The article was first published in Global Tax Weekly, issue 167. Below is the full text of the sixth article in the series on US taxes for US persons living outside the US.
The US Foreign Account Tax Compliance Act
This is the sixth article in a series of articles on key US tax compliance and planning issues that should be considered by US executives, entrepreneurs and investors living outside the United States. This article provides an overview of (1) the profound effects that the Foreign Account Tax Compliance Act (“FATCA”) has had on the US taxpayers and the rest of the world, (2) the compliance requirements for foreign financial institutions and non-financial foreign entities, and (3) the individual compliance requirements for US Persons.
The Foreign Account Tax Compliance Act (“FATCA”)1 requires foreign (non-US) financial institutions (“FFIs”) 2 and non-financial foreign (non-US) entities (“NFFEs”) to identify and disclose their US account holders and members or become subject to a 30 percent withholding tax with respect to certain US source income.
The US Congress enacted FATCA on March 18, 2010 as part of the Hiring Incentives to Restore Employment Act (a/k/a “Hire Act”). FATCA was enacted as a result of the US effort to target off shore tax evasion and recoup off shore tax revenue. The legislation was also prompted by the prosecution of Swiss banks that aided US account holders in US tax evasion. The purpose of FATCA is to detect, deter and discourage off shore tax abuse through increased reporting and strong sanctions. The goal of the legislation is for the US Internal Revenue Service (“IRS”) to obtain information about off shore accounts and investments beneficially owned by US taxpayers.
It is important to remember that FATCA imposes compliance obligations on FFIs that are subject to local laws and oversight that may be contrary to the reporting requirements mandated under FATCA. FATCA requires that FFIs obtain, verify, and transmit information to the IRS, close accounts of certain recalcitrant account holders , 3 and/or collect a 30 percent withholding tax on withholdable payments made to recalcitrant account holders or noncompliant FFIs. Where local law is contrary to the requirements of FATCA, the FFIs are not exempt from FATCA reporting obligations. The IRS guidance provides under these circumstances the FFI should attempt to obtain a waiver to release the information from the account holder, or if a waiver is not obtained, to close the account holder’s account.
FATCA uses a two-pronged approach to ensure US Persons 4 report their income from non-US accounts and assets. First, FATCA requires FFIs to report their US account holders either directly to the IRS or to the local jurisdiction that will exchange the information with the IRS. Second, FATCA requires US Persons to file a Form 8938 with their US income tax filing to report their foreign assets.
While the primary purpose of FATCA is worthy – combating US tax evasion – many around the world first5 saw FATCA as another instance of US overreach, burdening the rest of the world to further US interest, in that FATCA enlists FFIs as agents to report US account holders to the IRS. As part of an FFI’s due diligence in determining US account holders, non-US individuals and entities are required to certify they are not US Persons. Non-US entities are further classified as FFIs and non-financial foreign entities. With the level of due diligence required, it is certainly understandable that many around the world object to certifying they are not US Persons.
Why have FFIs around the world agreed to report their US account holders to the IRS? The US used a big stick to encourage FFIs to comply with FATCA. An FFI that elects not to comply with FATCA will be subject to a 30 percent withholding tax on its US source fixed, determinable, annual and periodic (“FDAP”) income and gross proceeds from securities producing US source income. Examples of FDAP income include US source interest and dividends, rents, salaries, wages, premiums, annuities, compensation and other gains, profits, and income classified as FDAP under US rules.
The impact of the 30 percent withholding is potentially significant for an FFI. For example, an FFI purchases a US corporate bond for USD900,000 and sells it for USD1m, resulting in a gain of USD100,000. A nonparticipating FFI 6 would pay a 30 percent withholding tax or USD300,000 on the sale of the corporate bond, three times its gain. It’s no wonder that the threat of a 30 percent withholding tax was enough to persuade FFIs competing in global financial markets to comply with FATCA.
FATCA requires FFIs to (i) create due diligence procedures to identify US Persons; (ii) report US Persons’ accounts and the income generated by the accounts; and (iii) collect the 30 percent withholding tax on US FDAP and gross proceeds from the sale or other disposition of any property of a type which can produce US-source interest or dividends, regardless of whether there was gain on the disposition with respect to the property. The cost of compliance for FFIs is significant, but warranted in their eyes to avoid the 30 percent withholding tax.
