On February 8, 2012, the Treasury Department and the Internal Revenue Service released muchanticipated proposed regulations under the Foreign Account Tax Compliance Act (“FATCA”). The proposed regulations provide significant guidance regarding the due diligence, withholding, and reporting obligations of persons affected by FATCA. The proposed regulations also indicate a revised timeline for FATCA’s implementation and detail new exceptions from its application.

General Background

FATCA, enacted as part of the Hiring Incentives to Restore Employment Act on March 18, 2010, added Sections 1471 through 1474 to the Internal Revenue Code (the “Code”). FATCA is an effort to combat tax avoidance by U.S. taxpayers through the use of offshore accounts and offshore intermediaries. To accomplish this objective, FATCA amends the Code by imposing new U.S. information reporting and withholding requirements on “foreign financial institutions” (“FFIs”) that maintain “United States Accounts.” An FFI includes any foreign entity that (i) accepts deposits in the ordinary course of a banking or similar business; (ii) holds financial assets for the accounts of others as a substantial portion of its business; or (iii) is engaged (or holds itself out as being engaged) primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, or any interest (including a futures or forward contract or option) in such securities, partnership interests, or commodities. This broad definition encompasses most foreign investment vehicles, including foreign hedge funds, private equity funds, venture capital funds, CLOs, and CDOs.  

FATCA also imposes increased disclosure obligations on certain “non-financial foreign entities” (“NFFEs”) (defined as foreign entities that are not FFIs) that present a high risk of tax avoidance. Generally, NFFEs must certify they have no significant U.S. owners or disclose those owners to avoid withholding. However, NFFEs are subject to less onerous information reporting and withholding requirements than FFIs.  

Generally, FATCA requires FFIs (but not NFFEs) to enter into an agreement (an “FFI Agreement”) with the IRS to comply with verification, due diligence, and information reporting procedures with respect to “United States Accounts,” which are defined as financial accounts held by U.S. taxpayers and foreign entities with substantial (i.e., greater than 10%) U.S. owners. FFIs that comply with these requirements will be considered “participating FFIs” (“PFFIs”).  

FFIs that do not sign an FFI Agreement and PFFIs and NFFEs that fail to comply with their reporting obligations under the FATCA rules will be subject to a 30% withholding tax on withholdable payments made to them. Withholdable payments include any payment of interest, dividends, rents, and other fixed or determinable annual or periodical gains, profits, and income (“FDAP income”), if from sources within the U.S. Withholdable payments also include gross proceeds from the sale or disposition of any property of a type that can produce interest or dividends from U.S. sources.  

FATCA also requires PFFIs to withhold on “passthru payments” (which, as discussed below, include both “withholdable payments” and certainnon-U.S. source payments, referred to as “foreign passthru payments”) made to “recalcitrant account holders” (i.e., account holders that will not provide the required information to determine if such accounts are United States Accounts) and to other FFIs that do not sign an FFI Agreement with the IRS (such FFIs are referred to as “non-PFFIs”).  

The IRS previously released three notices, Notice 2010-60, Notice 2011-34, and Notice 2011-53, containing preliminary guidance on the implementation of FATCA.1 The proposed regulations build on much of the guidance contained in these Notices, with several important changes.  

Highlights of the Proposed Regulations

1. Expansion of Grandfathering Period for Certain Obligations

As originally enacted, FATCA grandfathered certain obligations outstanding on March 10, 2012 from its withholding requirements. To help facilitate the implementation of FATCA, the proposed regulations extend the grandfathering by excluding from the definition of “withholdable payment” or “passthru payment” any payment under, or gross proceeds from the disposition of, any obligation outstanding on January 1, 2013.  

An obligation for this purpose is any legal agreement that produces or could produce a withholdable payment or passthru payment. Obligations do not include, however, instruments treated as equity for U.S. tax purposes or instruments that lack a stated expiration or term (i.e., demand deposits). Obligations also do not include agreements to hold financial assets for others’ accounts. Further, a material modification of a grandfathered obligation will result in the obligation being treated as though newly issued on the date of the modification.  

