Intergovernmental agreements will help foreign financial institutions more easily meet the requirements of the US Foreign Account Tax Compliance Act (FATCA), which aims to curtail tax evasion by US persons abroad.
Or so financial firms around the world were told by the US Internal Revenue Service (IRS) and their local tax authorities.
That’s not exactly a lie, but practically speaking it’s not entirely true either. The IGAs will be adding an additional layer of complexity to what is already an intense burden so fund managers, banks and broker dealers had better get ready — and fast, say FATCA experts — by understanding the differences and similarities between those measures and FATCA.
“While IGAs are intended, in part, to reduce the administrative burdens foreign financial institutions (FFIs) face in complying with FATCA, complying with IGAs may be difficult in the short term particularly in the case of large financial institutions operating in multiple jurisdictions each subject to a separate IGA,” cautions Angelo Ciavarella, a tax partner in New York with Reed Smith.
Fortunately, the IRS has granted withholding agents and foreign financial institutions a reprieve from financial penalties in 2014 and 2015 as long as they can prove they have made a good-faith effort to follow FATCA. While the IRS has provided only limited guidance on how it interprets good faith, the transition period still provides additional time to prepare, says Ciavarella.
Here is what FATCA requires: foreign financial institutions, coined FFIs for short, must register with the IRS and follow the rules it sets for providing the information it wants on US persons and US-sourced income and when it wants the data. The goal is two-fold: to ensure that the foreign firm becomes an IRS enforcement agent of sorts and helps the IRS collect its fair share of taxes which would otherwise be lost. The other is to prove the FFI isn’t enabling tax evaders.
IGAs vs FATCA
In the case of a version of IGA called Model I, FFIs — estimated at over 300,000 firms operating overseas — don’t have to worry about potentially violating local data privacy rules, because they can fulfill local reporting and investor due diligence requirements in reporting to local regulators. As long as they do so, they won’t be breaching FATCA’s rules and be hit with IRS’ penalties — a whopping 30 percent automatic withholding tax on all US-sourced income: dividends, income and gross proceeds from the sale of securities. When it comes to so-called Model II IGAs — signed by several countries including Switzerland, Bermuda and Japan — FFIs must fulfill the IRS’ reporting and investor due diligence requirements, but the local governments have agreed to let them off the hook when it comes to violating local customer privacy rules.
Sounds great, but there is just one glitch — and it’s a whopper. In explaining how FATCA must be implemented, the IRS has come out, albeit belatedly, with the necessary documentation and investor due diligence rules financial firms must follow. Unfortunately, the FFIs don’t have that clear direction in most other nations. With the exception of the UK, the dozens of foreign countries which have signed IGAs with the US are still crafting their similar so-called enabling legislation. Even worse, dozens of other countries have “agreed in substance” to signing IGAs, but haven’t gotten around to signing them.
“There are at least two distinguishing characteristics of IGAs — differences in the registration and investor due diligence reporting process,” explains Kathleen Celoria, director of DMS Offshore Investment Services Ltd in New York, which offers FATCA governance solutions and compliance services for investment fund managers.
Here is what IGAs say: the FFIs must still register with the IRS and follow the rules it sets for providing the information, but when doing so it must include information on why it thinks it is an FFI. Depending on just what the IGA it has signed with the US says, an FFI might well be exempt from the IRS’ FATCA requirements, if it falls under a specific category and type of business operations. Of course, there will be differences even between IGAs in just who meets the criteria for an exemption. Another issue: in countries which have signed a Model II IGAs with the US, the FATCA responsible officer — the internal compliance person on the hook for meeting FATCA’s rules — has far more certification requirements and responsibilities than his or her peers in countries which have signed Model I IGAs.
That’s just for starters. When it comes to reporting just who owns what accounts, the IGAs become far more complicated to follow. In the case of a Model I IGA, which most foreign countries have signed or want to sign, the foreign financial institution will have to provide its own tax authority with the data identifying US persons receiving US sourced income.
Foreign governments reserve the right to request additional information and without knowing what that extra data is, the FFIs are in a bit of a bind in knowing just how to prepare. So are fund administrators and other third-parties which must be ready to support each of its FFI clients and their jurisdiction’s IGA.
“If a fund manager has only one country’s IGA to deal with, understanding and following the guidelines for that IGA, even if not fully defined yet, should not be that cumbersome,” says Keith Diamond, a director with fund administrator Kaufman Rossin Fund Services in Miami. “If they operate in more than one country, as is often the case with large global institutions, they may have to understand the IGA signed by each country.”
The IGAs have provided some preliminary information on what data the home markets are looking for, so foreign financial firms can get a head start and collect whatever data they can now. “Operations, data management, tax, compliance and legal experts all need to sit at the table to come up with the new customer onboarding guidelines and go back to repaper or remediate any data gaps from the existing customers,” says Celoria.
Relying on third-party providers, such as fund administrators for help will certainly go a long way to easing compliance pains. But it’s still not a panacea. “Even if fund managers outsource the investor due diligence process to us, we won’t necessarily see the full picture,” explains Diamond.
The reason: Fund administrators aren’t involved in any initial emails or phone calls resulting in an investment. “Theoretically, there could be US indicia discovered for an offshore investor which triggers some follow-up procedures, potential reporting and withholding tax,” says Diamond. “Therefore, even if we do the subsequent due diligence after the subscription documentation and anti-money laundering documentation is signed, the fund manager still needs to notify us of anything it knows about the customer that might not be in the documentation.”
Case in point, an investment manager receives an email where an investor provides a US phone number as its contact number. However, in subscription documents, a W8-BEN form declaring foreign residency lists a non-US phone number. If a fund administrator isn’t informed of the difference, it wouldn’t know that it needs to do more work to determine whether or not the investor is really foreign or obtain a W9 changing its status to a US investor. The result: the FFI might be at risk for not complying with the IGAs and FATCA, says Diamond.
On the Horizon
There is one aspect of the IGA process which is unclear, and worrisome to several US fund managers contacted by FinOps Report. If a foreign country opts to enforce a so-called reciprocal version of an IGA, the US might end up obligated to provide the other country with information on the financial accounts of that country’s residents held by US financial institutions. Thus, if a foreign country has signed a Model I IGA with the US and enacts its own legislation that is substantially similar to FATCA, US-domiciled financial institutions would likely be subject to obligations that mirror those currently imposed by the IRS on FFIs, identifying US residents who are liable for non-US taxation.
Bottom line: the US financial institution has just been turned into an FFI under the a foreign country’s FATCA-like legislation. A US domestic fund manager or even bank, which might have thought it didn’t have to worry about identifying non-U.S. investors and any payments made to them now has plenty to worry about. “We aren’t operationally prepared to rigorously classify foreign investors right now,” acknowledges one fund management compliance specialist to FinOps. “It’s going to be a nightmare which we haven’t even begun to think about.”
Just when should they begin worrying? Some would say wait until you have something to fret over. Better advice might be to keep your ear to the ground. When there is tax money at stake, governments tend to be interested.