The Foreign Account Tax Compliance Act of 2009 ("FATCA") was enacted by the US to prevent offshore tax evasion by "US persons". This note looks at the impact of FATCA on UK pension arrangements, both occupational and contract-based and explains why the exemptions proposed in the latest draft FATCA regulations intended to cover non- US retirement schemes may not work for UK registered pension schemes. It also considers a proposed "inter-governmental" domestic approach to FATCA to determine whether, if the FATCA exemptions are not revised in favour of UK retirement schemes, it could make compliance with FATCA easier.
FATCA requires non-US financial institutions ("FFIs") to register with the US Internal Revenue Service ("IRS"), perform due diligence to identify US accounts and report client data to the IRS. Any FFIs that do not comply face a 30% withholding tax on US sourced income or payments. The reporting requirements are onerous and will be costly. However, FFIs must either comply with FATCA or, if they are not willing to do so, be subject to the withholding tax or exit the US capital markets.
WHY DOES FATCA AFFECT PENSION SCHEMES?
The definition of an FFI is wide enough to include non-US pension schemes. The definition includes an organisation that "holds financial assets for the account of others" which is broadly what trustees of occupational pension schemes do in respect of assets held on trust for the members of their schemes. The definition will therefore impact directly on pension schemes, as well as indirectly because it will also include insurance companies which administer group and personal pension scheme arrangements and invest the assets of those arrangements.
The US capital markets are substantial. Whilst in theory UK pension schemes could decide to withdraw from those markets in response to FATCA, in practice this would be impractical. It would put significant limitations on a pension scheme's investment options and arguably make it much more difficult for trustees of occupational pension schemes to comply with their duties in respect of the investment of scheme assets.
THE STORY SO FAR
Draft regulations giving effect to FATCA were issued in 2010 and these resulted in a huge volume of comments, not least from the UK pensions industry, because the exemption intended to cover non-US retirement schemes was not workable.
The exemption excluded pension schemes which had US citizens as members or beneficiaries unless those US citizens worked for the sponsoring employer in the country in which the scheme was established. This exemption would not have worked in practice as most pension schemes would not know whether their membership included US citizens. In particular if would have been difficult for a pension scheme to know whether members' dependants were US citizens.
The UK pensions industry proposed that the IRS instead exempted all tax qualified retirement schemes based in those countries (such as the UK) with a double tax treaty with the US.
The eagerly awaited revised draft regulations were issued in March 2012 and introduce two exemptions - the "certified deemed-compliant" and "exempt beneficial owner" exemptions - which are intended to cover FFIs viewed as being low-risk, such as non-US retirement schemes.
THE NEW EXEMPTIONS
A "certified deemed-compliant" FFI will not be required to identify US accounts or comply with verification and due diligence procedures and will be exempt from the 30% withholding tax. It must certify to the withholding agent that it meets the requirements for a "deemed-compliant" FFI. It will not need to register with the IRS. Payments to an FFI which meets the "exempt beneficial owner" requirements will be exempt from the 30% withholding tax.
A non-US retirement plan will be "deemed-compliant" (and its accounts will be exempted from the definition of "financial accounts" with respect to which reporting might be required) if it:
- is formed for the provision of retirement or pension benefits under the law of the country in which it is established;
- receives all of its contributions from government, employer or employee contributions that are limited by reference to earned income;
- does not have a single beneficiary with a right to more than five per cent of the retirement plan's assets; and
- is either exempt from tax on investment income under the laws of the country in which it is established or in which it operates due to its status as a retirement plan, or receives 50% or more of its total contributions from the government and the employer.
PROBLEMS WITH THE EXEMPTION
The "contributions limited by reference to earned income" requirement could cause difficulties for UK defined benefit pension arrangements because, although total benefits are typically linked to income, employers make deficit or other contributions that may not be limited in this way. In defined contribution arrangements, employer and member contributions are typically calculated by reference to income but problems might arise in relation to employer contributions to meet the administrative or other expenses.