The proposed regulations set forth the following as examples of agreements that can constitute “obligations”:  

  • Debt instruments, as defined under the Code (for example, a bond, guaranteed investment certificate, or term deposit);  
  • Binding agreements to extend credit for a fixed term (such as a line of credit or a revolving credit facility), if the material terms under which credit will be provided are fixed;  
  • Life insurance contracts that are payable upon either death or attaining a specific age;  
  • Term certain annuity contracts; and  
  • Derivatives transactions entered into between counterparties under an ISDA Master Agreement and evidenced by a confirmation.  

2. Transitional Rules for Affiliates with Legal Prohibitions on Compliance

Notice 2011-34 stated that the Treasury and IRS intend to require that each FFI that is a member of an expanded affiliated group must be a PFFI or deemed-compliant FFI (discussed further below) in order for any FFI in the expanded affiliated group to be treated as a PFFI. Treasury and IRS recognized, however, that some foreign jurisdictions have laws in place that prohibit an FFI’s compliance with certain FATCA requirements. In response to this, the proposed regulations provide a transition period for the full implementation of this requirement. Until January 1, 2016, a non-PFFI affiliate in a jurisdiction that prohibits reporting or withholding under FATCA will not prevent other FFIs in the same affiliated group from becoming PFFIs. For the affiliated PFFIs to qualify, the non-PFFI affiliate must agree to perform due diligence to identify its United States Accounts, maintain certain records, and meet certain other requirements. Similar rules also apply to branches of FFIs that are subject to prohibitions preventing FATCA compliance.  

3. Easing of Due Diligence Procedures for Identifying United States Accounts

PFFIs must perform due diligence to identify and report United States Accounts, recalcitrant account holders, and NFFE accounts. Notices 2010-60 and 2011-34 provided preliminary guidance regarding the required diligence procedures. In response to comments received, however, the proposed regulations outline several changes meant to ease the administrative burden on PFFIs by focusing primarily on electronic reviews of preexisting accounts. The regulations delineate the due diligence necessary for individual and entity accounts, for both existing accounts and accounts opened after the effective date of an FFI Agreement. The following summarizes the PFFIs’ diligence requirements.  

For preexisting individual accounts:

  • Accounts with balances or values of $50,000 or less are generally not treated as United States Accounts for FATCA reporting purposes and are thus exempt from due diligence review.  
  • Certain cash value insurance contracts with a value or balance of $250,000 or less are exempt from due diligence review.  
  • Accounts with a balance or value exceeding $50,000 but not $1,000,000 are subject to review of electronically searchable data for indicia of U.S. status. U.S. indicia include:
    • Identification of an account holder as a U.S. person;  
    • A U.S. place of birth;  
    • A U.S. address;  
    • A U.S. telephone number;  
    • Standing instructions to transfer funds to an account maintained in the U.S.;  
    • A power of attorney or signatory authority granted to a person with a U.S. address; or  
    • A U.S. “in care of” or “hold mail” address, if the only address identified for the account.  
  • Accounts with a balance exceeding $1,000,000 are subject to review of electronic and non-electronic files for U.S. indicia, including an inquiry of the actual knowledge of any relationship manager associated with the account. A manual review is limited to current files and is required only to the extent that the electronically searched files do not contain sufficient information.  

For preexisting entity accounts:  

  • Accounts with balances of $250,000 or less are exempt from due diligence procedures (until the balance exceeds $1,000,000).  
  • For remaining accounts, PFFIs can generally rely on anti-money laundering/know your customer (“AML/KYC”) records and other existing account information to determine whether the entity is an FFI, is a U.S. person, is excepted from documenting its substantial U.S. owners (for example, because it is engaged in a nonfinancial trade or business), or is a passive investment entity.  
  • For passive investment entities that have accounts in excess of $1,000,000, the PFFI must obtain information regarding all substantial U.S. owners or a certification that the entity does not have any substantial U.S. owners.  

For new individual accounts:

  • PFFIs must review the information provided at opening, including identification and any documentation under AML/KYC rules. If U.S. indicia are found, the FFI must obtain additional documentation or treat the account as held by a recalcitrant account holder. Accordingly, FFIs will generally not need to make significant changes to the information collected during the account opening process in order to identify United States Accounts, except to the extent that U.S. indicia are identified.  

For new entity accounts:

  • Accounts of other FFIs (other than owner-documented FFIs for which the PFFI has agreed to perform reporting) and entities engaged in an active nonfinancial trade or business are exempt from documentation of substantial U.S. owners.  
  • For all other entities, PFFIs must determine whether the entity has any substantial U.S. owners upon opening a new account. This is generally done by obtaining a certification from the account holder.  

