On March 18, 2010, the Hiring Incentives to Restore Employment Act of 2010, Public Law 111-147, enacted Chapter 4 of Subtitle A (“Chapter 4”), comprised of Sections 1471 through 1474 of the Internal Revenue Code of 1986, as amended (the “Code”). These provisions were originally introduced as part of the Foreign Account Tax Compliance Act of 2009, commonly referred to as FATCA. This client update will refer to Chapter 4 as FATCA. When fully effective, generally in 2017, FATCA will affect most United States persons who make certain types of payments to foreign entities and all foreign entities which, directly or indirectly, receive such payments. Even foreign entities which do not receive such payments may be affected.
FATCA was passed in response to the growing globalization of investments, in the course of which some United States persons have attempted to evade United States taxes by investing through foreign entities. FATCA requires a withholding agent to withhold 30 percent of payments, made to foreign entities, of certain types of “fixed and determinable annual income” from United States sources and 30 percent of the gross proceeds from the disposition of instruments which could produce interest or dividend income, unless the foreign entity establishes an exception to such withholding as set forth below. A withholding agent will include every United States person making such payments other than a United States individual not acting in the course of his or her trade or business. The withholding must be made even if the income represented by the payment is not otherwise taxable under the Code or would be exempt pursuant to a treaty.
A foreign entity may avoid withholding by complying with FATCA reporting rules. A foreign financial institution (an “FFI”), which includes banks, brokerage houses, investment vehicles such as hedge funds and certain insurance companies, will generally have to furnish to the Internal Revenue Service (the “IRS”) certain information relating to the accounts it holds for United States persons and certain foreign entities with United States owners, and any ownership of such FFI’s debt or equity by United States persons and certain foreign entities with United States owners, subject to certain exceptions. If the laws governing the FFI prevent such disclosure, the FFI must get a waiver from the account holder or close the account. The FFI may also have to withhold on payments made by it to United States persons, FFIs which haven’t complied with the FATCA reporting and withholding requirements, and certain other foreign entities. To avoid withholding, all other foreign entities (non-financial foreign entities or “NFFEs”) will have to report identifying information on United States persons who own, directly or indirectly, 10 percent or more of such entity. There are exceptions to the above rules, but, generally, the foreign entity must establish its right to any such exception.
A foreign entity may apply for a refund to the extent that the amount withheld under FATCA is in excess of its actual tax liability. However, if the beneficial owner of the payment is an FFI, the FFI will only be entitled to receive a refund to the extent that a treaty provision applies, and no interest will be paid on such refund. If no treaty provision applies, an FFI will not be entitled to a refund even if the FATCA withholding is made with respect to a payment that is not otherwise taxable under the Code. Similarly, a NFFE will also be entitled to receive a refund due to the application of a treaty provision, but if no treaty provision applies, the NFFE will be required to deliver to the IRS the identifying information which would have prevented the withholding in the first instance in order to obtain any additional refund.
The IRS has provided guidance on implementation of FATCA in several notices and on February 8, 2012, the Treasury issued proposed regulations (the “proposed regulations”) incorporating, supplementing and amending the provisions of the notices. The following discussion is based on these proposed regulations. It is intended only to give a very broad overview of the requirements of FATCA. Most statements made below are subject to specific exceptions and qualifications, which generally will not be discussed, and various rules are also subject to phase-in provisions, which will be discussed only in certain specific instances. Because the regulations are proposed, they are subject to change. Indeed, Treasury has already announced its intention to make certain changes to the proposed regulations. In addition, many details of application were not covered in the proposed regulations, and the preamble to the proposed regulations requested comments regarding the manner in which final regulations should deal with those particular areas. Nevertheless, the general outlines of FATCA are clear, and those who will be affected by it should begin to consider procedures for compliance.
The United States federal income tax system generally relies on voluntary compliance by taxpayers. As an important check on voluntary compliance, the Code has long required persons making certain types of payments to file information reports with the IRS with respect to such payments. Sections 6041 through 6049 of the Code require the reporting of certain payments made to certain United States persons. Chapter 3 of Subtitle A of the Code (consisting of Sections 1441 through 1464 of the Code) (“Chapter 3”) requires the reporting of certain payments made to foreign persons. With some exceptions, the persons required to file reports under the aforementioned Code sections are, as a practical matter, generally limited to United States persons.
Congress enacted FATCA to combat the avoidance of tax by many taxpayers who hold investments in accounts with foreign financial institutions, or invest through foreign entities which were not required to file the information reports. FATCA is intended to force disclosure by foreign entities of investments held by United States persons to increase federal tax compliance.