The United Kingdom (“UK”) has enacted a similar reporting regime to FATCA with its Crown Dependencies (Jersey, Guernsey, and Isle of Man) and Overseas Territories (Cayman Islands, Gibraltar, Montserrat, Bermuda, the Turks & Caicos Islands, the British Virgin Islands, and Anguilla) exchange of tax information agreements. This reporting regime in the UK is commonly referred to as the “UK CDOT.”
The OECD is developing a global framework for the automatic exchange of tax information through common reporting standards . The name of this reporting structure has been nicknamed GATCA, for FATCA on a global scale. It is anticipated that over 60 countries will participate in GATCA and the reporting standards will largely follow Model 1 Intergovernmental Agreements under FATCA (discussed later). While the US was the first to implement FATCA type legislation, there are a number of other nations looking to participate in GATCA and chase down their country’s tax evaders.
Compliance With FATCA For FFIs And NFFEs
FATCA requires a broad group of US and foreign persons to identify and document payees in new ways and to disclose additional information to the IRS. In order to lessen the likelihood of possible foreign legal barriers to the requirements of FATCA, the US Treasury Department has negotiated intergovernmental agreements (“IGA”) with foreign governments.
FFIs need a FATCA compliance program to ensure all necessary FATCA classifications, documentation, monitoring and reporting are properly completed. Written procedures and policies are required to ensure that there are controls in place to establish FATCA compliance. These compliance programs highlight new business practices required to ensure compliance with FATCA.
FFIs will be classified as follows based on their compliance with FATCA: participating, non-participating, or deemed compliant. Participating FFIs are FFIs that enter into an FFI agreement with the IRS and follow the due diligence and reporting procedures set in those agreements. A participating FFI is not subject to the 30 percent withholding tax. Nonparticipating FFIs are FFIs that do not enter into an IRS agreement and otherwise do not fall within an exception from entering into such an agreement. Non-participating FFIs are subject to the 30 percent withholding tax.
The third category – deemed compliant FFIs – are not required to enter into an IRS agreement, but are not subject to the 30 percent withholding tax.
An FFI will be deemed compliant if either:
- It complies with such procedures as the IRS may prescribe to ensure that the FFI does not maintain US accounts and the FFI meets such other requirements as the IRS may prescribe, with respect to accounts of other FFIs maintained by the FFI; or
- It is a member of a class of institutions with respect to which the IRS has determined that the application of the agreement/withholding provisions is not necessary.
Participating FFIs must enter into an agreement with the IRS and agree to:
- Obtain information on all account holders in order to determine US accounts;
- Comply with required due diligence and verification procedures and provide certification of completion of the procedures;
- Report their US accounts to the IRS; 7
- Withhold 30 percent tax on pass through payments to recalcitrant account holders or FFIs that are not participating FFIs or deemed compliant FFIs;
- Comply and respond to IRS information requests; and
- In jurisdictions where bank secrecy or other limitations would prevent the FATCA reporting, attempt to obtain a waiver of the applicable laws from account holders or close the account if the account holder will not provide the waiver.
The IRS created a web-based portal for FFIs to register to confirm they are compliant with FATCA reporting obligations. The IRS reviews registrations. If satisfied, it issues a Global Intermediary Identification Number (“GIIN”) to qualifying FFIs. These FFIs provide their GIINs to withholding agents8 to confirm their FFI status in order to avoid the 30 percent tax withholding.
Registration as a participating FFI will require a designation of a responsible officer and other persons acting as points of contact for the IRS. The FFI’s responsible officer will be required to electronically sign the FFI agreement with the IRS.
Non-participating FFIs are subject to the 30 percent withholding tax on withholdable payments which include:
- Payments of US-source interest and dividends, rents, salaries, wages, premiums, annuities, compensation, emoluments and other FDAP gains, profits, and income; and
- Gross proceeds from the sale or other disposition of any property of a type which can produce US source interest or dividends, regardless of whether there was gain on the disposition with respect to the property.
As part of their FATCA obligations, participating FFIs will need to withhold a 30 percent tax on any pass through payment to recalcitrant account holders or non-participating FFIs, which will require participating FFIs to develop strategies to manage such payments to ensure withholding is done.
Reporting under FATCA depends on which of the two model IGAs the country in which an FFI is located.
Under Model 1, FFIs will not enter into an FFI agreement with the IRS, but will report to the local government agency designated in the agreement, which agency will then report the information gathered from other FFIs in the jurisdiction to the IRS. IGA Model 1 is the most common agreement. It is also the basis for the proposed reporting standards under GATCA.
Under Model 2, the FATCA partner country agrees to direct and enable all FFIs located there to report directly to the IRS. The FFIs are then responsible for signing FFI agreements with the IRS.
