Any attorney who has practiced law for some period of time has encountered cocounsel or opposing counsel who release a thick set of documents (usually by e-mail robot) around the close of business on a Friday night with a call-in number to discuss comments bright and early on the next Monday morning. One wonders how many times these types got beat up in high school and sat home dateless through their college years before this behavior came to be considered "sport" in adulthood. It looks like the recession has driven at least some of these frustrated individuals from big law to the Internal Revenue Service (IRS). Late in the afternoon on Friday, August 27, 2010, the IRS released Notice 2010-60, a 62-page document with initial guidance on the Financial Account Tax Compliance Act (FATCA) provisions of the Hiring Incentive to Restore Employment Act (HIRE Act).  

I. Brief FATCA Background

The FATCA provisions, contained in Sections 1471 through 1474 of the Internal Revenue Code of 1986, as amended (the "Code"), contain an extraordinary set of penalty tax rules on foreign financial institutions (FFIs) that do not (i) conduct due diligence on their account holders, equity holders and debt holders to ferret out U.S. persons that are holding assets outside of the United States and (ii) disclose the identity of such persons to the IRS.1 The FATCA rules will likely have a chilling effect on already depressed U.S. capital markets, causing a flight of non-U.S. capital to other developed markets. No other developed market imposes such onerous preconditions on investing by foreign persons; FATCA will dramatically lessen the attractiveness of investing in the United States.  

Specifically, if the FFI does not comply with the FATCA rules, then "withholdable payments" to it for its own account and on behalf of its customers are subject to U.S. federal income tax withholding.2 Withholdable payments include items of U.S.-source income, such as interest and dividends, as well as gross proceeds "from the disposition of any property of a type which produce interest or dividends from sources within the United States."3 Unbelievably, if the payment is made is for the account of a non-participating FFI, "no credit or refund shall be allowed or paid with respect to such tax."4 In other words, if an FFI does not comply with the FATCA rules, it will be subjected to gross proceeds withholding on its U.S.-source income and will not be able to recover the withheld amounts. Uncle Sam is still carrying around a pretty big stick.  

Code § 1471(b) contains the six requirements that must be met in order for an FFI to be considered to be in compliance with the FATCA rules:  

A. The FFI must obtain the information necessary to determine if it has "United States accounts."  

B. The FFI must comply with IRS-specified due diligence and verification requirements with respect to U.S. accounts.

C. The FFI must annually report IRS-specified information to the IRS on its U.S. accounts.  

D. The FFI must withhold on U.S.-source payments made to recalcitrant account holders5 and non-compliant FFIs and withhold on payments to other FFIs who have elected not to withhold on their own recalcitrant account holders.  

E. The FFI must comply with IRS requests for additional information.  

F. The FFI must attempt to obtain a waiver of any foreign law that would prevent the transmission of the information sought by the IRS to the IRS on the FFI's accounts and, if such waiver cannot be obtained, to close the affected accounts.  

The statutory definition of a "U.S. account" is as extraordinary as the other FATCA provisions. U.S. accounts include accounts maintained by U.S. individuals provided that the aggregate value of all accounts maintained by the individual exceed $50,000.6 U.S. accounts also include accounts owned by "United States owned foreign entities." A U.S. owned foreign entity is one which has one or more "substantial United States owners."7 A substantial U.S. owner is a person who owns more than 10% of the vote or value of the stock of the foreign corporation or 10 percent of the profits or capital of a foreign entity taxable as a partnership.8 If the foreign entity is an investment vehicle, however, a substantial U.S. owner is a U.S. person who owns any percentage of the foreign entity.9 U.S. owners do not include publicly-traded companies, tax-exempt organizations and the U.S. government.10  