- Withholding on Payments
FATCA requires a withholding agent1 to withhold 30 percent of payments made to a foreign entity of:
(i) interest (including original issue discount), dividends,2 rents, salaries, wages, premiums, annuities, compensations, remuneration, emoluments, and other fixed and determinable annual or periodical gains, profits and income, if such amount is from sources within the United States (“FDAP income”) 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,3
unless the foreign entity complies with certain reporting and other requirements. The withholding requirements apply to the above listed items even though the payment would not otherwise be subject to tax under the Code (for example, portfolio interest) and even if a treaty would otherwise preclude taxation. Withholding does not apply, however, to payments of amounts which are effectively connected with the conduct by the payee of a trade or business within the United States, unless the payee has claimed that such effectively connected income is not taxable to it under a treaty because such payee lacks a permanent establishment in the United States.
Withholding is currently scheduled to be required for payments of FDAP income after December 31, 2013 and for payments of gross proceeds made after December 31, 2014. No withholding will be required for payments made with respect to certain obligations outstanding on January 1, 2013. Such obligations generally include any legal agreement that produces or could produce a payment withholdable under FATCA, other than an instrument that is treated as equity or that lacks a stated expiration or term. Obligations specifically mentioned in the proposed regulations as qualifying for the “grandfathering” include debt instruments, borrowings under a credit agreement in place on January 1, 2013, and notional principal contracts. A significant modification of the obligation will cause the obligation to be deemed newly issued on the date of such modification.
- Types of Foreign Entities
The procedure that a foreign entity must follow to avoid withholding under FATCA depends upon whether such foreign entity is an FFI or an NFFE.
An FFI is a foreign entity which:
- accepts deposits in the ordinary course of a banking or similar business;
- holds, as a substantial part of its business, financial assets for the accounts of others;
- is engaged (or holds itself out as being engaged) primarily in the business of investing or trading in securities, partnership interests, commodities, notional principal contracts, insurance or annuity contracts, or any interest (including a futures or forward contract or option) in any of the above;4 or
- is an insurance company making certain payments.
Thus an FFI includes not only traditional financial institutions such as banks, but also investment vehicles such as hedge funds and private equity funds.
An NFFE is any foreign entity that is not an FFI.
Certain entities are excluded from the definition of FFIs (and are thus NFFEs), such as:
- a foreign entity substantially all the activities of which is to own the stock of one or more subsidiaries that engage in trades or businesses and none of which is a financial institution, provided that this exception does not apply if the entity functions (or holds itself out) as an investment fund whose purpose is to acquire or fund companies and hold their interests in those companies as capital assets for investment purposes;
- start-up companies (for 24 months only), other than investment companies and entities described in the proviso of clause (a);
- non-financial entities that are liquidating or emerging from reorganization or bankruptcy,
- a foreign entity that primarily engages in financing and hedging services to members of its “expanded affiliated group”5 that are not financial institutions and that does not provide financing or hedging services to non-affiliates; and
- a foreign entity described in Section 501(c) of the Code.
- Avoiding Withholding on Payments Made to FFIs
In order to avoid withholding on payments made to it, an FFI will generally have to enter into an “FFI agreement” with the IRS.6
The FFI Agreement will generally include the following provisions:
- Withholding. The FFI will act as a withholding agent under the rules of FATCA with respect to payments made to recalcitrant account holders7 and non-participating FFIs.8 Withholding would be required with respect to FDAP income, gross proceeds from the sale of instruments which could produce FDAP income, as well as other types of income (the scope of which has been reserved in the proposed regulations).9 An FFI may elect, in lieu of withholding, to have withholding on payments of FDAP income made to it by furnishing the relevant information to the withholding agents with respect to such payments.
- Identification and Documentation of Account Holders. The FFI will be required to obtain information to determine whether any of its accounts are held by United States persons, United States owned foreign entities,10 recalcitrant account holders or non-participating FFIs.
- Information Reporting. The FFI will report on an annual basis on accounts held by United States persons, United States owned foreign entities and recalcitrant account holders. The information required to be reported will be phased in beginning in 2014 (for reports with respect to the 2013 calendar year). In 2017 (with respect to the 2016 calendar year) full reporting is required, which will include the name, address and taxpayer identification number of each account holder that is a specified United States person11 as well as the account number, the account balance or value and, generally, payments made with respect to the account.12 In the case in which the account holder is a United States owned foreign entity, the FFI must report the name address and taxpayer identification number of the entity and of each substantial United States owner of such entity, the account number, the account balance or value, and the payments made with respect to the account. The exact information to be returned may be somewhat modified under an election which may be made by the FFI.
The FFI will also be required to report to the IRS the aggregate number and aggregate value of accounts held by recalcitrant account holders, separated into those that have certain United States indicia, those that do not have certain United States indicia, and dormant accounts.
- Affiliated Group. The FFI agreement will generally require all the members of the FFI’s expanded affiliated group to comply with the FFI agreement.
