US Foreign Account Tax Compliance Act

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Finance Nation
March 2011

From 1 January 2013, the US so-called “FATCA” provisions will have a significant impact on financial institutions and investment vehicles around the world.

The Foreign Account Tax Compliance Act (“FATCA”) provisions, originally introduced to the US Congress in October 2009, were  ultimately incorporated into the Hiring Incentives to Restore Employment Act (“HIRE Act “), which passed the US Senate 18 March, 2010 and was signed into law by President Obama.

FATCA aims to make it more difficult for US persons to avoid paying US taxes by investing abroad or through foreign intermediaries and vehicles. This is achieved essentially by ensuring that foreign financial institutions (“FFIs”) provide information relating to US persons annually to the US Internal Revenue Service (“IRS”).

More precisely, FFIs will in practice have to:

  • enter into an agreement with the IRS to become participating FFIs (”PFFIs”),
  • apply due diligence rules to determine which of their direct and indirect clients are “US persons” for FATCA purposes,
  • either (i) certify that the FFI makes no payments to any US accounts (as defined by FATCA) or (ii) provide information concerning the US accounts they hold and the US owners of accounts and of certain non-US entities that are account holders, and obtain a waiver from such persons (if required under the laws of the country of the FFI) to allow such disclosure, failing which such accounts are ultimately to be closed;
  • withhold US tax of 30% (or arrange for an upstream payor to withhold) on “withholdable payments” and “pass-through payments” to “recalcitrant accountholders”, non-participating FFIs, and non compliant non financial foreign entities.

US payors and withholding agents will be required to apply 30% withholding tax on “withholdable payments” to FFIs that will not have become Participating FFIs. The scope of the Act is broad, as

  • a foreign financial institution is defined as a foreign entity that
    • (i) accepts deposits in the ordinary course of a banking or similar business, or
    • (ii) is engaged in the business of holding financial assets for the account of others, or
    • (iii) is engaged primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities or any interest in such securities, partnership interests or commodities. Thus, for example, Hedge Funds and Private Equity Funds would be treated as FFIs;
  • a “withholdable payment” includes not only payments of income and gains from US sources (including but not limited to dividends and interest, rents…) but also gross proceeds from the disposition of securities that can produce US sourced dividends or interest;
  • pass-through payments” broaden the scope by adding payments of non-US source that are allocable to withholdable payments;
  • “dividend equivalent payments” subject to the rules now include not only substitute payments on stock loans and repos but also payments under certain notional principal contracts (e.g. certain swap contracts), that reference the payment of a US dividend.

The 30% withholding tax is intended as a punitive measure, an incentive for FFIs to participate and to provide full disclosure of all US accounts, including account balances and amounts received and withdrawn from the account, and regardless of whether assets held are US securities. “US accounts” for these purposes include not only a US person’s accounts but also the accounts of foreign investment vehicles of which even a single share is owned by a US person and of other foreign entities of which at least 10% is owned by a US person.

This new regime would be in addition to requirements under the Qualified Intermediary (QI) program.

From the above few rules and definitions, it should already be clear that FATCA will have a significant impact on financial entities around the world and Luxembourg is no exception.

FFIs may in theory consider not becoming participating FFIs. However, this requires never to have a US person as a direct or indirect client and never to hold any US assets or US-related derivatives for any clients at all nor for their own account. Furthermore, any Participating FFI will also be responsible for the obligations under the FATCA rules of any non-participating FFI in its “affiliated group”.

Banks, having already in many cases implemented the QI rules, will nevertheless  face the additional burden of applying customer documentation and classification procedures that go beyond their national KYC rules and the existing QI regime and will have to ensure they are able to report the information required to the IRS.

Investment funds and entities providing administrative, distribution and payment services for them will, as US law currently stands, also come under these rules, as the investment funds (at least) are clearly FFIs. The efforts to convince the US Treasury that, as envisaged in the legislative history of FATCA, certain types of “widely held” investment funds should not be required to fulfill the obligations of a PFFI, and/or that existing restrictions to the access of US investors to European investment funds could be adapted from the current SEC-based rules to fit with FATCA definitions and requirements, have so far been inconclusive.

Insurance companies are also affected (with respect to insurance policies providing a “cash value”) and are also lobbying for certain alleviations of the rules.

Much of the implementation details required for non-US financial institutions to adapt their systems and procedures to these new rules are not yet published. Hopefully many of the significant gaps left by the IRS’ guidance published August 2010 will be closed by mid-2011.

In the meantime, we would recommend that all institutions affected by the FATCA rules start to assess what the impact is or could be on their existing customer base, business activities and processes.

The countdown to 1 January 2013 is clearly underway…

The information included in this article is not intended to constitute, and cannot be used as, tax advice.
Circular 230 – Disclaimer: Any U.S. tax advice contained in this article was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax laws.