II. Grandfather Rules & Effective Dates

Section 501(d)(1) of the HIRE Act provides that the FATCA provisions are effective for payments made after December 31, 2012. Section 501(d)(2) of the HIRE Act provides, however, that payments made on obligations outstanding on March 18, 2012 are not subject to FATCA. Section I of Notice 2010-60 provides that grandfather protection will not be afforded to equity investments "or any legal agreement that lacks a definitive expiration or term." Examples of such agreements include savings deposits, demand deposits and brokerage accounts. The U.S. deemed exchange rules are also implicated. If an instrument undergoes a material modification after March 18, 2012, it will be considered to be issued on the date of the material modification and, therefore, no longer entitled to grandfather treatment. Accordingly, FFIs will be required to determine if there have been deemed reissuances, using U.S. tax principles, of their otherwise grandfathered non-U.S. accounts to ensure that such accounts do not lose their grandfathered status.  

III. The Definition of an FFI

Code § 1471(d)(4) and (5) define an FFI as a non-U.S financial institution that accepts deposits in the ordinary course of its trade or business, holds financial assets for others as substantial part of its business, or is engaged in investing, reinvesting or trading securities, partnership interests or commodities.11 The legislative history pointedly notes that the last part of the definition picks up non-U.S. hedge funds and private equity funds.12 The legislative history grants wide discretion for the IRS to exclude various types of companies, such as holding companies, inter-group financing companies and research & development (R&D) companies. In Notice 2010-60, the IRS provided guidance on each of the three legs of the FFI definition.  

A. Non-U.S. Banks & Brokers

Depository institutions are defined to include entities that would be treated banks for U.S. tax purposes (if they were U.S. persons), including commercial banks, savings banks and credit unions. It is relevant, but not determinative, that an entity is subject to banking-like regulation. Broker-dealers and security custodians are included in the “holding financial assets” leg of the definition. Notice 2010-60 excludes payments from FATCA withholding if the FFI delivers a Form W-8ECI to the payer.13 In order for the FFI to receive customer payments free from FATCA withholding, however, the FFI must be FATCA-compliant. FFIs that receive U.S.-source customer payments will be entitled to use procedures specified for U.S financial institutions (USFIs) or execute an FFI Agreement (described below).  

B. Non-U.S. Private Funds

The IRS held that a hedge fund (or like entity) will be considered to be engaged in the business of investing even if such fund’s activities do not rise to the level of a trade or business for U.S. tax purposes. Indeed, a non-U.S. fund that engages in only isolated transactions could be considered to be in the business of investing, depending upon the “magnitude and importance” of the transaction in relation to the fund’s other activities. A special rule will be provided for certain closely-held funds that will be treated as “deemed-compliant FFIs.” For a closelyheld fund to be a “deemed-compliant FFI,” it must identify all of its direct and indirect owners to the withholding agent, provide the withholding agent with the information on such owners as would be disclosed if the owners were opening a new account at a bank or securities company FFI and the withholding agent must disclose to-be-determined information on any U.S. owners to the IRS. Thus, even closely-held non-U.S. funds will be subjected to significant reporting burdens.  

C. Exclusions from FFI Status

The IRS listed four types of entities that it will exclude from the FFI definition: (1) holding companies for groups that are not FFIs, provided that the holding company is not an investment vehicle to acquire or fund start-ups for a limited period of time, (2) start-up companies for their initial 24 months of existence, provided that the startup company does not intend to operate an FFI business (venture capital funds will not qualify as start-ups); (3) non-FFIs that are liquidating or reorganizing with the intent of recommencing operations and (4) financing and hedging centers for non-FFI groups that do not provide services to non-affiliates. The IRS left open as to how payers of U.S.-source income will be able to determine if a payee meets any of the four exceptions. Notwithstanding requests from observers, the IRS refused to provide an exemption from FATCA reporting for controlled foreign corporations that meet the definition of an FFI.  