4. The Definition of Financial Account

Under the Code, a “financial account” for FATCA purposes is any depository account, any custodial account, and any equity or debt interests in an FFI, other than interests regularly traded on established securities markets. The proposed regulations refine this definition to focus on traditional bank, brokerage, and money market accounts, and interests in investment vehicles, but include cash-value insurance contracts and annuity contracts issued by FFIs. The regulations exclude most debt and equity securities issued by banks and brokerage firms, as well as life insurance contracts that do not have a cash value, accounts held by exempt beneficial owners, and certain tax-favored retirement or pension fund savings accounts.  

5. Passthru Payments

FATCA requires PFFIs to withhold on passthru payments made to non-PFFIs and recalcitrant account holders. Under the proposed regulations, passthru payments include both withholdable payments and “foreign passthru payments” (passthru payments that are attributable to withholdable payments but are not themselves withholdable payments). The definition of “foreign passthru payment” is currently reserved for in the proposed FATCA regulations.  

As discussed above, withholdable payments include any FDAP income and gross proceeds from the sale or disposition of any property of a type that can produce interest or dividends from U.S. sources. PFFIs must begin to withhold on these payments on January 1, 2014.  

The proposed regulations reserve the definition of foreign passthru payments.2 Notice 2011-53 provided that PFFIs would not be obligated to withhold on foreign passthru payments made before January 1, 2015. In response to numerous comments regarding the cost and administrative complexity of identifying foreign

passthru payments, the proposed regulations provide that withholding will not be required with respect to foreign passthru payments before January 1, 2017. The proposed regulations do require, however, that PFFIs must report to the IRS annually the aggregate amount of certain payments made to each non-PFFI. This is meant to reduce the incentives for non-PFFIs to use PFFIs as “blockers” to avoid the application of FATCA.  

6. Deemed-compliant FFIs

The Treasury and IRS have the authority to authorize certain FFIs as “deemed-compliant” FFIs, and earlier notices have identified certain types of FFIs that would qualify. Such deemed-compliant FFIs may avoid FATCA withholding without having to enter into an FFI Agreement. The proposed regulations implement the exemptions provided in the earlier notices and expand the category of deemed-compliant FFIs. The proposed regulations also expand the category of retirement plans treated as posing a low risk of tax evasion.  

The proposed regulations provide that deemed-compliant FFIs can be either “registered” or “certified.” Registered deemed-compliant FFIs must register with the IRS and certify at least every three years that certain procedural requirements will be followed. Certified deemed-compliant FFIs are not required to register with the IRS but must use a Form W-8 to certify to a withholding agent that they meet certain requirements.  

Under the proposed regulations, FFIs that will be eligible to become registered deemed-compliant FFIs include:  

  • Local FFIs;  
  • Non-reporting members of PFFI groups;  
  • Qualified collective investment vehicles (an investment vehicle regulated as such by its country of incorporation or organization; all direct holders must be PFFIs, deemed-compliant FFIs, or exempt beneficial owners);  
  • Restricted investment funds (an investment fund incorporated or organized in a Financial Action Task Force compliant jurisdiction, regulated as such by its country of incorporation or organization, that (i) sells interests through compliant distributors only; (ii) has agreements prohibiting sales of interests to U.S. persons, non-PFFIs, or passive NFFEs with any substantial U.S. owners; and (iii) complies with account identification and redemption rules); and  
  • FFIs that comply with an agreement between the U.S. and the jurisdiction in which the FFI is located (see “Intergovernmental Framework” below).  

Because the types of entities that can qualify as “qualified collective investment vehicles” or “restricted investment funds” is so limited, compliance with FATCA is effectively mandated for foreign investment funds located outside the U.S. that are managed from within the U.S. and that trade in U.S. securities and commodities. Furthermore, many foreign limited companies that serve as feeder funds or investment managers will also be required to become FATCA compliant. Although the cost of compliance will be high, failure to enter into an FFI Agreement could make investing in the U.S. capital markets cost-prohibitive.  

