January 2012 Implications of Foreign Account Tax Compliance Act (FATCA) An update This article was first published in PLC January 2012 SPEED READ An article about recent developments relating to the U.S. Foreign Account Tax Compliance Act. Stephen Fiamma Partner U.S. Tax, London Contact Tel +44 (0)20 3088 3657 stephen.fiamma@allenovery.com Stefka Kavaldjieva Senior Associate U.S. Tax, London Contact Tel +44 (0)20 3088 2663 stefka.kavaldjieva@allenovery.com www.allenovery.com DP12010005-DPR177093 PLC FATCA (Naomi Seivwright).indd 1 1 13/02/2012 12:37
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Implications of Foreign Account Tax Compliance Act (FATCA) January 2012 Introduction to FATCA This article provides an update on the latest developments relating to the U.S. Foreign Account Tax Compliance Act (FATCA), part of the Hiring Incentives to Restore Employment Act of 2010 (the HIRE Act), previously discussed in Articles, FATCA Explained: Targeting Offshore Tax Evasion (www.practicallaw.com/8 501 8500) and Expert Q&A on FATCA (www.practicallaw. com/5 501 8115). To summarise, FATCA added a new component to the U.S. tax withholding and information reporting regime. The law effectively makes foreign financial institutions (FFIs) information gathering agents of the U.S. Internal Revenue Service (the IRS) by threatening an FFI s own U.S. source income and sale proceeds with a 30% withholding tax (30% Withholding). The expansive definition of FFI provided by the law means that these changes are of concern not only to banks, but also to investment funds, hedge funds, private equity funds, securitisation vehicles and many other forms of financial intermediary. FATCA also requires 30% Withholding from U.S. source income and sale proceeds paid to certain non-financial foreign entities (NFFEs), unless either the NFFE discloses to the payor the details of U.S. persons who own (directly or indirectly) more than 10% of the vote or value of the NFFE, or the NFFE certifies that it has no such owners. NFFEs which are part of publicly-traded groups, and foreign governments, central banks of issue, and similar entitles, as well as NFFEs of a type designated by the IRS, are exempt from 30% Withholding. This new regime is not intended to be a revenue raiser for the U.S. government, but rather to provide a mechanism to identify U.S. investors in FFIs and NFFEs. The 30% Withholding does not apply, for example, if the relevant FFI enters into an agreement with the IRS to report certain information in respect of financial accounts maintained by it which are held by U.S. persons (as well as certain non-u.s. entities which have a 10% U.S. owner), or complies with prescribed procedures to ensure that the FFI does not maintain any financial accounts held by such persons or entities. Based on the limited guidance contained in the law provided by Congress, the agreement with the IRS will require the FFI to: Identify which of its financial accounts is a United States Account. Report certain information to the IRS including details of the owner, value, income of, and withdrawal from, these accounts. Either: deduct 30% Withholding from a financial account if the owner of the account does not co operate in providing the required information (a recalcitrant account holder); or arrange for 30% Withholding to occur at source for income and gross proceeds of sale attributable to a recalcitrant account holder. www.allenovery.com 3
Material developments since 2010 DELAYED EFFECTIVE DATES FOR WITHHOLDING The effective dates for the commencement of withholding have recently been delayed from the originally scheduled 1 January 2013. Pursuant to IRS Notice 2011-53, published on 14 July 2011 (Notice 2011-53), unless an FFI enters into an agreement with the IRS, an FFI will be subject to a new withholding tax of 30%: On and from 1 January 2014 in respect of its U.S. source investment income. On and from 1 January 2015 in respect of the gross proceeds from the sale or other disposition of any property of a type which can produce interest or dividends from sources within the U.S. On and from 1 January 2015 in respect of passthru payments (see further Expansive definition of passthru payments ). DELAYED DATE FOR FILING FFI AGREEMENTS As stated in Notice 2011-53, the IRS will begin accepting FFI applications through its electronic submission process no later than 1 January 2013. Applications received by 30 June 2013 will be effective as of that date, whereas applications received after that date will be effective as of the date of approval by the IRS. An FFI must enter into an FFI agreement by 30 June 2013 to ensure that it will be identified as a participating FFI in sufficient time to allow U.S. withholding agents to refrain from the withholding which begins on 1 January 2014. FFIs that enter into FFI agreements after 30 June 2013 but before 1 January 2014 will be participating