FFIs located in a non-FATCA partner country are to register directly with the IRS portal and agree to comply with the terms of an FFI agreement in order to avoid being treated as non-participating FFIs subject to withholding.
FFIs are to report the names and tax identification numbers (“TINs”) of account holders who are US Persons and accounts of US Foreign Owned Entities. They are also to report the name, address and TIN of each Substantial US Owner of US Foreign Owned Entities. 9 Reports will also include each account number, account balance or value determined at such time and in such manner as the IRS may prescribe, and the gross receipts and gross withdrawals from such accounts.
The IRS has created withholding forms that FFIs are to use to obtain the required information from their account holders as part of the due diligence process. There are separate forms for US Persons, non-US Persons, and non-US Entities.
The Form W-9 is used to request the TIN (i.e., the social security number) of US persons, obtain certain certifications and identify claims of exemption from the account holder. Withholding agents may require a signed Form W-9 to document the account holder’s US status.
Form W-8BEN is used to establish a foreign individual’s non-US status for purposes of the 30 percent withholding tax on certain FDAP income. The 30 percent withholding tax is imposed on the gross income received by the foreign individual. Signing Form W-8BEN confirms a foreign individual’s status as a non-US Person. US Persons are not supposed to sign Form W-8BEN.
Form W-8BEN-E is used to document foreign entities’ status under FATCA, establish that they are not US entities, and if applicable, establish their eligibility to claim treaty benefits. Foreign entities that refuse to document their FATCA status may be treated as recalcitrant account holders or nonparticipating FFIs, subject to the 30 percent withholding tax on withholdable payments.
NFFEs that derive withholdable payments can avoid the withholding tax regime by complying with certain informational requests, principally by correctly completing Form W-8BEN-E. NFFEs are not required to enter into FFI agreements with the IRS. They have to provide withholding agents with a W-8BEN-E that contains a certification that the NFFE does not have a Substantial US Owner or provide the name, address, and TIN of each Substantial US Owner.
As long as NFFEs complete the W-8BEN-E correctly and withholding agents do not know or have reason to know that any information provided by an NFFE is incorrect, FFIs will not withhold on withholdable payments to them.
The idea spawned by FATCA is evolving rapidly, especially as other countries implement their own regulations and procedures. It is critical that FFIs develop compliance plans to ensure FATCA due diligence and accurate, timely reporting.
Compliance With FATCA For US Persons
US Persons have a FATCA compliance obligation independent of the Foreign Bank Account Report (“FBAR”) depending upon their status and the amount of foreign assets they own. FATCA compliance is satisfied by filing Form 8938, Statement of Specifed Foreign Financial Assets. If required, the Form 8938 must be filed with the US Person’s income tax return. The FATCA form was first required to be filed with the 2011 US tax return.
US Persons (“FATCA Filers”) must file Form 8938 depending upon their FATCA reportable assets and whether they live in or outside the US.
FATCA defines foreign assets to include financial accounts maintained by a foreign financial institution (most commonly bank and securities accounts)and other foreign financial assets held for investment if they are not at a foreign financial institution, such as stocks or securities issued by a non-US Person, interests in private, non-traded foreign corporations, interests in foreign partnerships, life insurance policies with a cash value, pension funds, retirement savings accounts and financial instruments, or contracts that have non-US Person issuers or counterparties, e.g. , a bond or promissory note issued by a foreign corporation or foreign person.
Individual FATCA Filers residing in the US with foreign assets in aggregate worth more than USD50,000 on the last day of the year or USD75,000 at any time during the year, must file Form 8938. Married FATCA Filers residing in the US who file jointly with foreign assets in aggregate worth more than USD100,000 on the last day of the year, or USD150,000 at any time during the year, must file Form 8938. Married FATCA Filers residing in the US who file separately are subject to the same thresholds as individuals.
Individual FATCA Filers residing outside the US with foreign assets in aggregate worth more than USD200,000 on the last day of the year, or USD300,000 at any time during the year, must file Form 8938. Married FATCA Filers residing outside the US with foreign assets worth in aggregate more than USD400,000 on the last day of the year or USD600,000 at any time during the year must file Form 8938. Married FATCA Filers residing outside the US who file separately are subject to the same thresholds as individuals.
Form 8938 requires detailed information regarding the foreign assets reported. The information includes the maximum value, the currency in which the account or asset is held, the address where the account is located or where the entity is located, certain details on when the account was opened or closed, when an entity was formed or dissolved, whether an account is held jointly or individually, whether the account or entity generated income reported on the US income tax filing, identifying where the income reported in Form 8938 is reported on the income tax return.
