On January 17, 2013, the US Internal Revenue Service (IRS) released final Treasury regulations (the Regulations) under sections 1471 through 1474 of the US Internal Revenue Code of 1986, as amended (Code), commonly referred to as the Foreign Account Tax Compliance Act (FATCA). Although the Regulations are unclear in many respects and could be further modified in the future, non-US entities1 that intend to comply with FATCA should begin preparing for FATCA now, if they have not already done so. Identifying its Related Entities and the members of its expanded affiliated group should be a foreign financial institution’s (FFI’s) first step toward compliance with the FATCA regime.

This White Paper is part of a series of Latham & Watkins publications highlighting significant developments under FATCA and outlining some of the major workstreams that FFIs must complete in order to comply with FATCA.2 The discussion below addresses a group of entities that has:

  1. determined that at least one member is an FFI as defined under FATCA or an applicable intergovernmental agreement (IGA)3 between the United States and the applicable foreign country in which the FFI is resident (or a branch of the FFI is located) and
  2.  decided to comply with FATCA by having each member either (i) enter into an agreement (FFI Agreement) with the IRS to comply with the requirements specified under the Regulations (which requirements may be modified by an applicable Model 2 IGA) or (ii) comply with similar requirements under an applicable Model 1 IGA, if resident in a Model 1 IGA country. For purposes of this discussion, an FFI satisfying item (i) or (ii) above will be referred to as a “Reporting FFI.”

Relevance of Expanded Affiliated Group and Related Entities

One of the first actions a Reporting FFI must take to become FATCA-compliant is to determine which entities are part of its “expanded affiliated group” under the Regulations and/or are “Related Entities” under an applicable IGA. Properly identifying all members of an expanded affiliated group and Related Entities (the FATCA Group) is critical for many reasons. Most importantly, to be treated as FATCA-compliant under the Regulations, every other FFI in such FFI’s expanded affiliated group generally also must be FATCA-compliant.4 The model IGAs appear to impose a similar requirement that all Related Entities of a Reporting FFI be FATCA-compliant if they are also FFIs, subject to exceptions.5

A Reporting FFI’s expanded affiliated group also implicates many other aspects of FATCA compliance. For example, under certain circumstances a Reporting FFI may treat a new account as a “preexisting obligation” (which requires less onerous FATCA due diligence) if the account holder has a preexisting account with another member of the expanded affiliated group.6 In addition, some or all of the members of an expanded affiliated group may elect to be part of a consolidated compliance program. Furthermore, many important determinations, such as whether an entity is an FFI, may depend in part on the composition of the entity’s expanded affiliated group.

Expanded Affiliated Group and Related Entities Defined

An expanded affiliated group is composed of one or more chains of “includible corporations”7 connected through stock ownership with a common parent (which is also treated as an includible corporation), where:

  1.  the common parent directly owns stock meeting the ownership requirement of at least one of the other members of the expanded affiliated group, and
  2. stock meeting the ownership requirement in each of the members (other than the common parent) is owned directly by one or more of the other members of the expanded affiliated group.

For this purpose, the ownership requirement is met if (1) more than 50 percent of the total voting power of the includible corporation is owned and (2) more than 50 percent of the total value of the includible corporation’s stock is owned.8

Although not entirely clear, if (1) an includible corporation holds an option or warrant to acquire stock in another includible corporation, an obligation convertible into such stock or other similar interest and (2) it is “reasonably certain” that the owner of such interest will exercise its right to acquire such stock, such owner could be treated as owning such stock for purposes of determining whether an includible corporation is a member of an expanded affiliated group. In addition, an entity that is not treated as a corporation for US federal income tax purposes (Passthrough Entity) will be treated as part of an expanded affiliated group if the members (including other member Passthrough Entities) of such group “control” such entity. For this purpose, control means direct or indirect ownership of more than 50 percent of the value of the beneficial interests9 in such entity.10 The Regulations exclude from the expanded affiliated group certain investment entities that were formed with “seed capital” from a member of the expanded affiliated group (the Seed Capital Exception).