FFIs, but might not be identified as such in time to prevent withholding beginning on 1 January 2014. RETROSPECTIVE CERTIFICATION OF COMPLIANCE BY CHIEF COMPLIANCE OFFICER Pursuant to IRS Notice 2011-34, published on 8 April 2011 (Notice 2011-34), the chief compliance officer (CCO) of an FFI must certify to the IRS when the FFI has completed certain verification and due diligence with respect to account holders existing as of the effective date of its FFI agreement (existing account holders). As part of the certification of compliance, the CCO will be required also to certify that, from 8 April 2011 until the effective date of the FFI agreement, management personnel of the FFI did not engage in any activity, or have any formal or informal policies and procedures in place, directing, encouraging, or assisting account holders with respect to strategies for avoiding identification of their accounts as U.S. accounts. Finally, the CCO will also be required to certify that the FFI had written policies and procedures in place as of the effective date of the FFI agreement prohibiting employees from advising U.S. account holders on how to avoid having their U.S. accounts identified. This means in effect that FFIs intending to enter into agreements with the IRS need already to have implemented procedures to ensure compliance. www.allenovery.com 4
Implications of Foreign Account Tax Compliance Act (FATCA) January 2012 DEFINITION OF OBLIGATIONS ELIGIBLE FOR GRANDFATHERING RULE The 30% Withholding will apply to obligations which produce withholdable payments only if they are issued on or after 18 March 2012. The 30% Withholding will, however, apply to all equity securities and, as clarified by Notice 2011-53, all legal agreements that lack a definitive expiration or term, irrespective of when they were issued. The scope of the grandfathering rule is significant in a number of contexts. If an existing obligation is modified on or after 18 March 2012, it may be treated as a new obligation for U.S. federal income tax purposes and lose its grandfathering. For a debt instrument, this would require a significant modification (generally an economically significant change in the legal rights and obligations under the debt instrument). Further, certain instruments may be legally issued in the form of debt, but treated and taxed as equity for U.S. federal tax purposes. Index-linked notes without principal protection, notes with a very long or no maturity, deeply subordinated notes or notes issued by thinly capitalised entities are potential examples of this sort of instrument. Thus, not all issuances taking the form of debt which occur on or before 18 March 2012 will necessarily benefit from the grandfathering rule. EXPANSIVE DEFINITION OF PASSTHRU PAYMENTS Notice 2011-53 provided guidance on the definition of passthru payments, which dramatically expands the number of FFIs that will need to comply with FATCA. According to such definition, a portion of any payment made by an FFI as an issuer or payor will be treated as a passthru payment and therefore subject to 30% Withholding, in proportion to the ratio of the FFI s U.S. assets to its total assets (the FFI s passthru percentage). An FFI that has entered into an agreement with the IRS will need to deduct 30% Withholding from each passthru payment it makes to a recalcitrant account holder or to an FFI that does not enter into an agreement with the IRS. As most FFIs are likely to hold some U.S. assets (such as U.S. Treasuries or U.S. equities), most FFIs will have a positive passthru percentage. Thus, a passthru payment subject to 30% Withholding need not relate in any direct way to U.S. source income of the FFI. The definition of passthru payment is currently so expansive that it would cover not only payments by an FFI on its securities, but also its non-financial payments. This expansive definition of passthru payment is intended by the U.S. to expand the number of FFIs which become FATCA-compliant to include those which may have little or no direct contact with the U.S. DEEMED-COMPLIANCE Pursuant to Notice 2011-34, an FFI is considered to be deemed-compliant if the FFl: Applies for deemed-compliant status with the IRS. Obtains an FFI identification number identifying it as a deemed-compliant FFI. Certifies every three years that it meets the requirements for deemed-compliant treatment. That is, the FFI: follows certain procedures to ensure it does not maintain any U.S. accounts; or www.allenovery.com 5
