On April 8, 2011, the Treasury and IRS issued Notice 2011-34 (the "Notice") which provides some, but not all, of the guidance foreign financial institutions need to satisfy their obligations under the Foreign Account Tax Compliance Act ("FATCA"). Under FATCA, foreign financial institutions are subject to complex information reporting rules with respect to their U.S. account holders. If such reporting obligations are not met, the United States will impose withholding, at a rate of 30%, on certain U.S. source payments to foreign financial institutions not in compliance with FATCA.
On March 18, 2010, the Hiring Incentives to Restore Employment Act of 2010, including the FATCA provisions of the Internal Revenue Code, became law. The FATCA rules require three categories of foreign financial institutions ("FFIs")1 to furnish the Treasury with information regarding their U.S. account holders. To induce FFIs to become "Participating FFIs" by entering into an agreement with Treasury to provide such information, FATCA requires that a U.S. payor of a "withholdable payment" to an FFI that has not entered into such an agreement, to withhold tax at a rate of 30%. Withholdable payments include U.S. source dividends, interest and gross proceeds from the disposition of U.S. securities.
The Treasury and the IRS subsequently issued Notice 2010-60 providing initial guidance on FATCA compliance. Such compliance includes the regular performance of due diligence with respect to account holders to determine if any holders are U.S. persons. If any account holder is identified as a U.S. person, a Participating FFI is required to provide Treasury with information about the identity of the U.S. person, the account balance, withdrawals and deposits, and the income such person derives from the account.
For additional background regarding FATCA and FFIs subject to its information reporting requirements, see Bracewell & Giuliani's May 6, 2010 client alert available here.
Additional Guidance Provided by the Notice
The Notice provides guidance on the due diligence protocols and procedures that Participating FFIs must observe with respect to disclosure agreements with the Treasury necessary to obtain, or maintain, their exemption from the 30% FATCA withholding tax.
The Notice primarily provides clarity regarding: (i) the reporting procedures a Participating FFI must undertake with respect to existing account holders, (ii) the definition of the term "passthru payment" that Participating FFIs receive and pay to their account holders, and (iii) how FATCA will affect investment funds.
Procedures for Participating FFIs to Identify U.S. Accounts
The Notice provides that an FFI generally can rely on information it has about existing account holders to determine if such holder is a U.S. person. First, all accounts with holders already documented as U.S. persons for other U.S. tax purposes are treated as U.S. accounts. From the remaining accounts, the FFI can treat an account with a balance that does not exceed $50,000 as a non-U.S. account. For the larger remaining accounts, the FFI must search electronic information it has about the account holder to determine if such holder has U.S. indicia, which include specific information such as: (i) a U.S. residence, (ii) instructions on file that funds should be wired from the account to a U.S. account, or (iii) a U.S. place of birth. With respect to existing accounts with U.S. indicia, a Participating FFI has one year to request certain documentation from an account holder to affirmatively establish whether the account is a U.S. account.
Scope of Passthru Payments
FATCA requires Participating FFIs to withhold U.S. tax at a rate of 30% on passthru payments made to nonparticipating FFIs or other account holders that have not provided the appropriate information regarding their identity. Passthru payments include withholdable payments and payments attributable to withholdable payments.
The general rule provides that a payment made by an FFI (the payor FFI) will be a passthru payment to the extent of: (i) the amount of the payment that is a withholdable payment, plus (ii) the amount of the payment that is not a withholdable payment multiplied by (A) in the case of a custodial payment, the passthru payment percentage of the entity that issued the interest or instrument, or (B) in the case of any other payment, the passthru payment percentage of the payor FFI.
With respect to (ii)(A) above, a custodian must obtain the passthru payment percentage of the entity that issued the interest to compute the amount of the payment subject to withholding. In the case of (ii)(B) above, the payor FFI must determine its own passthru payment percentage equal to the value of its U.S. assets divided by the value of its total assets. FFIs will determine their passthru payment percentages as of each quarterly testing date.