D. Insurance Companies & Possessions Banks

Special rules are provided for insurance companies. Non-U.S. property and casualty companies will be exempted from the definition of a FFI. Non-U.S. life insurance companies that issue whole or variable life policies will be included as FFIs, but the Notice reserves on including these companies at this time. Special rules will provided for FFIs organized in U.S. possessions allowing them to act as withholding agents and not be treated as FFIs for FATCA purposes. In addition, possessions-organized FFIs will be treated as non-FFIs (NFFEs)14 with respect to payments that they receive for their own account.  

E. Non-U.S. Retirement Plans

The IRS will exempt certain foreign pension plans form the definition of an FFI. If a foreign pension plan (i) qualifies as retirement plan under the laws of the country in which it is established, (ii) is established by a foreign employer, and (iii) only allows U.S. participants for the period during which they are employees, it will not be treated as a FFI.

IV. FATCA Due Diligence Requirements

From and after January 1, 2013, payers of U.S.-source income to non-U.S. entities will have to categorize non- U.S. payees into one of seven types of persons for FACTCA withholding tax purposes:  

1. U.S. persons;  

2. Participating FFIs;15  

3. Deemed compliant FFIs;  

4. Non-participating FFIs;  

5. Entities statutorily exempt from FATCA reporting (foreign governments, international organizations, foreign central banks and others identified by the IRS as exempt);16  

6. Excepted NFFEs; or  

7. Other NFFEs.  

Notice 2010-60 contains the procedures that payers of U.S.-source income (both U.S. and non-U.S.) must use determine the type of person to which it is making a payment and to comply with applicable statutory rules. FFIs will be incorporated into the reporting regime through their execution of FFI Agreements.  

A. U.S. Persons  

An FFI who receives an IRS Form W-9, certifying that the payee is a U.S. person, may rely on such Form to assume that the payee is a U.S. person and not subject to FATCA withholding.  

B. Participating FFIs  

For the (unspecified) short-term, participating FFIs will identify themselves to payers of U.S.-source income through a self-certification system. After IRS systems are in place, the IRS will issue special employer identification numbers to participating FFIs (FFI EINs). Participating FFIs will provide their FFI EINs to payers of U.S.-source income to avoid the imposition of FATCA withholding. Notice 2010-60 states that participating FFIs will be required to report detailed information on recalcitrant account holders and non-participating FFIs. The IRS is considering, however, whether to exempt actual withholding on pass-thru payments to recalcitrant account holders where the IRS can obtain information on such persons under an information exchange agreement with a non-U.S. jurisdiction.  

Special due diligence procedures are mandated for accounts maintained by participating FFIs. Notice 2010-60 specifies detailed rules for individual accounts that are existence when the FFI Agreement becomes effective. First, if the average month-end value of the aggregate accounts maintained by an individual for the year preceding entry into the FFI Agreement is less than $50,000, the FFI will be permitted to treat such individual as other than a U.S. person. After segregating these small accounts and accounts maintained by U.S. persons, the FFI must search its electronic files to see if there is any information that would suggest other individual accounts are U.S. accounts. These filters include a U.S. address and standing wire instructions to forward funds via directions emanating from the U.S. If any of these filters suggest the account is a U.S. account, the FFI must follow certain due diligence procedures, including obtaining documentary evidence (such as passports). If the requested information is not provided within one year, the FFI must treat the account as a “recalcitrant account.”  

All individual accounts opened after the FFI Agreement is effective must meet certain due diligence standards, even if the account opener has a pre-existing account with the participating FFI, to determine if the individual is a U.S. person. FFIs must follow the procedures for new accounts for non-U.S. individual grandfathered accounts with average balances of more than $1 million within 2 years after the effective date of the FFI Agreement. All non-U.S. grandfathered accounts must be tested under the more robust account procedure within 5 years of the effective date of the FFI Agreement.  