is a member of a class of institutions that are inherently deemed-compliant. Such institutions may include certain local banks (banks that do not solicit or maintain accounts for non residents), local FFI members of participating FFI groups, and certain investment vehicles. Currently, the IRS and the U.S. Treasury are considering the inclusion of certain foreign retirement plans into this group, as they appear to pose a low level of tax evasion risk. DISCLOSURES REGARDING PRE-EXISTING ACCOUNTS Pre-existing individual accounts are financial accounts held by individuals as of the date that a participating FFI agreement becomes effective. In the case of pre existing individual accounts, the participating FFI is required to determine whether such accounts are to be treated as U.S. accounts, accounts of recalcitrant account holders, or other accounts, according to the procedures set out in IRS Notice 2011-34. Different procedures are prescribed with respect to pre existing individual accounts that are not private banking accounts, pre-existing individual private banking accounts, and pre-existing entity accounts. While seeking verification and due diligence in reliance on broadly similar principles, each procedure is distinct with respect to the manner in which the search for indicia of U.S. status is conducted. The verification of individual, non-private banking, accounts and entity accounts allows for the search of such indicia to be done on the basis of electronically searchable information, whereas the verification of individual private banking accounts is to be accompanied by a paper search as well. The latter is likely to prove prohibitively burdensome and costly to many FFIs specialising in private banking, so that they may seek to either eliminate their U.S. source income or close down their U.S. accounts, or both, to minimise the effect of FATCA on their operations. DISCLOSURES REGARDING NEW ACCOUNTS Published on 27 August 2010, IRS Notice 2010-60 (Notice 2010-60) listed the procedures for verification and due diligence with respect to new individual and entity accounts opened after the date on which an FFI agreement enters into effect, In broad terms, such procedures require the request for documentation establishing U.S. or non-u.s. status. In the case of new entity accounts, the participating FFI will be required not only to determine whether such accounts are to be treated as U.S. accounts, but also whether such accounts are those of participating FFIs, accounts of recalcitrant account holders, accounts of excepted NFFEs, or accounts of other NFFEs. CATEGORIES OF EXEMPT NFEE Notice 2010-60 described certain categories of NFFE which are exempt from 30% Withholding. These include holding companies of a group which is not primarily engaged in a financial institution business, hedging and financing centres of a non-financial group, and start up companies. www.allenovery.com 6
Implications of Foreign Account Tax Compliance Act (FATCA) January 2012 Issues yet to be addressed DETAIL OF FFI AGREEMENT Notice 2011-53 has indicated that the IRS and the U.S. Treasury are expecting to issue a draft FFI agreement in the summer of 2012, at which time FFIs will be able to appreciate the full extent of the responsibilities they would be taking on by becoming a participating FFI. INVESTMENT VEHICLES Institutions caught by FATCA include a wide range of investment entities, including funds and securitisation vehicles. Even though many such investment entities may have no direct U.S. investments, they will nevertheless need to be concerned about FATCA compliance, especially in light of the expanded definition of passthru payment. The ability of existing investment vehicles to comply with FATCA will often depend on the cooperation of their investors, who, in the absence of specific relief in Treasury Regulations, will generally be regarded as financial account holders. Not all investors will be willing voluntarily to provide the investment vehicle with the relevant information and any necessary certifications of non-u.s. status. Some investment vehicles will find it difficult even to attempt to comply. Many, such as securitisation vehicles, are special purpose entities set up without an independent operations function. These vehicles would generally not be able to allocate the cost of any withholding to the recalcitrant investors, which may have triggered the withholding in the first place. Further, because of the expanded definition of passthru payments, even if the investment vehicle has no U.S. investments, an FFI receiving payments from other FFIs, for example, with respect to swaps, interest on bank deposits and so on, it may find such payments subject to 30% Withholding to the extent of the passthru percentage of the payor. TIERED FFIS U.S. source payments made via a series of FFIs will oblige each FFI in the chain to comply with the FATCA rules to avoid the imposition of 30% Withholding. Given the inability of the final recipient of a withholdable payment to monitor or control the compliance of an entire chain of financial intermediaries, in the absence of further guidance from the U.S. Treasury, the HIRE Act rules introduce significant tax risk in such circumstances. www.allenovery.com 7