There are exceptions to reporting certain assets or accounts on Form 8938 when reporting duplicate information on other forms being filed. For example, if Form 5471 must be filed,10 assets reported on that form do not have to be reported again on Form 8938. However, in determining if a Form 8938 filing obligation exists, FATCA Filers need to include the value of all their foreign assets, even if the asset is not reported on Form 8938.
As mentioned above, even though the FBAR contains many, if not all, of the same assets reported on Form 8938, both forms must be filed annually. They are separate reporting obligations and filing one form does not excuse the non-filing of the other. This is important as both filings carry significant penalties for failure to comply.
Failure to timely file a complete and correct Form 8938 by the due date of the FATCA Filer’s US tax return (or an extended filing date) could result in a penalty of USD10,000. Additional penalties are imposed if a correct and complete Form 8938 is not filed within 90 days after the IRS mails the FATCA Filer a notice of the failure to file. For example, failure to file Form 8938 after being notified of the failure could subject the FATCA Filer to an added penalty of USD10,000 for each 30-day period (or part period) for which the failure continues. The maximum additional penalty for a continuing failure to file Form 8938 is USD50,000.
An underpayment of tax resulting from the sale of an undisclosed foreign asset could subject the FATCA Filer to a penalty equal to 40 percent of the underpayment. If the underpayment of tax relating to the undisclosed foreign asset is due to fraud, the FATCA Filer is subject to a penalty of 75 percent of the underpayment attributable to the fraud. Finally, failure to file Form 8938 or to properly disclose all of one’s foreign assets could result in criminal penalties. On the other hand, no penalty will be imposed if the failure to file Form 8938 or to disclose one or more foreign financial assets on Form 8938 is due to reasonable cause. FATCA is not just for banks. It has far-reaching implications for individuals, too. Tax advisers and withholding agents must be familiar with the new reporting regime to ensure documentation and reporting obligations are satisfied. Failure to follow the new FATCA regime can result in significant penalties and tax liabilities for individuals and substantial withholding taxes for financial institutions or their customers.
1FATCA provisions are contained in Sections 1471– 1474 of the US Internal Revenue Code and the related Treasury Regulations.
2FFIs are foreign entities that: (i) accept deposits in the ordinary course of a banking or similar business;(ii) hold financial assets for the account of others as a substantial portion of their business; (iii) are foreign investment entities, including entities that conduct certain investment and asset management activities for customers, entities that are managed by other FFIs and the gross income of which is primarily attributable to investing, reinvesting or trading in financial assets and certain collective investment vehicles with investment strategies of investing, reinvesting or trading in financial assets; (iv) are insurance companies that issue investment-like contracts or annuity contracts; or (v) are holding companies or treasury centers that are members of corporate groups that include FFIs or that are formed by certain investment vehicles.
3A recalcitrant account holder is a person who (i) fails to comply with reasonable requests for information pursuant to IRS mandated verification and due diligence procedures to identify US accounts, or (ii) fails to provide a waiver upon request.
4US Persons include: (1) US citizens, (2) resident aliens of the US, (3) a nonresident alien who makes an election to be treated as a resident alien for purposes of filing a joint income tax return, (4) a nonresident alien who is a bona fide resident of American Samoa or Puerto Rico, and (5) US corporations, partnerships, and trusts.
5″First” is appropriate as related later in this article. Foreign governments, led by the Organisation for Economic Co-operation and Development (OECD), have embraced FATCA and are in the process of creating their own multilateral version of FATCA reporting. The use of foreign bank accounts to evade tax is not a uniquely American undertaking.
6A nonparticipating FFI is an FFI that does not enter into an IRS agreement and otherwise does not satisfy any other exception to entering into an IRS agreement.
7As part of its due diligence procedures, FFIs will need to identify (i) US accounts; (ii) each account holder that is a specified US Person; (iii) each US Owned Foreign Entity; (iv) each Substantial US Owner of such entity; and (v) the classification of company account holders or transactions as FFI (including type), non-FFI, governmental or other exempt entity, corporation, etc.
8Under FATCA, a withholding agent includes all persons/entities in whatever capacity having control, receipt, or custody, disposal or payment of any payment subject to withholding.
9For FATCA purposes, a US Foreign Owned Entity means any foreign entity which has one or more Substantial US Owners and a Substantial US Owner is a US Person who owns more than 10 percent of a foreign corporation, partnership or trust.
10Form 5471 will be discussed in a future article.