than interests that are regularly traded on an established securities market. The proposed regulations modify the definition of financial accounts to include traditional bank, brokerage, money market accounts, and interests in investment vehicles, and to exclude most debt and equity securities issued by banks and brokerage firms, subject to an anti-abuse rule.
  6. Extension of the Transition Period for the Scope of Information Reporting. Notice 2011-53 provides for phased implementation of the reporting required under chapter 4 with respect to U.S. accounts. Pursuant to Notice 2011-53, only identifying information (name, address, TIN, and account number) and account balance or value of U.S. accounts would be required to be reported in 2014 (with respect to 2013). Recognizing the complexity and width of the various provisions, the proposed regulations provide that reporting on income will be phased in beginning in 2016 (with respect to the 2015 calendar year), and reporting on gross proceeds will begin in 2017 (with respect to the 2016 calendar year). In addition, the proposed regulations provide that FFIs may elect to report information either in the currency in which the account is maintained or in U.S. dollars.
  7. Passthru Payments. Section 1471(b)(1)(D) requires participating FFIs to withhold on passthru payments made to nonparticipating FFIs and account holders. Notice 2011-53 states that participating FFIs will not be obligated to withhold on passthru payments that are not withholdable payments (foreign passthru payments) made before January 1, 2015. In response to complaints about the complexity of the rules as well as the effective date becoming closer, the proposed regulations provide that withholding will not be required with respect to foreign passthru payments before January 1, 2017. Instead, until withholding applies, to reduce incentives for nonparticipating FFIs to use participating FFIs to block the application of the chapter 4 rules, the proposed regulations require participating FFIs to report annually to the IRS the aggregate amount of certain payments made to each nonparticipating FFI. With respect to the scope and ultimate implementation of withholding on foreign passthru payments, the Treasury Department and the IRS request comments on approaches to reduce burden, for example, by providing a de minimis exception from foreign passthru payment withholding and a simplified computational approach or safe harbor rules to determine an FFI's passthru payment percentage.As mentioned the government is exploring the use of an alternative method or system for complying with FATCA for jurisdictions that enter into agreements to facilitate FATCA that provide a practical alternative approach to achieving the policy objectives of passthru payment withholding. In addition, where such an agreement provides for the foreign government to report to the IRS information regarding U.S. accounts and recalcitrant account holders, FFIs in such jurisdictions may not be required to withhold on any foreign passthru payments to non-compliant account holders.

Continued Work with Foreign Countries

The joint statement issued by the Treasury with France, Germany, Italy, Spain, and the United Kingdom has been applauded by one commentator, Alan Granwell, as "dramatic evidence of the intention of the participating countries to ultimately provide for automatic exchange of information on a broader basis….and reflects a continuation and expansion of the OECD's by-request exchange of information standard and the activities of the Global Forum on Transparency and Exchange of Information for Tax Purposes”. Still there a certain conflict of laws issues as well as other policy issues that must be addressed

Stay tuned. The FATCA regulations project is a big one for which there will be additional comments by bar associations and tax professionals.