Similar procedures are specified for accounts maintained by entities. If the account is maintained by a U.S. person, the FFI must determine whether the account is maintained by a “specified U.S. person.”17 In order to establish that the account is not maintained by a specified U.S. person, the account holder must provide information to the FFI within one year of the date that the FFI Agreement becomes effective. The FFI must then use its electronic database to determine whether other entity accounts are maintained by specified U.S. persons. If such due diligence does not disclose that the account holder is a U.S. person, the FFI may presume that it is a non-U.S. person. Following these procedures, the FFI must determine whether it is maintaining an account for another FFI. Again, if the account holder does not respond within one year, the FFI must presume that the account holder is a non-participating FFI. If the account holder is not treated as an FFI, the FFI must determine whether the account holder is engaged in an active trade or business. Even if the account holder is treated as a NFFE, the FFI must obtain documentation as to its ownership to determine whether any specified U.S. persons hold an ownership interest in such account holder, within 2 years from the effective date of the FFI Agreement. Importantly, the IRS is considering the revocation of FFI Agreements if a participating FFI does not take appropriate measures to “address long-term recalcitrant accounts.”  

Notice 2010-60 prescribes even more rigorous due diligence standards for accounts that are opened after the FFI Agreement becomes effective. FFIs must not only search their electronic databases but also must use “all information collected by the FFI,” including regulatory information and anti-money laundering/know your customer information. Notice 2010-60 makes clear that the FFI must act as a withholding agent for payments to NFFEs.  

The IRS is considering permitting FFIs to rely on investigations performed by financial auditors to satisfy applicable due diligence requirements. It is likely that the “big 4” accounting firms will make extensive submissions to the IRS to support this approach.  

C. Requirements on USFIs

U.S. financial institutions, in their capacity as withholding agents, must make determinations as to the status of their payees for FATCA withholding tax purposes. The due diligence requirements for USFIs parallel the requirements for participating FFIs. Instead of the due diligence requirements varying by when the FFI Agreement becomes effective, however, they vary depending upon whether the account was opened prior to January 1, 2013, the effective date of the FATCA rules.  

V. FATCA Reporting Requirements

Notice 2010-60 contains a detailed list of the information that must be reported to the IRS on U.S. accounts maintained by the FFI. This information includes name, address, taxpayer identification number, the name of each substantial U.S. owner of the account and information as to the amount in the account. The IRS is developing a new form for the transmission of this information. Unless the IRS receives compelling comments to the contrary, the account balances will be reported using the highest account balances during the relevant period. In addition, Notice 2010-60 states that affected persons will be required to submit this information electronically.  

In Notice 2010-60, the IRS recognized that many FFIs may have difficulty in determining whether a particular payment is a withholdable payment, especially in the case of pass-thru payments. The IRS has requested suggestions for methods upon which FFIs could rely to make this determination. The IRS also requested comments on the types of accounts for which it should permit an election for a FFI to elect to have the payer of withholdable payments act as a withholding agent.18  

VI. Election for Participating FFIs to Be Treated as U.S. Persons

The advantage for a FFI to elect to be treated as a U.S. person and not be subject to FFI treatment is that it will not be required to report account balance or information on deposits and withdrawals. Notice 2010-60 leaves the procedure for this election to future guidance.  

VII. Presumption for FFIs that Cannot Maintain U.S. Accounts

Code § 1471(b)(2) allows an FFI to be treated as deemed compliant with FATCA if it meets IRS requirements for not maintaining any U.S. accounts. In Notice 2010-60, the IRS stated that it is considering allowing certain FFIs that are subject to laws and procedures that prohibit such FFIs from maintaining U.S. accounts to be considered FATCA-compliant. The IRS, noting seven factors that must be considered, and has asked interested FFIs to submit suggestions for the implementation of such a rule.  

VIII. Elimination of Duplicative Reporting

Notice 2010-60 notes that duplicative reporting can occur when an FFI uses a custodian. In such cases, both of the FFI and custodian could have overlapping reporting responsibilities under FATCA. In such cases, only the FFI with the direct relationship with the account holder will be subject to FATCA reporting.