The Foreign Account Tax Compliance Act (“FATCA”) legislation signed into law in March 2010 is designed to curb offshore tax evasion by U.S. taxpayers and will have a profound impact on the insurance industry when it becomes effective on 1 January 2013. FATCA applies to “foreign financial institutions” (“FFIs”), generally banks and other custodians of property, as well as entities that primarily engage in investing, trading or reinvesting in securities. Guidance issued by the Internal Revenue Service (“IRS”) clarifies that insurance companies, other than a company that issues only property and casualty policies, would be considered an FFI and subject to FATCA.

As a general matter, FATCA imposes a 30 percent withholding tax on certain “withholdable payments” to FFIs, including payments of U.S. source income and on gross proceeds from the sale of property that produces U.S. source dividends and interest (e.g., U.S. securities). In some cases, FATCA’s withholding tax would be imposed on certain “passthru payments,” which are payments that are not themselves withholdable payments but are attributable to a withholdable payment (e.g., non-U.S. source interest where the borrower has derived income from U.S. sources).

In order to avoid the imposition of FATCA’s withholding tax, an FFI must enter into an agreement with the IRS that would require that the FFI conduct certain due diligence with respect to its clients and be obligated to report information pertaining to US clients to the IRS. To the extent that a client fails to provide the FFI with sufficient information needed by the FFI to conduct its due diligence obligations, the client would be considered “recalcitrant” and withholdable or passthru payments made to the client’s account would be subject to a 30 percent withholding tax. In particular, the IRS considers a life insurance policy that has a cash value to be the equivalent of a bank or securities account. Accordingly, an insurance company that issues such policies would, pursuant to FATCA, be obligated to conduct due diligence and information reporting with respect to such policies. In certain instances, an FFI may be required to terminate its relationship with a recalcitrant client.

To the extent that an insurance company enters into an agreement with the IRS such that withholding tax is not imposed on payments to the insurance company, an insurance company may be obligated to withhold tax on payments made to its clients. As discussed further below, if an insurance company is required to treat a client as a recalcitrant client, the insurance company may be obligated to treat the payment of death benefits as a passthru payment subject to FATCA’s withholding tax. The possibility of withholding tax being imposed on the payment of death benefits is likely to be a significant concern to the industry. Additionally, to the extent that a recalcitrant client receives a payment with respect to the surrender of a policy, such payment is likely to also be treated as a passthru payment subject to FATCA’s withholding tax.

In the context of the insurance industry, FATCA’s due diligence and information reporting requirements pose several concerns that differ from other financial institutions. One area of concern relates to the different types of insurance products that may be subject to the client identification and reporting requirements. Generally, FATCA looks to whether the FFI has “U.S. accounts,” which do not, in practice, relate to products offered by insurance companies. For example, private placement insurance products, insurance wrappers, and separate account policies may be treated as accounts for purposes of FATCA. Accordingly, insurance companies will need to identify which of their products may be equivalent to an account for purposes of FATCA.

Insurance companies may not have sufficient information on hand needed to comply with the proposed account due diligence rules. In some instances, insurance companies do not collect or review documentary evidence or IRS forms that are necessary to identify the beneficial owner of the policy for U.S. federal income tax purposes. Accordingly, an insurance company may not be in a position to identify a policy holder as a U.S. or non-U.S. person. Insurance companies, unlike banks and other financial institutions, are likely to have limited contact with existing clients and could have difficulty in obtaining information needed to conclude that a client is not a U.S. person. It is possible that the insurance industry may have a greater amount of clients treated as recalcitrant clients subject to FATCA’s withholding tax, as discussed above. Moreover, to the extent that an insurance company is obligated to treat a client as a recalcitrant client, because the company has not received such information from a client, the company is often barred by local law from cancelling the client’s policy.