FATCA was enacted into law under the Hiring Incentives to Restore Employment Act of 2010 (“HIRE Act”)   which set forth, in new Chapter 4, Sections 1471-1474, an additional and complex withholding tax regime which generally was to become effective on January 1, 2013. FATCA’s most notable feature is the automatic withholding of 30% on the gross amounts of “withholdable payments” made to foreign financial institutions ("FFIs") and  nonfinancial foreign entities (“NFFEs”) where such organizations do not satisfy certain information reporting requirements. 

The 30% automatic withholding rules is not based on income in contrast with the withholding rules under chapter 3 on withholding on U.S. source income payments such as dividends interest and other forms of U.S. source income payments and also on foreign partners in partnerships and required witholding on sales of interests in U.S. real property. Thus, the gross receipts from the sale of assets that may also yield U.S. source interest for example, are subject to the FACTA withholding rules. Withholding may be avoided where required information reporting requirements are met. There are also several exceptions and exclusions from FATCA withholding. 

After the FATCA legislation was enacted, the Service issued guidance in the form of three notices, i.e., Notice 2010-60, 2010-37 I.R.B. 329; Notice 2011-34, 2011-19 I.R.B. 765 and Notice 2011-53, 2011-32 IRB 124. Then, last year, the Service issued long-awaited Proposed Regulations. Under proposed regulations which become effective when published as final regulations in the federal register, a withholding agent has to withhold on any withholdable payment made to a payee FFI after Dec. 31, 2013 unless it can reliably associate the payment with documentation on which it can rely to treat the payment as exempt from withholding or the payment is made under a so-called grandfathered obligation.

The IRS and the Treasury just issued final regulations (T.D. 9610) for implementing the Foreign Account Tax Compliance Act, which requires information reporting by foreign financial institutions (FFIs) regarding U.S. accounts and withholding on some payments to FFIs and other foreign entities. Effective January 28, 2013, the final regulations adopt, with changes, the provisions contained in the proposed regulations (REG-121647-10) which were published in February 2012.

The final regulations attempted to respond to numerous comments that were made to the Service on various aspects of the FACTA provisions for which clear guidance was needed. The government also received criticisms from tax professionals, financial services organizations and foreign governments each echoing concerns over the cost and burdens associated with complying with the new rules. As to foreign government comments, FACTA received criticism that it ignored disclosure laws of various jurisdictions. In response, the Treasury and IRS drafted model intergovernmental agreements or IGAs to serve as substitutes for direct reporting by FFIs to the IRS where the jurisdiction involved enters into a definitive IGA with the U.S.

The final regulations attempt to broaden the scope of grandfathered obligations, treat passive entities that are not professionally managed as nonfinancial foreign entities (NFFEs) rather than as FFIs, and expand the categories of FFIs that are deemed to comply with FATCA without the need to enter into an agreement with the IRS. The final regulations also detail additional procedural rules involving the implementation of IGAs.

FACTA Basics: Sections 1471 thru 1474

Section 1471(a) requires any withholding agent to withhold 30 percent of any withholdable payment to an FFI that does not meet the requirements of section 1471(b). A withholdable payment is defined in section 1473(1) to mean, subject to certain exceptions: (i) any payment of interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income (FDAP income), if such payment is from sources within the United States; and (ii) any gross proceeds from the sale or other disposition of any property of a type which can produce interest or dividends from sources within the United States.

An FFI meets the requirements of section 1471(b) if it either enters into an agreement (an FFI agreement) with the IRS under section 1471(b)(1) to perform certain obligations or meets requirements prescribed by the Treasury Department and the IRS to be deemed to comply with the requirements of section 1471(b). An FFI is defined as any financial institution that is a foreign entity, other than a financial institution organized under the laws of a possession of the United States (generally referred to as a U.S. territory in this preamble). For this purpose, section 1471(d)(5) defines a financial institution as, except to the extent provided by the Secretary, any entity that: (i) accepts deposits in the ordinary course of a banking or similar business; (ii) as a substantial portion of its business, holds financial assets for the account of others; or (iii) is engaged (or holding itself out as being engaged) primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, or any interest in such securities, partnership interests, or commodities.