- Waiver. In any case in which foreign law would (but for a waiver) prevent the reporting required of the FFI with respect to an account owned by a United States person or a United States owned foreign entity, the FFI will obtain a valid and effective waiver of such law, and if a valid and effective waiver is not obtained within a reasonable time, will close the account.
- Verification. The FFI will adopt written policies and procedures for identifying and documenting account holders and for carrying out its withholding and reporting requirements. The FFI must conduct periodic reviews of its compliance with the policies, and a responsible officer of the FFI must certify to the IRS its compliance with the requirements of the FFI agreement. The IRS may request further information and may require compliance to be verified by an external auditor approved by the IRS.
FFIs which hold accounts (including debt and equity interests) in FFIs that receive withholdable payments will have to comply with the requirements of FATCA or be subject to withholding on payments made to its accounts.
- Avoiding Withholding on Payments Made to NFFEs
A withholding agent does not withhold under FATCA on any payment made to an NFFE if the following conditions are met:
- the beneficial owner of the payment is the NFFE or any other NFFE;13
- the withholding agent has received information (generally from the NFFE itself) which allows it to treat the NFFE as an NFFE that has no substantial United States owners or as an NFFE that has identified its substantial United States owners; and
the withholding agent reports to the IRS the following information (also generally received from the NFFE) with respect to each substantial United States owner:
- the name of such owner;
- the taxpayer identification number of each such owner;
- the mailing address of each such owner; and
- any other information required by the designated form and accompanying instructions.
The following NFFEs are exempt from withholding:
- a corporation, the stock of which is regularly traded on one or more established securities markets and any corporation which is part of the same expanded affiliated group with such corporation;
- any entity formed in a United States territory which is directly or indirectly wholly owned by bona-fide residents of such territory;
- any entity of the type set forth in the second paragraph of footnote 6;
- any entity if less than 50 percent of its gross income for the preceding calendar year is passive income (as specially defined) or less than 50 percent of the assets held by the NFFE at any time during the preceding calendar year are assets that produce or are held for the production of passive income;14 and
- any entity described in Section III (a)-(e) above.
The NFFE will generally need to provide the withholding agent with documentation supporting its qualification for any such exemptions.
NFFEs which hold accounts (including debt and equity interests) in FFIs that receive withholdable payments have to comply with the requirements of FATCA or be subject to withholding on payments made to its accounts.
As noted above, withholding under FATCA applies whether or not the amount is otherwise taxable under the Code. Thus, a beneficial owner15 of a payment may apply for a refund to the extent that such beneficial owner would not otherwise be taxable on an amount withheld under FATCA. If the beneficial owner demonstrates that it is qualified for full or partial exemption from taxation pursuant to a tax treaty, the refund will be granted to the extent of such full or partial exemption. However if the beneficial owner of the payment is an FFI, no further refund will be granted and no interest will be paid on the amount refunded due to a treaty exemption. An NFFE will be entitled to receive a refund due to the application of a treaty provision, but if no treaty provision applies, in order to obtain a refund the NFFE will be required to deliver to the IRS the identifying information which would have prevented the withholding.
Treasury intends to have regulations under FATCA finalized later this year. Although the proposed regulations contain comprehensive procedures to be followed by withholding agents and payees, many details remain open. The proposed regulations mitigate some of the administrative burdens associated with procedures set forth in prior IRS notices, and the final regulations may further relieve the burden. Nevertheless, the costs and challenges of complying with these rules will be significant.
The IRS expects to finalize a form of FFI agreement by the fall of 2012. The current position of the IRS is that an FFI must sign such an agreement by June 30, 2013 in order to be considered a compliant FFI when FATCA starts to become operative on January 1, 2014.
Every entity filing an FFI agreement and every entity registering as a deemed compliant FFI will receive an identification number (an “FFI-EIN”) for purposes of FATCA. The IRS will publish a list of FFI-EINs which must be consulted by withholding agents.
It is intended that withholding under FATCA will be coordinated with withholding under Chapter 3. The reporting forms under Chapter 3 will be modified to encompass withholding under FATCA, and certain agreements with the IRS entered into by foreign entities pursuant to Chapter 3, such as qualified intermediary agreements and withholding partnership or trust agreements, will be modified to include provisions with respect to FATCA.
It is also possible that procedures may be developed in coordination with other countries as an alternative to FATCA. On the same day the proposed regulations were announced, Treasury and the governments of France, Germany, Italy, Spain and the United Kingdom issued a joint statement that outlines those countries’ intention to explore common approaches to facilitating information reporting of the type covered by FATCA. Under a possible framework, FFIs in a participating jurisdiction would report information relevant under FATCA to the government of such jurisdiction, which would relay the information to the United States. FFIs in such jurisdiction would not be subject to withholding under FATCA, would not have to withhold on payments to recalcitrant account holders, and would not have to terminate the accounts of recalcitrant account holders.