FFIs that will be eligible to become certified deemed-compliant FFIs under the proposed regulations include:  

  • Non-registering local banks;  
  • Retirement plans;  
  • Non-profit organizations;  
  • FFIs with only low-value accounts (no account in excess of $50,000; affiliated group does not have assets in excess of $50,000,000); and  
  • Owner-documented FFIs (but only certified deemed-compliant with respect to a specific withholding agent; that agent must be a PFFI or a U.S. institution).  

7. Refunds

A beneficial owner may claim a refund for an overwithheld amount, to the extent withholding on a payment under FATCA exceeds the owner’s underlying U.S. tax liability. Non-PFFIs, however, may not seek a refund for payments beneficially owned by them, except if otherwise required under an income tax treaty. Under the proposed regulations, an NFFE claiming a refund (other than as required by treaty) must provide information regarding its substantial U.S. owners or a certification that it does not have any substantial U.S. owners.  

8. Expanded Categories of Non-Financial Foreign Entities Exempt from FATCA

The proposed regulations expand the types of NFFEs that are exempt from withholding tax and information reporting under FATCA, including certain publicly traded companies and their affiliates, NFFEs predominantly engaged in active businesses, and nonfinancial holding companies.  

Intergovernmental Framework

On February 8, 2012, the Treasury, France, Germany, Italy, Spain, and the United Kingdom issued a joint statement outlining an intergovernmental framework as an alternative to FATCA. Under this framework, the U.S. and a country with which the U.S. signs an agreement (the “FATCA Partner”) will create automatic exchanges of information.  

In this alternative, the U.S. and the FATCA Partner would enter into an agreement under which the FATCA Partner would require FFIs within that country to perform due diligence to collect and report information directly to that country’s tax authority. This information would then be automatically transferred to the U.S. In return, the U.S. would agree to reciprocal collection and reporting of information to FATCA Partners. For certain FFIs located in a FATCA Partner, the U.S. would allow the FFIs to avoid entering into FFI Agreements with the IRS. These FFIs would also not be required to terminate recalcitrant account holder accounts or impose passthru payment withholding on recalcitrant account holders or FFIs organized in any FATCA Partner jurisdiction. The U.S. government plans to include more countries in this framework in the future.  

Additional IRS guidance

The IRS will hold a public hearing on May 15, 2012. Final regulations are expected to be published in the summer of 2012, and the Treasury has announced that it plans to release a draft model FFI Agreement by mid- 2012. The Treasury also plans to modify the existing Qualified Intermediary,

Withholding Partnership, and Withholding Trust agreements to better coordinate with FATCA.  

FATCA Timeline

March 18, 2010

  • FATCA enacted.  

August 27, 2010

  • IRS issues Notice 2010-60, 2010- 37 I.R.B. 329, which provided preliminary FATCA guidance.  

April 8, 2011

  • IRS issues Notice 2011-34, 2011- 19 I.R.B. 765, which supplemented Notice 2010-60.  

July 14, 2011

  • IRS issues Notice 2011-53, 2011- 32 I.R.B. 124, which provided a timeline for the implementation of FATCA.  

February 8, 2012

  • IRS issues proposed regulations and the intergovernmental statement.  

Summer 2012

  • Final regulations and draft FFI Agreement anticipated.  

January 1, 2013

  • Obligations outstanding as of this date, and gross proceeds from the sale of such obligations, are not subject to FATCA.
  • IRS begins accepting FFI Applications through its electronic submissions process.  

June 30, 2013

  • FFI Applications submitted before this date will be effective on July 1, 2013, and will avoid withholding beginning January 1, 2014. FFI Applications submitted after this date will be effective as of the date entered into with the IRS.  

January 1, 2014

  • Withholding on U.S.-source FDAP payments (including passthru payments that are withholdable payments) begins.  
  • Reporting of name, address, TIN, account number, and account balance with respect to United States Accounts begins (for calendar year 2013). Reports are due by September 30, 2014, with respect to calendar year 2013. Reports thereafter are due by March 31 of each succeeding year.  

January 1, 2015

  • Withholding on gross sales proceeds begins. January 1, 2016  
  • Reporting expanded to include income associated with United States Accounts (for calendar year 2015).  

January 1, 2017

  • Withholding on foreign passthru payments begins (no earlier than this date).  
  • Full reporting, including information on the gross proceeds from broker transactions, begins (for calendar year 2016).