A Reporting FFI subject to an IGA must determine which entities are “Related Entities.” The definition of a Related Entity differs from the definition of a member of an expanded affiliated group. An entity is a Related Entity of another entity if either entity controls the other entity, or the two entities are under common control. For this purpose, control includes direct or indirect ownership of more than 50 percent of the vote or value of such entity.11 However, under the terms of its IGA, the foreign country has the option not to treat an entity as a Related Entity for purposes of its IGA, if such entity would not have been a member of the expanded affiliated group, as defined under FATCA. If a Reporting FFI has a Related Entity or branch that operates in a country whose laws prevent such Related Entity or branch from fulfilling the requirements under FATCA, the failure of such Related Entity or branch to comply with FATCA will not cause the Reporting FFI to be treated as failing to comply with its FATCA obligations as long as specified requirements are met.12 Neither model IGA explicitly provides a Seed Capital Exception.

Identifying Members of the FATCA Group

Identifying members of the FATCA Group may be straightforward for smaller groups of entities with simple ownership structures. However, for large institutions with hundreds, if not thousands, of entities within its ownership structure, merely taking inventory of potential members of the expanded affiliated group and Related Entities will require substantial time and effort. Entities formed for special purposes, such as temporarily to hold specific assets or to engage in a specific activity, may have been formed with no centralized database tracking their existence. If a Reporting FFI cannot ensure that an electronic search will identify all possible entities that are part of its expanded affiliated group or are Related Entities, alternative measures should be considered, such as distributing questionnaires to relevant employees asking them to identify known entities that may be part of the FATCA Group. Going forward, Reporting FFIs should consider implementing a system, automated to the extent possible, that will comprehensively track when new members of the FATCA Group are created or acquired and when members are dissolved or otherwise leave the FATCA Group.13

Once the initial list of potential FATCA Group members has been created, the potential FATCA Group must determine whether (1) all potential members are resident in IGA countries, (2) all potential members are resident in countries where no IGAs are in effect or (3) some potential members are resident in IGA countries and some potential members are resident in non-IGA countries. A FATCA Group described in scenario (1) will determine which of the potential members on its initial list meet the definition of Related Entity provided under the applicable IGAs with respect to the other potential members. A FATCA Group described in scenario (2) will determine which of the potential members on the initial list are members of the expanded affiliated group.

A FATCA Group described in scenario (3) initially may want to determine its FATCA Group under both the Regulations’ definition of the expanded affiliated group and the IGA definition of Related Entities. Two entities could possibly be treated as Related Entities, but would not have been treated as members of the same expanded affiliated group.14 If the relevant IGA country has elected to apply the rule treating such entities as not Related Entities in such circumstances, then both definitions necessarily apply to determine which entities are part of the same FATCA Group. Also possible, but probably far less common, two entities could be treated as members of the same expanded affiliated group but not be Related Entities under an IGA.15 In such a situation, if the entity in the non-IGA country is an FFI and chooses not to comply with FATCA, but the other entity is an FFI resident in a Model 1 IGA country and complies with the requirements under the IGA, the IGA-resident entity should be treated as FATCA-compliant. This result is less clear if such entity is located in a Model 2 IGA country.16 In determining which entities are part of the expanded affiliated group under the Regulations, determining whether an entity is a Passthrough Entity or a corporation for US federal income tax purposes may be necessary, because the determination differs depending on the entity status.17 Entity status is generally irrelevant under the IGA definition of Related Entities, as the test is generally the same whether the entity is a Passthrough Entity or a corporation.18

Conclusion

Determining the members of its FATCA Group is likely to be the first major workstream an FFI must undertake toward achieving FATCA compliance. After this step, the FATCA Group must initiate several additional workstreams, including, among others, determining (1) which members are “exempt beneficial owners,” (2) which members are FFIs or nonfinancial foreign entities (and the various subcategories of each type of entity) and (3) which accounts require information reporting under FATCA.