Section 1471(b)(1)(A) and (B) requires an FFI that enters into an FFI agreement (a participating FFI) to identify its U.S. accounts and comply with verification and due diligence procedures prescribed by the Secretary. A U.S. account is defined under section 1471(d)(1) as any financial account held by one or more specified United States persons, as defined in section 1473(3), (specified U.S. persons) or United States owned foreign entities (U.S. owned foreign entities), subject to certain exceptions. Section 1471(d)(2) defines a financial account to mean, except as otherwise provided by the Secretary, any depository account, any custodial account, and any equity or debt interest in an FFI, other than interests that are regularly traded on an established securities market. A U.S. owned foreign entity is defined in section 1471(d)(3) as any foreign entity that has one or more substantial U.S. owners (as defined in section 1473(2)).

A participating FFI is required under section 1471(b)(1)(C) and (E) to report certain information on an annual basis to the IRS with respect to each U.S. account and to comply with requests for additional information by the Secretary with respect to any U.S. account. The information that must be reported with respect to each U.S. account includes: (i) the name, address, and taxpayer identifying number (TIN) of each account holder who is a specified U.S. person (or, in the case of an account holder that is a U.S. owned foreign entity, the name, address, and TIN of each specified U.S. person that is a substantial U.S. owner of such entity); (ii) the account number; (iii) the account balance or value; and (iv) except to the extent provided by the Secretary, the gross receipts and gross withdrawals or payments from the account (determined for such period and in such manner as the Secretary may provide). In lieu of reporting account balance or value and reporting gross receipts and gross withdrawals or payments, a participating FFI may, subject to conditions provided by the Secretary, elect under section 1471(c)(2) to report the information required under sections 6041, 6042, 6045, and 6049 as if such institution were a U.S. person and each holder of such U.S. account that is a specified U.S. person or U.S. owned foreign entity were a natural person and citizen of the United States. If foreign law would prevent the FFI from reporting the required information absent a waiver from the account holder, and the account holder fails to provide a waiver within a reasonable period of time, the FFI is required under section 1471(b)(1)(F) to close the account. Section 1471(b)(1)(D)(i) requires a participating FFI to withhold 30 percent of any passthru payment to a recalcitrant account holder or to an FFI that does not meet the requirements of section 1471(b) (nonparticipating FFI). A passthru payment is defined in section 1471(d)(7) as any withholdable payment or other payment to the extent attributable to a withholdable payment. Section 1471(d)(6) defines a recalcitrant account holder as any account holder that fails to provide the information required to determine whether the account is a U.S. account, or the information required to be reported by the FFI, or that fails to provide a waiver of a foreign law that would prevent reporting. A participating FFI may, subject to such requirements as the Secretary may provide, elect under section 1471(b)(3) not to withhold on passthru payments, and instead be subject to withholding on payments it receives, to the extent those payments are allocable to recalcitrant account holders or nonparticipating FFIs. Section 1471(b)(1)(D)(ii) requires a participating FFI that does not make such an election to withhold on passthru payments it makes to any participating FFI that makes such an election.

Section 1471(e) provides that the requirements of the FFI agreement  will 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, as defined in section 1471(e)(2).

Section 1471(f) exempts from withholding under section 1471(a) certain payments beneficially owned by certain persons, including any foreign government, international organization, foreign central bank of issue, or any other class of persons identified by the Secretary as posing a low risk of tax evasion.

Section 1472(a) requires a withholding agent to withhold 30 percent of any withholdable payment to an NFFE if the payment is beneficially owned by the NFFE or another NFFE, unless the requirements of section 1472(b) are met with respect to the beneficial owner of the payment. Section 1472(d) defines an NFFE as any foreign entity that is not a financial institution as defined in section 1471(d)(5).

The requirements of section 1472(b) are met with respect to the beneficial owner of a payment if: (i) the beneficial owner or payee provides the withholding agent with either a certification that such beneficial owner does not have any substantial U.S. owners, or the name, address, and TIN of each substantial U.S. owner; (ii) the withholding agent does not know or have reason to know that any information provided by the beneficial owner or payee is incorrect; and (iii) the withholding agent reports the information provided to the Secretary.

Section 1472(c)(1) provides that withholding under section 1472(a) does not apply to payments beneficially owned by certain classes of persons, including any class of persons identified by the Secretary. In addition, section 1472(c)(2) provides that withholding under section 1472(a) does not apply to any class of payment identified by the Secretary for purposes of section 1472(c) as posing a low risk of tax evasion.