"EXEMPT-BENEFICIAL OWNER" EXEMPTION
A non-US retirement scheme will fall within this exemption if it is:
- the beneficial owner of payments credited to the scheme deriving from US investments;
- established in a country with which the US has an income tax treaty in force;
- generally exempt from income tax in that country;
- operated principally to administer or provide pension or retirement benefits; and
- entitled to benefit under the income tax treaty on USsource income.
PROBLEMS WITH THE EXEMPTION
This exemption broadly describes a typical UK tax-registered pension scheme. However, under UK law a pension scheme has no legal personality. It is, therefore, not itself the beneficial owner of payments credited to the pension scheme deriving from scheme investments. It is the trustees (in the case of a trust-based scheme) or the administrator (in the case of a contract-based scheme) who legally (rather than beneficially) own scheme assets, including investments. The scheme member or members have a beneficial interest in (rather than ownership of) those investments.
This means that, on a strict interpretation, the "beneficial owner" requirement might not be met and the exemption could not, therefore, be relied on by UK pension schemes. This is frustrating as it is clearly the IRS's intention that taxfavoured pension schemes should fall within the exemption.
The term "beneficial owner" is interpreted helpfully for pension schemes in the US/UK Double Taxation Treaty (see box below) and it is to be hoped that the same interpretation will be used in relation to FATCA.
International fiscal meaning of beneficial owner
The term "beneficial owner" is also used in the US/UK Double Taxation Treaty (the “Treaty”). Under the Treaty a tax exempt pension scheme resident in the UK is viewed as the beneficial owner of dividends paid in the US subject to certain conditions being met. The conditions are that the pension scheme must not be entitled to US dividends derived from the carrying on of a business, directly or indirectly, by the pension scheme and more than 50% of the beneficiaries, members or participants of the scheme must be a resident of either the UK or the US.
The Treaty definitions of "pension scheme" and the concept of "beneficial owner" have been extended to include trustbased pension scheme investment pooling arrangements, and (subject to certain conditions being met) UK resident unit trusts in which a UK pension scheme participates, and funds, schemes or arrangements to which a UK pension scheme contributes by paying premiums to an insurance company.
The IRS has been asked to confirm that the concept of a "beneficial owner" used in the FATCA regulations would be interpreted in the same way as it is under the Treaty.
The IRS has also been asked to consider an amendment to the "contributions by reference to earned income" requirement.
In the absence of appropriate clarification from the IRS it would be impossible for the majority of UK pension schemes to meet the requirements and so rely on the "exemptbeneficial owner", "deemed-compliant FFI" or "financial account" exemptions.
On 8 February 2012, the US, UK and a number of other European countries including France and Germany announced their intention to adopt an inter-governmental approach with the intention of implementing FATCA and improving international tax compliance through domestic reporting and the reciprocal automatic exchange of information on accounts held in US financial institutions. This will be based on existing double tax treaties. This approach is intended to overcome problems for FFIs under existing national data transfer and privacy laws by providing for government-to-government transfers of data, rather than the transfer of data by FFIs individually to the IRS.
On the one hand, the inter-governmental approach should reduce the administration costs involved for FFIs in identifying and reporting client information because reporting will be to the domestic government, not the IRS (although it seems that FFIs will still need to register with the IRS unless exempted from this requirement under the agreement or FATCA guidance). And, the fact that compliance will be based on existing double tax treaties should mean that UK pension arrangements which are subject to favourable treatment under the Treaty can feel more confident that they will be treated as exempt.
However, it is not clear how FATCA and the intergovernmental approach will work together in practice and there have been concerns raised that the inter-governmental approach might simply add another layer of compliance.
The IRS announced, at the end of 2011, that final FATCA regulations would be issued in Summer 2012. The IRS has publicly stated that it views pension schemes as low risk. The hope is that it will revise the two draft exemptions in line with the UK pension industry's comments. It would be a shame if UK pension schemes were not exempted because of a misunderstanding of the way they work in practice.
A version of this note first appeared as an article in the July 2012 issue of PMI News