For purposes of computing an FFI's passthru payment percentage, the Notice clarifies the scope of the term "U.S. asset." Generally, (a) debt or equity interests in a domestic corporation are U.S. assets, (b) debt or equity interests in a non-financial foreign entity ("NFFE"), which is defined as a foreign entity that is excluded from the definition of a financial institution, are solely non-U.S. assets, and (c) an interest in, or other non-custodial account held with, another FFI (a "Lower Tier FFI") constitutes a U.S. asset in an amount equal to the value of the interest in, or account with, the Lower Tier FFI multiplied by the Lower Tier FFI's passthru payment percentage. An FFI may rely on the passthru payment percentage of a Lower Tier FFI that is a participating or deemed-compliant FFI, if such FFI publishes its passthru payment percentage. If a Participating FFI or deemed-compliant FFI does not publish its passthru payment percentage, it will be deemed to have a passthru payment percentage of one hundred percent. An FFI that is not a participating or deemed-compliant FFI will be presumed to have a passthru payment percentage of zero percent. It is apparently assumed that a non-participating FFI would have already suffered the 30% FATCA withholding on the underlying "withholdable payments" so no additional withholding should be due.
To illustrate these rules, assume Fund A is a Participating FFI that operates as a fund of funds. As of the relevant testing date, Fund A's assets consist of (a) a $20 million interest in Fund B, a non-participating FFI, (b) a $30 million interest in Fund C, a Participating FFI with a passthru payment percentage (a "PP%") of 50 percent; (c) a $10 million interest in Fund D, a Participating FFI that does not publish its PP%, and (d) a $40 million interest in Fund E, a domestic corporation. Fund A's U.S. assets are $65 million (($20 million x Fund B's PP% of 0%) + ($30 million x Fund C's PP% of 50%) + ($10 million x Fund D's PP% of 100%) + ($40 million x Fund E's PP% of 100%)). Therefore, Fund A's passthru payment percentage for the relevant testing date is equal to $65 million divided by $100 million, or 65%. Accordingly, an owner of Fund A who failed to provide identifying information will be subject to 30% withholding tax on 65% of its Fund A income.
Deemed-Compliant Status for Certain FFIs
Treasury can designate certain categories of FFIs as deemed-compliant with the FATCA reporting rules. In general, an FFI that is an investment fund will be deemed compliant if: (i) all holders of record of direct interests in the fund are Participating FFIs, certain foreign governmental investors, or deemed-compliant FFIs holding on behalf of other investors, (ii) the fund prohibits the subscription for or acquisition of any interests in the fund by any person that is not included within (i) above, and (iii) the fund certifies its passthru payment percentage. Treasury welcomes comments on whether a category of funds may be treated as deemed-compliant because (a) all direct interest holders in the fund are Participating FFIs, U.S. financial institutions, deemed-compliant FFIs or non-participating FFIs acting as distributors, (b) distribution arrangements prohibit the sale of its ownership interests to U.S. persons, certain NFFEs, and non-participating FFIs holding for their own account, (c) each distributor agrees to enforce the sales prohibitions, and (d) the fund satisfies other requirements that may be imposed. Treasury intends to issue guidance clarifying that, while deemed-compliant FFIs are responsible for ensuring that the requirements are met, they may use agents to perform the necessary due diligence and take any required action associated with maintaining deemed-compliant status on their behalf.
Centralized Compliance Option for Foreign Investment Funds
The Notice also provides that the IRS and Treasury are considering whether investment funds with a common asset manager or agent could contract with such manager or agent to execute a single Participating FFI agreement with Treasury and perform all obligations under the agreement on behalf of such funds. Such option would be limited to managers and agents that are able to monitor each participating funds' compliance. Despite such an arrangement, each fund participating would remain liable for its obligations under the agreement.
The likely practical effect of the guidance with respect to foreign funds contained in the Notice is to drive such funds to avoid FATCA withholding by either: (i) limiting their ownership and achieve deemed compliant status or (ii) taking all actions necessary to become a Participating FFI and maintain such status, which may cause them to incur significant compliance costs.
The Notice provides useful guidelines regarding FATCA compliance, but also creates additional questions. As the January 1, 2013 general effective date for FATCA approaches, many significant questions remain unanswered. We will continue to monitor future guidance on due diligence protocols to identify U.S. accounts, entities treated as deemed compliant, and to what extent investment funds can rely on an agent such as a common investment manager or general partner to undertake compliance functions. The Treasury and IRS welcome comments on these and other FATCA issues.