Section 1474(a) provides that every person required to withhold and deduct any tax under chapter 4 is made liable for such tax and is indemnified against the claims and demands of any person for the amount of any payments made in accordance with the provisions of chapter 4. In general, the beneficial owner of a payment is entitled to a refund for any overpayment of tax actually due under other provisions of the Code. However, with respect to any tax properly deducted and withheld under section 1471 from a payment beneficially owned by an FFI, section 1474(b)(2) provides that the FFI is not entitled to a credit or refund, except to the extent required by a treaty obligation of the United States (and, if a credit or refund is required by a treaty obligation of the United States, no interest shall be allowed or paid with respect to such credit or refund). In addition, section 1474(b)(3) provides that no credit or refund shall be allowed or paid with respect to any tax properly deducted and withheld under chapter 4 unless the beneficial owner of the payment provides the Secretary with such information as the Secretary may require to determine whether such beneficial owner is a U.S. owned foreign entity and the identity of any substantial U.S. owners of such entity.

Section 1474(c) provides that information provided under chapter 4 is confidential under rules similar to section 3406(f), except that the identity of an FFI that meets the requirements of section 1471(b) is not treated as return information for purposes of section 6103.

Section 1474(d) provides that the Secretary shall provide for the coordination of chapter 4 with other withholding provisions under the Code, including providing for the proper crediting of amounts deducted and withheld under chapter 4 against amounts required to be deducted and withheld under other provisions.

Section 1474(f) provides that the Secretary shall prescribe such regulations or other guidance as may be necessary or appropriate to carry out the purposes of, and prevent the avoidance of, chapter 4.

Overview of the Final Regulations

The final regulations to FACTA prescribe the set of substantive requirements applicable to an FFI under the FFI agreement. The regulationss include the requirements for verifying compliance with the FFI agreement, allow participating FFIs to file collective refund claims on behalf of specified account holders and payees for amounts overwithheld, and provide procedural requirements if a participating FFI is legally prohibited from reporting or withholding as required under the FFI agreement. The final regulations do not restrict a participating FFI’s ability to terminate an FFI agreement and allow an FFI the flexibility to reconsider its status as further guidance is issued.

Consistent with outstanding IGA effective dates, the final regulations delay the effective date of the FFI agreement until December 31, 2013, for all participating FFIs that receive a global intermediary identification number before January 1, 2014. An FFI is not required to withhold on foreign passthrough payments until the later of January 1, 2017, or six months after the date that final regulations defining the term "foreign passthrough payments" are published.

On the pre-existing accounts and depository account exception contained in section 1471(d)(1)(B), the final regulations create a $50,000 exception for cash value insurance contracts. The final regulations state that an account held by a disregarded or “defective” entity is treated as held by the person owning the entity and limit the scope of the term "depository account" in a number of ways. Presumably the same rule would apply to a grantor to a grantor trust. To avoid requiring multiple entities to document, withhold, and report regarding a financial account, the final regulations identify the entity that will be treated as maintaining a financial account. The proposed regulation definition of an FFI is revised in the final regulations to provide that an applicable IGA determines whether a resident entity described in the applicable IGA is an FFI.

The final regulations widen the set of circumstances in which some classes of entities qualify as exempt beneficial owners and modify when an entity qualifies as an exempt beneficial owner under Treas. Reg. §1.1471-6(g). The final regulations further clarify that, in general, an entity cannot qualify as an exempt beneficial owner unless it is the beneficial owner of the payment. The definition of an exempt beneficial owner is expanded to include any entity identified as an exempt beneficial owner under an IGA. The final regulations expand the definition of international organization and broaden the classes of pension funds qualifying as exempt beneficial owners by including several new categories of pension funds.

The final regulations provide that withholding agents are required to withhold under section 1472 only for withholdable payments made after December 31, 2013. Withholding agents are also not required to withhold under section 1472 on payments made before January 1, 2015, for a preexisting obligation to a payee that is not a prima facie FFI and for which a withholding agent does not have documentation indicating the payee's status as a passive NFFE with one or more substantial U.S. owners. Also the final regulations clarify the exceptions fro withholding for payments to active NFFEs and expand the exceptions to passive income.

The final regulations suspend the withholding requirement on gross proceeds and foreign passthrough payments until 2017. The final regulations replace the ordinary course of business exception to withholdable payments with a more comprehensive exception for excluded nonfinancial payments. The final regulations clarify the reporting requirements for a withholding agent and a participating FFI or registered deemed-compliant FFI that acts as an intermediary or is a flow-through entity.