Non-tax issues central to FATCA compliance CUSTOMER AGREEMENTS According to the verification and due diligence procedures for existing accounts prescribed in IRS Notice 2011-34, an FFI will need to request verification from accounts with indicia of U.S. status, and if such U.S. status is confirmed, report information about such accounts to the IRS, or otherwise withhold and eventually close the account. The verification and due diligence procedures, however, are likely to give rise to difficult issues if the customer agreements governing the relationship between the FFI and the account holders do not require the account holders to provide information to the FFI. Few if any agreements drafted without FATCA in mind will contain such a requirement particularly because such information is for purposes of avoiding withholding on the FFI s own income, rather than necessarily on the income of the account holder. Further, reporting of information to the IRS may conflict with the FFI s contractual duty of confidentiality under such customer agreements. BANK SECRECY RULES FATCA provides that if local bank secrecy laws or similar laws prevent an FFI from reporting information to the IRS about its U.S. account holders, the FFI must either get a waiver by the account holders of such laws or close the account. This element of FATCA poses a direct conflict with local laws and raises significant legal issues, including the legality of closing a customer s account under these circumstances. The availability of banking facilities may, for example, be a basic right under local law. DATA PROTECTION RULES Data protection rules generally restrict both disclosure of personal data to third parties (including tax authorities), and the cross-border transfer of personal information from one country or economic area (such as the European Union), to another. Consequently, local data protection rules are likely to restrict the transfer of data by FFIs to the IRS. One possible solution might be to obtain consent of the account holders to the transfer. Relying on consent, however, is not problem-free either. Obtaining consent would give rise to administration costs and amendments to existing documentation; it will have to be freely given, specific and informed. Further, in most cases, consent can be withdrawn at any time, because account holders generally cannot waive their right to withdraw consent under data protection statutes. www.allenovery.com 8
Implications of Foreign Account Tax Compliance Act (FATCA) January 2012 RULES REGARDING WITHHOLDING AGAINST INCOME OF CUSTOMERS AND CLIENTS If a compliant FFI has a proportion of its account holders treated as recalcitrant account holders, the FFI will have to apply 30% Withholding with respect to the U.S. source investment income and passthru payments of such account holders. In the case of investment vehicles, such as securitisation vehicles, the governing documentation may not allow for such allocation, even if information verification and reporting are already allowed by governing documents. Absent such allocation mechanics, investors in, for example, a securitisation vehicle may suffer a loss of economic return attributable to such withholding even if they are not considered recalcitrant account holders if investors higher up the payment waterfall are recalcitrant account holders but are entitled to be paid in full regardless of any cash shortfall. Conclusion FATCA was identified as a problem for all varieties of FFIs from the moment it was introduced. Since that time, the guidance provided by the IRS has largely increased its scope, so that even FFIs with no direct U.S. investments now need to be concerned about FATCA compliance. Further, the IRS has shown little willingness to restrict the scope of FATCA or materially limit the administrative burdens it creates, despite evidence of the difficulty FFIs will have in complying with its terms. Finally, material areas of importance to FFIs remain unaddressed by IRS guidance, even as the time for implementation of FATCA compliance procedures draws closer. FFIs will need to monitor future guidance with care to ensure that they are prepared to deal with the challenge of FATCA. www.allenovery.com 9
Key contacts If you require advice on any of the matters raised in this document, please call any of our partners or your usual contact at Allen & Overy. Stephen Fiamma Partner U.S. Tax, London stephen.fiamma@allenovery.com Tel +44 (0)20 3088 3657 Dave Lewis Partner U.S. Tax, New York dave.lewis@allenovery.com Tel +1 212 756 1147 Jack Heinberg Partner U.S. Tax, New York jack.heinberg@allenovery.com Tel +1 212 610 6383 Amanda Thomas Partner Head of International Capital Markets Know-How, London amanda.thomas@allenovery.com Tel +44 (0)20 3088 2821 www.allenovery.com 10
Implications of Foreign Account Tax Compliance Act (FATCA) January 2012 www.allenovery.com 11
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