As further explained in the Preamble to the final regulations, FATCA registration will be accessible through an IRS registration portal for FFIs by July 15, 2013. The IRS will electronically post the first list of participating FFIs and registered deemed-compliant FFIs on December 2, 2013. The list will be updated monthly. A financial institution must register by October 25 to ensure its inclusion on the December 2013 list. Before the portal opens for registration, Treasury and the IRS will issue a revenue procedure with the terms and conditions applicable to FFIs for chapter 4 purposes and for FFIs also assuming chapter 3, general withholding under the FDAP and related provisions.

A Note on IGAs: Intergovernmental Agreements

The Treasury and the Service have long been aware that for many FFIs operating in certain foreign jurisdictions, the domestic law of such jursidction would prevent an FFI from reporting directly to the IRS the information required by the FATCA and underlying regulations. In response, the Treasury worked with various foreign countries in developing two alternative model intergovernmental agreements that facilitate the implementation of FATCA in a manner that avoids foreign law hurdles and yet fosters Congress’ intent in enacting FACTA.

Under the first model IGA (7/26/2012), a partner jurisdiction signing a Model 1 agrees to adopt rules to identify and report information about U.S. accounts that meet the standards set out in the Model 1 IGA. FFIs covered by a Model 1 IGA that are not otherwise excepted or exempt pursuant to the agreement must identify U.S. accounts pursuant to due diligence rules adopted by the partner jurisdiction and report specified information about the U.S. accounts to the partner jurisdiction. The partner jurisdiction then exchanges this information with the IRS on an automatic basis. These standards ensure that the IRS will receive the same quality and quantity of information about U.S. accounts from FFIs covered by a Model 1 IGA as it receives from FFIs applying these final regulations.

Under the second model IGA (11/14/2012), a partner jurisdiction a Model 2 IGA agrees to direct and enable all FFIs that are located in the jurisdiction, and that are not otherwise excepted or exempt pursuant to the Model 2 IGA, to register with the IRS and report specified information about U.S. accounts directly to the IRS in a manner consistent with chapter 4 and these final regulations, except as expressly modified by the Model 2 IGA. In the case of certain non—forthcoming  account holders, the information reported to the IRS by FFIs covered by a Model 2 IGA is supplemented by government-to-government exchange of information.

Both model IGAs rely on the representation made by the foreign government- partner jurisdiction  will require all financial institutions that are located in the jurisdiction, and that are not otherwise excepted or exempt pursuant to the agreement, to identify and report information about U.S. accounts.  In return, the model IGA simplify and streamline to some extent the reporting burdens imposed under the normal FACTA rules. While approximately 7 countries have entered into IGAs, the United Kingdom is the only country to have issued draft regulations and guidance indicating how it will implement its obligations under its IGA with the United States. The United States recently entered into an IGA with Norway and has previously announced agreements with Denmark, Ireland, Mexico, Spain, Switzerland, and the United Kingdom. It is reported that the Treasury is in discussions with more than 50 other countries and jurisdictions. Perhaps the IGA will eventually be the governing rule especially as to foreign based FFIs.

IGAs And the Final Regulations

As announced in the rulemaking, FFIs covered by a Model 1 IGA, and that are in compliance with local laws implemented to identify and report U.S. accounts in accordance with the terms of the Model 1 IGA, will be treated as satisfying the due diligence and reporting requirements of chapter 4 (FATCA).

Accordingly, consistent with the terms of the Model 1 IGA, these FFIs do not need to apply the final regulations for purposes of complying with and avoiding withholding under FATCA. In certain cases prescribed in the Model 1 IGA, the laws of the partner jurisdiction may allow the resident FFI to elect to apply provisions of the regulations instead of the rules otherwise prescribed in the Model 1 IGA.

FFIs covered by a Model 2 IGA with the United States will be required to implement FATCA in the manner prescribed by the final regulations except to the extent expressly modified by the Model 2 IGA.

The final regulations are quite lengthy and complex. This posting only highlights the development and the set of rules contained in the FACTA provision. Anyone interested in understanding the specific application of FACTA to a specific foreign based investment, whether in an FFI or NFFE, or the impact that an IGA would have on the chapter 4 withholding rules,  must consult with his tax counsel or advisor.